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Edited Transcript of MKSI earnings conference call or presentation 31-Jul-19 12:30pm GMT

Q2 2019 MKS Instruments Inc Earnings Call

ANDOVER Aug 22, 2019 (Thomson StreetEvents) -- Edited Transcript of MKS Instruments Inc earnings conference call or presentation Wednesday, July 31, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Gerald G. Colella

MKS Instruments, Inc. - CEO & Director

* John T. C. Lee

MKS Instruments, Inc. - President & COO

* Seth H. Bagshaw

MKS Instruments, Inc. - Senior VP, CFO & Treasurer

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Conference Call Participants

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* Amanda Marie Scarnati

Citigroup Inc, Research Division - Semiconductor Consumable Analyst

* J. Ho

Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector

* Krish Sankar

Cowen and Company, LLC, Research Division - MD & Senior Research Analyst

* Mark S. Miller

The Benchmark Company, LLC, Research Division - Research Analyst

* Shek Ming Ho

Deutsche Bank AG, Research Division - Director & Senior Analyst

* Thomas Robert Diffely

D.A. Davidson & Co., Research Division - MD & Senior Research Analyst

* Weston David Twigg

KeyBanc Capital Markets Inc., Research Division - MD & Senior Research Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the second quarter 2019 earnings conference call. (Operator Instructions) As a reminder, this call is being recorded.

I would now like to turn -- introduce your host for today's call, Mr. Seth Bagshaw, Senior Vice President and Chief Financial Officer. You may begin.

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [2]

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Yes, thank you. Good morning, everyone. I'm Seth Bagshaw, Senior Vice President and Chief Financial Officer. And I'm joined this morning by Jerry Colella, our Chief Executive Officer; and John Lee, our President and Chief Operating Officer. Thanks for joining our earnings conference call. Yesterday, after market closed, we released our financial results for the second quarter of 2019. Our financial results and scheduled revenue by market have been posted to our website, www.mksinst.com.

As a reminder, various remarks about future expectations, plans and prospects for MKS comprise forward-looking statements. Actual results may differ materially as a result of various important factors, including those discussed in yesterday's press release and in our most recent annual report on Form 10-K for the company. These statements represent the company's expectations only as of today and should not be relied upon as representing the company's estimates or views as of any date subsequent to today, and the company disclaims any obligation to update these statements.

Today's call also includes non-GAAP adjusted financial measures. Reconciliations to GAAP measures are contained in yesterday's earnings release. In addition, we refer to certain pro forma measures as of the acquisition of Electro Scientific Industries, Inc., or ESI, which closed on February 1, 2019, and occurred at the beginning of the first quarter of 2018.

Now I'll turn the call over to Jerry.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [3]

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Thanks, Seth. Good morning, everyone, and thank you for joining us today. I'll start with our results for the second quarter 2019 followed by several business and market highlights, and then I'll turn the call over to John, who will share additional details on our strategy, customers and markets. Seth will then provide additional information on our financial results and third quarter 2019 guidance before we open up the call to your questions.

Second quarter revenue was $474 million, which was within our guidance range. Non-GAAP net earnings for the second quarter were $59.9 million or $1.09 per share, which was above the midpoint of our guidance. In the second quarter, we saw headwinds in our Advanced Markets. This is primarily due to the disruption of the global trade environment highlighted by softening in consumer electronic devices, tariffs and the Huawei ban.

We see the impact both directly in China and indirectly across other regions as this uncertainty continues to be an overhang in many of our markets and for our customers worldwide. We expect these headwinds to continue to impact our Advanced Markets into the third quarter. Despite these headwinds, though, we're very pleased to report that revenue in our Advanced Markets achieved a new quarterly record, $260 million, and comprised 55% of our revenue in the quarter.

We do still see moderation in semiconductor capital spending, as we mentioned last quarter our business appears to have stabilized with planning for market recovery remaining a bit uncertain. One of the strengths over the years has been to manage through cycles. The underlying strategy is the MKS business process, which is a disciplined approach to all aspects of our business focusing on operational and financial stewardship. Managing our business with this approach enables us to quickly adapt to any short-term fluctuation and positions us to address future opportunities.

