Good day. Welcome to the Veeco Instruments Inc. corporate-hosted Q3 2019 earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Anthony Bencivenga, investor relations. Please go ahead, sir.
Thank you, and good afternoon, everyone. Joining me on the call today are William Miller, Veeco's Chief Executive Officer, and Shubham Maheshwari, our Chief Operating Officer and Chief Financial Officer. Today's earnings release is available on the Veeco website. Please note that we have prepared a slide presentation to accompany today's webcast. We encourage you to follow along with the slides on veeco.com. This call is being recorded by Veeco Instruments and is copyrighted material. It cannot be recorded or rebroadcast without Veeco's express permission. Your participation implies consent to our recording. To the extent that this call discusses expectations about market conditions, market acceptance, and future sales of the company's products, future disclosures, future earnings expectations, or otherwise makes statements about the future, such statements are forward-looking and are subject to a number of risks and uncertainties that could cause actual results to differ materially from the statements made.
These factors are discussed in the Business Description and Management's Discussion and Analysis sections of the company's report on Form 10-K and annual report to shareholders, in our subsequent quarterly reports on Form 10-Q, current reports on Form 8-K, and press releases. Veeco does not undertake any obligation to update any forward-looking statements, including those made on this call, to reflect future events or circumstances after the date of such statements. During this call, management may address non-GAAP financial measures. Information regarding such non-GAAP financial measures, including reconciliation to GAAP measures of performance, is available on our website. With that, I will turn the call over to Bill for his opening remarks.
Thank you, Anthony. Good afternoon, everyone, and thank you for joining the call. I will first highlight some of our Q3 results, then provide an update to our transformation, and finally give product and market updates. Q3 revenue was $109 million, which was above the midpoint of our guidance. We achieved strong revenue in our front-end semi market with shipments of our second production EUV mask blank system and revenue from multiple LSA systems. Additionally, sales of our ion beam products to the data storage market remained solid. Non-GAAP gross margin was 40.3%, which was higher than our guidance range, resulting from improved product mix on higher volume and well-managed expenses. We are happy to report non-GAAP operating income was $4 million, resulting in earnings per share of $0.05, marking a return to profitability.
Our bookings were $115 million, which are driven by strength in both data storage and EUV mask blank markets. Now, I will provide an update on the company's transformation. The transformation will be completed in two phases: returning the company to profitability and driving growth. Phase 1, returning the company to profitability, is well underway and includes our MOCVD shift from the commodity LED markets to photonics and emerging applications, making general infrastructure reductions, and rationalizing our product lines by reprioritizing R&D expenditures. On our last earnings call, we alluded to slow-moving inventory. We also mentioned reducing expenses to improve profitability. We made progress in both areas. Shubham will provide more details in a few minutes. Phase 2 of our transformation, driving growth, is in the early stages. We are taking steps to grow our existing front-end semi, advanced packaging, and data storage markets.
In addition to growing in our current markets, we are investing in new applications such as EUV mask blank production and compound semi applications with our MOCVD products. When we complete our transformation, we'll be a leaner and more focused company on a path to growth. Now for a business update. The data storage market remains strong. Our ion beam deposition, ion beam etch, diamond-like carbon, and mechanical products enable hard disk drive manufacturers to improve their areal density as they pursue lower cost per bit to compete with solid-state storage. The next revolution in areal density improvements is coming from energy-assisted magnetic recording, also known as HAMR or MAMR, which is expected to increase the number of manufacturing steps required to produce read/write heads. This is good news for Veeco.
A recent Mizuho report forecasted the cloud-based hyperscale data center market will grow at a 15%-25% CAGR through 2025. With hard disk drives currently storing greater than 70% of total bits, hard disk drives should remain an important contributor. Seagate recently conducted an Analyst Day where they provided their technology roadmap, which relies on increasing areal density at an accelerated pace over the next decade. Consequently, drive storage will increase, and the average number of heads per drive is forecasted to increase from five heads today to 10 heads by 2023. The data storage market will remain strong through 2020. In the front-end semiconductor market, we enable the evolution to EUV lithography by providing ion beam depositions that create mask blanks. EUV lithography allows more sophisticated chip designs to be made with fewer layers.
The proof points for EUV market adoption continue to occur. According to TSMC, their EUV tools recently reached production maturity, with tool availability reaching target goals for high-volume production. In fact, they recently announced their 7 nanometer plus EUV lithography technology is delivering customer products to market in high volume. This EUV-enabled node provides 15%-20% higher density and improved power consumption versus the same node without EUV. Demand for EUV lithography systems is strong, with ASML recently announcing orders for 23 systems in the third quarter. Accordingly, we shipped our second production EUV mask blank system in Q3 and received an order for an additional system. Another contributor to our front-end semiconductor results is our laser annealing product lines. Industry leaders such as Samsung and TSMC announced they are ready for production at 5 nanometers.
Advanced nodes reduce device feature size and shrink overall area, driving significant performance improvements over prior nodes. As devices shrink, annealing requires higher temperatures for extremely short and precise durations. Our LSA product is ideally suited to meet these advanced requirements. In Q3, we continued our progress and recognized revenue on another system at a leading-edge node. When our customers ramp and move into their next nodes, we are well-positioned to increase our market share. Now, I will move to the compound semiconductor market, which includes photonics, 5G RF, power devices, and advanced display applications. Veeco has a long history of technology leadership with our gallium nitride MOCVD systems. Our product portfolio includes a multi-wafer system for blue, green, mini- and micro-LEDs, and a 200 millimeter single wafer system for power applications.
On top of that, we completed development and shipped a 300 millimeter fully automated single wafer GaN cluster system to a leading-edge semiconductor fab. This system has exceptional uniformity and outstanding film quality. I'm excited to share that we recently obtained acceptance from our customer on this tool. High-quality GaN film stacks are key enablers for emerging semiconductor applications, including 5G RF, blue-green micro-LED, and power electronics. In addition to our GaN products, last quarter, we announced the shipment of a beta version of our improved arsenide phosphide MOCVD system optimized for photonics applications, including VCSELs, edge-emitting lasers, mini-LEDs and micro-LEDs, and red, orange, yellow LEDs. This beta is going well, and we are on target to receive customer acceptance in the next few quarters. We have been working closely with other customers as well to place another evaluation tool for VCSELs.
When this market begins to grow, we hope to be well-positioned and gain market share. We are confident in our product's performance, and we are ready with best-in-class MOCVD technology solutions to address the needs of the photonics, 5G RF, power, and advanced display markets. As we come toward the end of 2019, we made significant progress. We continue to ship into the EUV mask blank market. We completed development and shipped a 300 millimeter single wafer GaN MOCVD system to a leading-edge semiconductor fab. We are making progress with our MOCVD beta system designed for photonics applications, including VCSELs. We made improvements to our next-generation advanced packaging lithography system, and we made progress penetrating the sub-seven nanometer with our laser anneal product. Lastly, we achieved non-GAAP profitability. Our gross margins continue to improve, and we expect to further improve the operating leverage of the company going forward.
With that, I'll turn it over to Sam for further details on the financials.
Thanks, Bill. Good afternoon, everyone. I will be discussing our non-GAAP financial performance. You can find a detailed reconciliation between GAAP and non-GAAP results in the press release and on our website. Q3 bookings were $115 million, and ending backlog grew to $279 million. As a reminder, beginning in 2020, we will discontinue providing bookings and backlog results. Revenue for the quarter was $109 million, which was slightly above the midpoint of our guidance range. Scientific and industrial market made up 37% of total revenue, driven by ion beam systems shipment to our data storage customers, as well as sales of ion beam sputtering systems to high-end optical coating customers. Front-end semi market was 31% of revenue, driven by shipment of our second production EUV mask blank system, as well as sales of multiple laser annealing systems.
LED lighting, display, and compound semi was 22% of overall revenue, and improved shipment of our 300mm single wafer MOCVD system, and service and upgrades for our LED customers. Advanced packaging, MEMS, and RF filter market made up 10% of overall revenue, reflecting continued softness in this market. By region, rest of the world, which includes Japan, Taiwan, Korea, and Southeast Asia, was 41% of overall revenue, driven by our EUV mask blank system sale, data storage products, as well as our LSA product sale. U.S. was 25% and included sales to the data storage market, and EMEA was 18% of overall revenue driven by sales to scientific and industrial customers. Lastly, China was 16% of overall revenue driven by LSA product shipment to foundries. Now turning to non-GAAP operating results.