We continuously refine our operating model as well as manage expenses. However, we're also committed to maintaining our investments in key growth segments, so that we'd ready for the recovery in 2020 and beyond. Our capital deployment strategy delivers significant value creation with a strong emphasis towards generating organic growth and funding M&A.

We've been very successful with the execution of our disciplined acquisition strategy, and we anticipate the ESI acquisition will be an integral part of our Advanced Markets growth for many years to come. We understand the importance of introducing innovative solutions that lead to key design wins as they position us for ongoing success. John will give you more details on some of our key second quarter wins, but I wanted to highlight a significant design win in our power solutions business for the semiconductor market.

In the quarter, we were designed into a new conductor etch tool at 13.56 megahertz, which is the third recent significant win at this important frequency. We continue to invest in our power solutions business expanding our leadership and enabling critical high-growth applications. Historically, MKS would experience significant growth after down cycle turns positive, and we have consistently outperformed the semiconductor and Advanced Market growth rates.

For example, during the years 2014 to 2018, our semiconductor business grew at more than 2 times the rate of the WFE CAGR with MKS at 20% versus WFE rate of 9.7%. And from an Advanced Markets perspective, during the same 5-year period, we grew at a 34% CAGR versus a market growth of 4%. In addition, our non-GAAP EPS CAGR has grown at over 50% in that 5-year period or over twice the growth rate of our revenue.

Turning to our Q3 2019 revenue and earnings guidance. We estimate that sales in the third quarter could range from $415 million to $465 million. Third quarter non-GAAP net earnings per share could range from $0.69 to $1.02 per share. Seth will provide the balance of third quarter guidance in his remarks.

At this point, I'd like to turn the call over to John.

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John T. C. Lee, MKS Instruments, Inc. - President & COO [4]

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Thanks, Jerry. Over the last 5 years, we have transformed MKS from primarily a semiconductor component supplier to a company that delivers solutions for the most challenging problems in advanced manufacturing processes. Well, broadly, our solutions address markets that drive the information economy and the clean tech economy.

Information economy is built around key enablers such as data storage, passive computation and increasing communications bandwidth. To address these challenges within the semiconductor market, the industry has developed vertical structures such as FinFETs and VNAND, a major inflection in how chips are made. Vertical features require increased deposition in next steps. High aspect ratio features require increased power, [improved] control and timely player processing.

In the second quarter, we secured a significant design win in our power solutions business on a new conductor etch tool for a VNAND memory application. Each chamber requires a multiple of 13.56 megahertz power generators and custom matching networks. We took this business from a competitor based on our technical performance and our strong in-region support capabilities.

Our power solutions group was also honored with The Excellent Partner award from NAURA Technology Group, a leading China-based OEM. We also had a number of design wins for Atomic layer deposition and semiconductor applications for our ozone generators, direct pressure measuring, flow and balance solutions.

To address the increasing communications bandwidth challenges for the information economy, the industry has adopted flexible and high density interconnect PCBs. We continue to see excellent progress with our ESI acquisition, which enables us to address these markets with complete system solutions to raise our microprocessing and component testing.

In the second quarter, we received our first order in Europe for our new flexible PCB laser drilling solution, which incorporates our Spectra-Physics nanosecond-pulsed laser. This order complements multisystem orders already shipped to customers in Asia. We also received a strategic partner and excellent quality awards from Zhen Ding Technologies or ZDT, a leading flexible PCB and HDI supplier.

We're pleased with the progress we're making with our newly introduced HDI PCB via drilling solution. This system's design is based on a higher throughput, smaller footprint platform that is purposeful from ground-up specifically for HDI laser processing. We have shipped the first beta tools into our regional application centers in Taiwan, Japan, and China.