Gross margin of 40.3% was a two percentage point sequential improvement from Q2, driven by improved product mix, higher volume, and lower expenses. OPEX for the quarter was $40 million and roughly in line with where we expected it to be. We continue to take actions to reduce infrastructure costs as well as rationalize ongoing investments in certain product lines. As a result, we expect OPEX to reduce in the coming quarters. Our target is to eliminate approximately $16 million from the current run rate on an annualized basis, or about $4 million per quarter. We expect the reductions to be fully realized by Q3 of 2020. Tax expense for the quarter was $0.2 million. Net income came in at $2.6 million, with EPS of $0.05 on a diluted share count of 48 million shares. Moving to the balance sheet and cash flow highlights.
We ended the quarter with cash and short-term investments of $232 million, which included $42 million of cash held offshore. Cash flow from operations was negative $15 million due to biannual interest payment on our debt and an increase in contract assets on the balance sheet. The increase in contract assets is driven by an uninvoiced tool shipment, which was recorded as per SEC revenue recognition rules. Inventory declined to $135 million. We have made progress reducing overall inventory. However, a portion of the inventory is slow-moving, which is related to the LED business and certain other products. We believe the slow-moving inventory is no more than $25 million, and we are pursuing steps to sell this inventory. Long-term debt on the balance sheet was recorded at $297 million, representing the carrying value of $345 million in convertible notes. Lastly, our CapEx during the quarter was $1.7 million.
Turning to Q4 guidance. Q4 revenue is expected between $100 million and $120 million, with non-GAAP gross margin between 39%-41%. We expect non-GAAP OPEX to be around $39 million. GAAP EPS is expected between a loss of $0.32 and a loss of $0.10 per diluted share. Non-GAAP EPS is expected between a loss of $0.03 and $0.18 per diluted share. Now for some additional color beyond Q4. At this time, based on our current visibility, we see Q1 trending similar to Q4 2019. Additionally, as I mentioned earlier, we expect OPEX to decline towards our target of $36 million per quarter by Q3 of 2020 at current revenue levels. With that, Bill and I will be happy to take your questions. Operator, please open the line.
Thank you. If you would like to ask a question, please signal by pressing star one on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star one to ask a question. We'll pause for just a moment to allow everyone the opportunity to signal for questions. Our first question comes from Patrick Ho of Stifel. Please go ahead.
Thank you very much, and nice work on the quarter, getting back to non-GAAP profitability. Bill, maybe my first question, in terms of the LSA business, you mentioned that you saw some strength there. Is it with the same application that you had won previously and you're just seeing increased capacity buy, or have you broadened it out to additional applications and that's why you're seeing the strength?
I think it's actually both, Patrick. We saw some order activity and business activity as that node ramps, and we're also working with that customer on their next node, where we will have an opportunity to broaden out beyond the one application to two or three applications.
Right. As my follow-up, additional target of $4 million a quarter. Are those additional facility consolidation, or how can I characterize what type of OPEX cuts these will be?
Sure. Patrick, this is Sam. I'll take your question there. What is happening there is we have been working on a number of products and product development efforts. There is a little bit of facilities and administrative-oriented planning and optimization that we are going to be working through, but a larger portion of the reduction is going to come from the R&D line, and that is really driven by optimizing and reducing consultants, contractors, and project material related spending as a number of our products are getting towards the late stages in terms of their development cycles.
Great. Thank you very much.
Thanks, Patrick.
If you find that your question has been answered, you may remove yourself from the queue by pressing star two. Once again, if you would like to ask a question, please press star one. We'll take our next question from Brian Lee of Goldman Sachs. Please go ahead.
Hey, guys. Thanks for taking the questions. Sam, maybe first just on the outquarter guidance, always appreciative when you give a bit more forward color. Just want to clarify. When you say Q1 similar to Q4, that's top line and gross margin? I guess that'd be the first part of the question, I suppose you start to see some of the OPEX reduction coming in in Q1 as well, as you get some portion toward that $4 million quarterly reduction?