Clean tech economy continues to serve as a significant long-term growth opportunity for MKS. Examples included laser-based industrial applications to improve the efficiency of solar cells, more efficiently manufacture batteries and the use of ozone instead of chemicals for cleaning applications in semiconductor and display manufacturing.

Ozone has proven to be an excellent green alternative that reduces dangerous chemical use and chemical disposal cost. MKS has been a leader in this area, and our dissolved ozone systems continue to gain traction with key customers. In the second quarter, our ozone generated solution was selected for an advanced lithography photomask cleaning application as well as for an OLED display cleaning application.

Turning to our laser business. In the second quarter, we introduced a new IceFyre laser solution, which is a high-power 50-watt UV picosecond laser with industry-leading performance, versatility and cost of ownership. This new laser addresses many applications in the manufacturing of solar cells, batteries and advanced displays. We remain very bullish about MKS's future because of our exposure to multiple high-growth markets, our innovative technology portfolio and the strength and depth of our customer relationships cultivated over years of technical collaboration.

At this point, I'd like to turn the call over to Seth.

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [5]

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Thank you, John, and I'll cover our Q2 2019 financial results and discuss our Q3 2019 guidance. Sales for second quarter was $474 million, an increase of 2% sequentially compared to the first quarter. Revenue was slightly under the midpoint of our Q2 guidance as the semiconductor market pause is [left more] than expected. In addition, our Advanced Market is impacted by the general slowdown in industrial markets, which occurred later in the quarter as well as uncertainty caused by global trade tensions. 55% of our sales were customers in our Advanced Markets, while 45% were the customers in the semiconductor market, consistent with our long-term goal of achieving a balanced market mix.

Sales to our Advanced Markets were a record $260 million, an increase of 7% sequentially due to the full quarter's impact of the ESI acquisition. Sales to the semiconductor customers were $214 million, a decrease of 3% sequentially. Non-GAAP gross margin was 45%, which was favorable to our expectations at this revenue volume due to product mix and continued cost controls.

Non-GAAP operating expenses were $125 million, which was $7 million below the midpoint of our guidance due to strong focus on managing our cost structure. Non-GAAP operating margin was 19%, which was 130 basis points favorable to the midpoint of our guidance range. This strong financial performance reflects our ability to effectively manage the company through all phases of the operating cycle.

GAAP gross margin was 44.5%, included the impact of $2.5 million of inventory purchase accounting charges. GAAP operating expenses were $147 million, included $17.6 million in amortization of tangible assets, $3.2 million in acquisition integration costs and $1.2 million in restructuring costs.

GAAP net interest expense was $12.7 million, and non-GAAP net interest expense was $11.4 million. Our GAAP tax rate was 27%, and our non-GAAP tax rate was 23%. Tax rates were higher than expectations due to mix of geographical income. GAAP net income was $37.7 million or $0.69 per diluted share, and non-GAAP net earnings of $59.9 million or $1.09 per diluted share.

The integration of the ESI acquisition continues to proceed very well and exiting the second quarter with almost $7 million of annualized cost synergies. We're on target to realize the $15 million announced total synergies in 18 to 36 months subsequent to the transaction closing. In the second quarter, revenue for the equipment and solutions division was $56 million, and non-GAAP operating margin was approximately 16% or ahead of our expectations at the sales volume due to favorable product mix and realization of cost synergies ahead of schedule.

Now turning to the balance sheet. In June, we completed a $50 million voluntary prepayment on our term loan and on June 30 had outstanding balance of $947 million. Our goal is to continue to delever the balance sheet and lower interest costs. This most recent voluntary prepayment is our 9th since loan origination in April 2016.

Exiting the quarter, we maintain a strong balance sheet and liquidity with $460 million of cash and investments, $100 million of incremental borrowing capacity under an asset-based line of credit and a modest 12-month net leverage ratio of under 1x. Free cash flow for the quarter was $64 million, 13% of sales, an increase of $49 million from the first quarter of 2019. Free cash flow in the first quarter included payments of ESI acquisition cost, which closed on February 1.

We continue to demonstrate a balanced approach to capital deployment. In the quarter, we paid a cash dividend of $10.9 million or $0.20 per share. Turning to working capital, days sales outstanding were 60 days at the end of the second quarter compared to 66 days on a pro forma basis at the end of the first quarter. Inventory turns were 2.2x and consistent with the first quarter on a pro forma basis.

Finally, I'll discuss our Q3 2019 guidance. Based upon current business levels, we estimate that our sales of third quarter could range from $415 million to $465 million, and our non-GAAP gross margin could range from 43.5% to 45.5%.

Q3 non-GAAP op expenses could range from $122 million to $129.5 million. R&D expenses could range from $41.5 million to $44 million, and SG&A expenses could range from $80.5 million to $85.5 million. Non-GAAP interest expense is estimated to be approximately $10.8 million and a non-GAAP tax rate to be approximately 22%. Given these assumptions, third quarter non-GAAP net earnings could range from $38.2 million to $56.6 million or $0.69 to $1.02 per diluted share.

In the third quarter, amortization of intangible assets is expected to be approximately $17.2 million, integration related costs expected to be approximately $1.7 million, restructuring cost estimated at $1.8 million, interest income is expected at $1.2 million and GAAP interest expense estimated to be approximately $11.6 million. GAAP net income is expected to range from $21.4 million to $39.8 million or $0.39 to $0.72 per diluted share or approximately 55.3 million shares outstanding. This concludes our prepared remarks.

We'll now open the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Patrick Ho with Stifel.

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J. Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [2]

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Jerry, maybe just as a follow up to some of your comments this morning regarding the Advanced Markets and the impact from some of the global macro and market trends we're seeing today, can you give a little color maybe qualitatively in terms of either the products that were affected, whether they were like ultrafast, the ultraviolet lasers or even the markets that felt some of this impact?

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [3]

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Yes. So maybe if I can answer that by kind of setting all the different markets and product areas we participate in. So I'll start with semi and work my way through it. I will answer your question, Patrick. Thank you. So on the semi side, we still see this lumpy and bumpy around the bottom. But we are encouraged over the last several days of 2 leading drivers of semi and industrial and then more positive commentary about the business positioning and what they see going forward. And we are having more positive discussions with the semi customers as of late. So -- but that affects both semi and the industrial side, which is good. The light -- it has signs, the research and defense, talks about business are solid and consistent. The industrial side has lightened up, and the discussions with the customers are more around about timing and eventuality, and it's pretty much an effect from the trade issues in Asia, particularly in China.

So even though we set our records for Advanced Markets, we are seeing that the industrial side of our business more affecting the previous Newport Corporation, has been impacted by some of the concerns of trade. And that resonated out into Europe and other possible world. We are emboldened by the pockets of strength in China though directly, both in terms of semi and solar. We saw some good strength there. So it's pretty much the industrial side, pretty much affecting mostly like motion, and it's a matter of -- there's lots of engagements. There's lots of design in. There's lots of customers saying, "I want to buy." Just a little hesitant right now given some of the circumstances -- going circumstances, being expected business to come back in a very strong position. And we consider the Advanced Markets right now to be probably flat from where we are now maybe to the end of the year, but with the ability to recover if conditions change. Does that help?

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J. Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [4]

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No, that's very helpful. Maybe as my follow-up question for John, because you spent some time talking about the evolving laser strategy. And particularly with the introduction of new accessory products on the Light and Motion side of things. Can you give investors an update on how that progress is going? And how that can be a growth driver on a going forward basis?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [5]

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Sure, Patrick. So we didn't have all the lasers in our portfolio, and so that's why we talked a little bit about picosecond IceFyre laser that we released. That's the second picosecond laser we released this year. The first one was at a lower power. And that was a gap in our portfolio. Even though we had talked about our laser business growing and it has over the last several years, it was growing without a complete portfolio. So now we continue to fill that portfolio, and we believe that because of that we'll continue to grow the laser business going forward.