Thanks, Brian. Yes, I think you have a good understanding there. My color in terms of Q1 trending similar to Q4 is, in fact, around gross margin and top line, like you just said. In terms of OpEx, as I said, we are targeting $36 million by Q3 of 2020. In a linear fashion or in some sort of a staircase down, the spending in Q1 is expected to be lower than Q4. We won't hit all the way to 36 by Q1, but it's expected to be lower than Q4.
Okay. Fair enough. That's helpful. Then maybe just one more modeling one. I might have missed this, the cash flow from operations in the quarter was a negative mid-teens number. Can you kind of outline what was going on there? I didn't see anything meaningfully off from a working capital perspective, I know the inventory's kind of staying in the same range. Can you tell us what the drivers were there, what we should be thinking about for cash flow in 4Q?
Sure. I covered that a little bit in my prepared remarks, Brian. What happened is, if you look at the accounts receivable line, you see that, but then there is another line, which is the contract assets line. Essentially what that is it went up by about $10 million or so quarter-over-quarter. As per following the revenue recognition rules, we shipped a tool to a Japanese customer, and we are following the Japanese business practice where the tool is shipped, but then we invoice the customer only when the tool has been received by the customer, installed, and then accepted by the customer. At that time, we invoice the customer. Following the GAAP rules here, when we ship it, we recognize the revenue, and we record it as contract asset. Essentially it is kind of an uninvoiced accounts receivable.
When you add that to the accounts receivable line, you would see that overall, call it proxy accounts receivable, including the true AR and the contract asset, it's gone up. That is in line with our growth here, so that is where a significant amount of cash went in terms of cash flow from operations. The second piece I would like to highlight or provide some color is that in our business, cash kind of moves from quarter to quarter. It is lumpy depending upon the timing of the machine shipments and the proportion of the machines that ship in third month versus first month of the quarter and some of those factors. If you put all of that together, essentially this quarter in Q3, we consumed cash, but in Q2, we generated cash.
In Q1, we consumed cash, and in Q1 and Q2, we were also generating operating income loss. I expect Q4 with that type of a background, essentially what I'm trying to say is cash is lumpy in our business, and in Q4, I'm expecting cash to be neutral to positive from here on, compared to Q3.
Okay, great. I appreciate the color. Maybe just one on the product side, the VCSEL opportunity. Last quarter you had the customer take the beta tool. It sounds like you have one more customer lined up for a beta tool if I heard you right. Do you anticipate that occurs in 2019, or is that a 2020 event? I guess given the 6-12 month beta conversion cycle you've talked about in the past, is it fair to assume there really isn't a P&L impact from VCSEL tools until probably 2021? Thank you, guys.
Yeah. Sure, Brian. Just to follow up on your question, we did say that we shipped one arsenide phosphide tool to a customer as a beta eval agreement. That's actually going very well. We've actually turned the tool over to the customer, and they're actually putting it through its paces and going through the qualification process. I would expect that to revenue early 2020, maybe the first quarter, second quarter of '20. I did not say we have a second beta customer. We are working with a number of customers, trying to close an agreement or a commercial sale, and have not been successful with that to date. Obviously, that's a very high focus for the company and remains as such. I think your final point was, will it have a material impact on, was it 2019 P&L? The answer is. All right. Fair enough. Thanks, guys.
Continue.
Our next question comes from David Duley of Steelhead Securities. Please go ahead.
Thank you. Thanks for taking my question. I guess first question is on the backlog. Could you give us some idea about the relative breakout of the backlog, and I guess it's more than a couple of quarters now. Is there any way that you might de-accelerate the delivery of this backlog?
Sure, David. This is Sam here. We've been growing backlog, although the pace of growth of backlog has moderated. What has happened is, we've been shipping tools. The reason for a significant growth in backlog, say 6 months or 9 months back, was really driven by EUV tools and a lot of bookings in the data storage side of the business. In that part of our business, the lead times run anywhere from 9 months all the way up to 12 months. We just started shipping EUV tools, beginning one tool in Q2, and we shipped another tool in Q3. We now are in a position that we keep on servicing this demand at a measured pace, how our customers are able to digest this demand and how we are able to supply these orders. That is the reason backlog has been growing.