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J. Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [6]

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Great. And final question from me, Seth, in terms of the gross margin profile, it actually came in pretty well despite the projected decline in revenues in the September quarter. What are the key variables there? Is it the product mix and the market mix that are helping margins -- gross margins to stay pretty much close to that 45% level?

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [7]

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Yes, thanks, Patrick. So yes, again in Q2, we have unexpected margins through product mix, the ESI grew particular, our ENS division. It was very favorable in the quarter. Usually, as you know, our model, the 50% variable gross margins, particularly the Q3 guidance exactly how that rolls out. We've been very proactive on controlling our cost structure. We started back in really Q3 of last year, the 2018, to continue to mitigate the cost in the business, including cost of goods sold. So across-the-board, I think very favorable margin profile. We're driving the cost structure down. Our margins definitely across all divisions are relatively consistent, a little higher in Advanced Markets piece of it as well. But generally, again, we're value -- when we invoice customers, we're a value-based proposition, and I think it's held on very well even in the downturn. So all those factors are kind of hanging in there pretty well. So we're pretty happy with where we are in the model.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [8]

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Yes. Even in the -- this is Jerry, Patrick. Even within this -- the past quarter, we took cost reduction actions based on what we saw in the volume of the business. So one of the things that we've always are proud of is our financial stewardship of this business. It has never been an impact to our growth of the company. We make -- we shift our investments where the high growth opportunities are, and we will take cost out where we think the cost is either not appropriately based on the volume of the business or we don't see the future growth coming. So that's one thing that -- we can't necessarily control the markets, but we'll certainly control the cost structure and execution of that within the company. We're proud of that over our 20-year history of being a public company.

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Operator [9]

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Our next question comes from Amanda Scarnati with Citi.

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Amanda Marie Scarnati, Citigroup Inc, Research Division - Semiconductor Consumable Analyst [10]

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Just a quick follow-up question. I just want to confirm that you said that you expect the Advanced Markets to be somewhat flattish throughout the year. And then how would that impact sort of going for next quarter in the semiconductor space? That implies somewhat like a down high single-digit to low double-digit growth in semiconductors. Does that seem -- can grow as with sort of the moderation in companies that you're seeing?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [11]

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Yes, Amanda, this is John. I'll take that. So I think there's still variability in both markets on the order of plus and minus 5%. So we kind of expect both to be still bumping around and flattish. We've guided down a little bit. But really it's just to be a little cautious. So I'm going to take that as any kind of message about semi versus Advanced Markets.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [12]

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Yes. Some part of the problem is -- look, with the advantage the company has that we can ramp faster than others is our lead times are very, very short. So we -- the business -- we have a very quick turns business going into a quarter. So sometimes that color is how we look at things. But we feel very optimistic as the business goes towards this -- the next quarter towards the end of the year, the things will turn around. But I think, like John said, we want to make sure that we are credible and consistent in the way we project the business right now. And I agree with John. It could be a mix that goes 5% here or 5% there. They're pretty close when you're 50/50 almost in mix. An order or 2 can make a big difference in the mix between semi and nonsemi or Advanced Markets.

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Amanda Marie Scarnati, Citigroup Inc, Research Division - Semiconductor Consumable Analyst [13]

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All right. And then within the semiconductor market, are you starting to see inventory at a more comfortable level at your customers in such that when your customers start really ramping up there isn't going to be that sort of one quarter inventory delay? Or is there still just not enough visibility to see what's happening there?

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [14]

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No. From what we can see, it looks as though the inventories have relatively stabilized and normalized. So yes -- no, I think we're at a point right now where the inventory reduction is not the main concern at this point. It's just purely demand.