Going forward, I hope that our book-to-bill remains greater than one. Again, we are doing pretty good in Q3. We did greater than 1.0 in terms of book-to-bill. It's always a good situation or good setup for us that we are increasing the revenue and at the same time our book-to-bill is greater than one. That's the setup where we are, how we are entering 2020, and seems to be a good setup for us.
Can you give us the rough breakout within the four segments that you report, or any sort of idea?
of the relative size of the pieces, just for reference point.
Sure. Yeah, generally, we do not provide it quantitatively, the breakout of the backlog by the four segments we report. However, I would say that the backlog contribution of front-end semi and scientific, industrial, and data storage segments, those two segments are very strong in our revenue results for the recent quarter, and similarly is the case as you look at our Q3 ending backlog. I would say that the advanced packaging segment, in terms of our backlog makeup, is weak. The lighting display and compound semi sector is also, I would say, somewhat on the weak side. We are trying to penetrate a number of opportunities in power semi. You know about our commentary on the VCSEL side, and certain other arsenide phosphide applications, including edge-emitting lasers and photonics-related applications.
With all of that, we are providing our progress there, but the backlog is weak, and similarly in the advanced packaging, the backlog continues to remain weak, driven largely by the smartphone unit-related softness. There is a little bit of an improvement in the smartphone-driven business in Q3, but overall, I would characterize it as still soft.
I guess I would just add, David, that the advanced packaging market does work on more of a book in turn, so we wouldn't expect to be carrying large backlog there.
Okay. Very helpful color. Could you help us understand perhaps what the EUV incremental opportunity might be next year or the next couple of years, however you'd like to characterize it, so that we can understand what sort of growth driver this is for the overall business?
Yeah. We've been kind of working with our customer to understand that model. It is a bit of a challenge to model it out. It varies pretty significantly, obviously, based on the number of EUV steps, the lifetime of a mask blank, the yield of mask blanks, and obviously the number of tape-outs or applications that are using EUV can really cause this number to move around a lot. What we've been booking business at kind of around the $40, $50 million kind of range. This year, we're expecting it to be in about that size range next year, caveated by those four or five variables that I just mentioned to you. I think the number could move around a fair amount. ASML is continuing. I think they are going to ship 26 systems this year, 30 next year. The demand's real. The demand is there.
We're going to have to keep monitoring it to see how this industry matures here. We're sizing it in that $40 million-$50 million range next year.
Since you had the relative orders this year, that's kind of what you would expect for revenue next year, just to be clear?
Yes.
Okay.
Yes.
Final thing from me, I guess it's a little bit of a follow-on from Patrick's question on the LSA business. I know you've penetrated at least one customer at an advanced node. Did you mention that you have now two customers at advanced nodes, or I guess 10 nanometers or 14 nanometers and below, however you'd like to characterize the advanced node?
Yeah, David, that's actually a great clarifying question. Actually, on Patrick's question, I was kicking myself for not mentioning that, so thank you for bringing that up. We do have a second customer, and I would say an advanced node is seven nanometer or better. We are working with a second customer as well. Each of those customers today, we have one application. At the next node, we are working to qualify a second or a third application at each of those customers. I wouldn't expect that node to be of significant volume for another few years out, though.
Okay. Just a final question from me. I'm sorry I keep rambling. The overall TAM of the annealing market, do you have a number there on an annual basis so we can just understand what the overall potential opportunity is?
I would say that's about $100 million opportunity.
Thank you.
Thank you.
Our next question comes from Gus Richard of Northland. Please go ahead.
Yes. Thanks for taking my question. Just a little bit of color on the MOCVD market. You had a nice step-up in the quarter, and I was just wondering if you could give us a little sense of whether that was RF or that was more power.
Thanks, Gus. Good question. In my prepared remarks, I did mention that we have shipped, and the customer has accepted a 300 millimeter single wafer, a gallium nitride cluster tool. That does make up probably most of that step-up that you're seeing in MOCVD. The end application is pretty confidential, but I would say that the GaN tool is capable for RF 5G, as well as micro-LED blue-green applications, as well as power.
Okay. Is this in a development environment, or is it moving into a production environment?
Today it's in a, I would call it a development pilot production, maybe environment. We are working with the customer to see how this application matures.