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Amanda Marie Scarnati, Citigroup Inc, Research Division - Semiconductor Consumable Analyst [15]

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And then the other last question I have is just on different customers. Are you seeing different behavior at your key customers, Applied and Lam? Or is everything sort of similar across-the-board?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [16]

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Amanda, it's John. I think we don't see any real differences between our semi OEM customers beyond the Applied and Lam. I think they're all affected equally by discussions and announcements by the key chip end users. So no, I don't think there's any real difference between them.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [17]

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They do order differently though. They all have different techniques for ordering, which gets some of the customers in an over inventory position. Whether some -- some customers are just in time line side supply, which we prefer. Other customers buy bulk quantities. So you have a pig going to the python as they say or [water going through holes]. And others are more MRP level setting. So inventory and procurement practice are different, but in terms of how they are discussing with us, this is -- that appears to be consistent at this point.

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Operator [18]

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(Operator Instructions) Our next question comes from Sidney Ho with Deutsche Bank.

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Shek Ming Ho, Deutsche Bank AG, Research Division - Director & Senior Analyst [19]

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Want to make sure -- want to go back to that guidance. And to get to the midpoint of the guidance is down 7%, but you seem to think that both semis and the Advanced Markets are flat plus or minus 5%. Just wanted to make sure I don't miss anything. Is it because of -- maybe the other way to ask the question is what are you specifically relate to -- what are you specifically forecasting ESI is going to do in Q3?

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [20]

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Yes. So it's Seth. So Q3 is about $50 million, we believe, plus or minus in the quarter. And then back to your question before. On Advanced Market, we said that we think in Q3 it feels flat going forward. So certainly Q2 to Q3 we expect a little bit of headwind there because of trade and the Huawei ban has a little impact as well. And then, again, semi, again, as Jerry mentioned, short lead times. Basically, we're seeing the business level is going to bounce around plus or minus today's rates. And again, that can turn pretty quickly. AM has turned around their business. So right now, based on the level of the business and the order rates, that's kind of what we're seeing.

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Shek Ming Ho, Deutsche Bank AG, Research Division - Director & Senior Analyst [21]

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Okay. Great. The follow up to that related to semi business. You guys have been using the term consistent for the last few months. And you guys kind of talk about inventory has kind of stabilized. If you kind of look at the month-on-month basis in terms of orders, is there any sudden change in order pattern in the latter part of the Q2 or the first month of this quarter? Reason I'm asking is because the customers -- some of the customers have talked about strength in foundry and logic and maybe some weakness in memory. I want to see if you're seeing the same kind of pattern as well.

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John T. C. Lee, MKS Instruments, Inc. - President & COO [22]

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Yes. Sidney, this is John. So I don't think we've seen it yet. But I think, as Jerry had mentioned, our discussions with customers are consistent with those kinds of commentary by the foundry -- foundry customers. So I think going forward, that's why we're a little hopeful that we're maybe at the bottom, but we haven't seen that as yet in Q2.

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Shek Ming Ho, Deutsche Bank AG, Research Division - Director & Senior Analyst [23]

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Okay. Maybe my last question is on Advanced Markets. You talked about headwinds that will continue in Q3. The business has been -- if you take out ESI in that equation, the business has been down year-over-year by about 10% -- 10%, 11%, 12% the first and second quarter and maybe in the third quarter. Do you see an inflection point that you'll start seeing year-over-year growth again? And I guess it depends on the headwinds. But more importantly, I don't want to overreact to 1 to 2 quarters, but it does look like a business moves around based on what global GDP does -- GDP. Do you still believe this is a GDP plus kind of growth rate in the longer term?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [24]

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Sidney, yes, we do. And I think we know exactly when things started tightening for the Advanced Market and industrials, and that was really when the Huawei ban came in. And it was right then and there that many discussions with customers -- key customers became much more muted. And so we're still very positive on that market because this is a geopolitical issue. That's not really a demand issue. And so when we -- when those things get settled, we expect that the Light and Motion Division and our Surround the Workpiece portfolio should also benefit from that.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [25]

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Yes. And historically, for about a 10-year or 12-year period, our CAGR on the Advanced Markets "nonsemi" was about 8% historically and consistently. So the history or our long track record would suggest that our -- suggesting that something 2x the normalized growth rate is appropriate for us. And the 6-month trends, 9-month trend, I think that's very short-term view of looking at a business. Just as I would look at, people worried about Q2, Q3, I think that's very short-term view. You have to look at the long-term track record and then again consider the financial performance of the company regardless of the market conditions.