Got it. On the drives business, that's running quite strongly. It's both IBD match and depth. Is it better for you if it's MAMR or is it better for you if it's HAMR?
We're actually pretty agnostic either way.
Got it. Are you seeing multiple customers ramp energy enhanced heads recording?
Yes. We are seeing a number of customers have had HAMR and MAMR programs going on for years. Maybe even coming up to a decade, I've been involved in various programs with many of these customers. They each have their own integration schemes, but they're all actively working it. I think it's really important because historically, in the last five years, six years, the CAGR of areal density growth has been less than 10%. With HAMR or MAMR, they can increase that areal density growth to over 20%, that's how they can really start driving performance and cost per bit down to stay competitive with other memory storage types.
Right. Okay. What inning would you say we're in terms of the upgrade to enhanced energy enhanced recording? Are we first inning, 10th inning, late innings? What would you say?
I would say this is a very long baseball game. We've been in it for a long time, but I would say we're very much in the early innings. I think Seagate has said that they've shipped, I can't remember the number of drives, but not very many drives, that they're just starting to ship.
Got it. Then-
Very early.
the last one. Yeah. The last one for me, in terms of your litho offering, what's the competitive environment in China and elsewhere?
We do see some competitors in China. Most of our business, a lot of our business for our advanced packaging lithography, is not in China today. It's really at the larger IDMs and OSATs predominantly in Taiwan, where we still maintain, we think, a very strong market share.
Okay. What are the applications driving it? Is it fan-out high bandwidth memory? Is it flip chip? Can you give a little bit of color there as well?
Sure. I would say, Gus, we've had some success with high bandwidth memory this year, winning a key memory customer there. We've also seen some order activity this year from OSATs for GPUs and AI-type applications. We have not seen a lot of follow-on activity in fan-out wafer level packaging. As Sam mentioned, in the smartphone market, the AP lithography, there's a fair amount of excess capacity that need to be worked down.
Got it. That's it for me. Thank you so much.
Thanks, Gus.
Once again, if you'd like to ask a question, please press star one, we'll take our next question from Mark Miller of The Benchmark Company. Please go ahead.
Thank you for taking my question. When we were talking about your backlog and trying to break that down, you said that the AP was fairly weak in terms of the backlog distribution. Does that mean if you would look at the margins of the tools and backlog, they'd be somewhat lower or about the same in what you had last quarter?
Mark, I think margin profile, I assume you're saying gross margins.
Right.
The margin profile versus the backlog situation, they're quite different. In the sense, for the advanced packaging business, the way that industry works, at least for our products there, is that we get what I would say low lead times. When I say lead times, meaning from the time we get the order to the time we ship the tool, and that typically for advanced packaging side is three, four, maybe maximum five months. I was just contrasting there that compared that to the EUV and data storage industry, we get upwards of eight or nine months, or even 10 months.
You're projecting a $3 million lower in terms of non-GAAP OpEx by the third quarter of next year. How does that break out between COGS and operating expenses?
Mark, that is largely related to OpEx.
Okay, most of it, is that split equally between R&D and SG&A?
Correct. A little bit skewed more towards R&D than SG&A.
All right. Tax next year, 10% tax rate, 8% tax rate. What can we model?
From a modeling perspective for taxes, we have about $280 million in U.S. NOLs. Really percentage tax doesn't really work for our P&L. We pay very small amount of taxes because of the NOL position. You could model anywhere from $0.5 million to $1 million of taxes for non-GAAP purposes a quarter. It could be $2 million-$4 million of taxes per year.
Thank you.
We really do not pay taxes in the U.S. Whatever taxes these are, that is really driven by the taxes we pay in foreign jurisdictions, and depending upon which specific jurisdiction the sale is and what the tax rates in those countries are, that's why it varies. We really aren't paying taxes in the U.S. due to the NOL position.
Thank you.
It appears there are no further questions at this time. I'd like to turn the conference back to William Miller for closing remarks. Please go ahead, sir.
Yes. We're excited that we got back to non-GAAP profitability, and we look forward to meeting with you again next quarter to discuss our progress. Thank you.
This concludes today's call. Thank you for your participation. You may now disconnect.