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Operator [26]

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Our next question comes from Krish Sankar with Cowen.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [27]

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I had a few of them. Jerry, on your semi or Vacuum and Analysis business, how do you characterize the June quarter like compared to 3 months ago? Did it progress per your plan? Did it deteriorate or get materially better over the quarter?

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [28]

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It was pretty good, pretty consistent. Overall, the semi business is about 2% down. So that's in the noise as far as I'm concerned. So no, it was pretty consistent the last quarter or so, Krish. Like I said, in quarter-to-quarter, until the overall conditions solidify and look very strong, you can get things that bump around a bit, a project or a big technology buy that gives you a bump in the business. But relatively -- I would say it's relatively consistent. And by the way, one of the things to let you know about our confidence in that business, particularly the Vacuum and Analysis, is we put in, in one product line over $15 million worth of capital in the last year to give us some upside, search, ramp capacity. And if we didn't feel good about that business, both the short and long-term, we'd never put $15 million of capital in a single product line. So that's the cost we have in that business right now.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [29]

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All right. And then the conductor etch power supply win that you mentioned, I remember you spoke about 1 prior quarter ago or 2. So is this a different win? Is it the same and is the same customer? Is this for a critical etch application or a not so critical etch application?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [30]

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Krish, it's John. I'll take that. Yes. So we've actually announced 3 conductor etch design wins. So a year ago we announced the first one. Couple of months ago we announced the second one. And this one is the third one. It's multiple customers, and it's all critical conductor etch.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [31]

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This has been an area of focus. We lead in dielectric etch for critical applications. In the last several years, we have made significant investments in engineering and capital to extend our lead in dielectric and to capture the conductor etch business, which we are and we will do. No question.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [32]

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And then maybe, John, as a follow up to that, between conductor etch and dielectric etch, which would you say is more power supply intensive?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [33]

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Yes, dielectric etch is more power supply intensive because of the -- driven a lot by the VNAND stacks. So there's more power content per chamber as you need to etch higher aspect ratio features. While I would say, though, that conductor etch is starting to be applied to tougher processes, some of them are also high aspect ratio. So we see a trend that conductor etch -- the power content on conductor etch is also going to be increasing over time.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [34]

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That's our sweet spot, Krish. We're not interested in low-end, low technology commodity pricing power. There's plenty of people that do that. It makes the revenue look higher. We're interested in the more critical long-term high-growth applications, where it's worth the investment for us. And that's where we're taking the business from, which is really a better strength of our semiconductor business in the last several years, right, John?

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [35]

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Fair enough. And then I just have 2 other questions, John and Jerry. One is on the ESI it looks like, if you look at some of the downstream data points, looks like the PCB is stabilizing, but the MLC capacitor is not yet. Is this the way to think about your ESI revenue potential as well? Is it going to follow that? Or is there something else going on?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [36]

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Krish, it's John. I'll take that. So you're right. The PCB industry -- looks like it's stabilizing in. So we had talked a little bit about this first order for our CapStone, which is the next-generation flex tool in Europe. But as I mentioned in the prepared remarks, we've also shift double-digit numbers to Asia customers off CapStone already for PCB flex drilling. When you look at MLCC, we look at it from a long-term trend perspective. Test systems that we have made historically for MLCCs have been testing small capacitors. And you're right. That has had an overbuild, and it's a digestion period right now. But we recently released last fall the large chip tester, and that's more targeted towards automotive where the small ones are targeted more towards communications. And so that part of the test system actually has been very consistent. So automotive has really continued to incorporate more MLCCs into the cars. And so we see that as a long-term positive driver, and it's been very consistent over the last couple quarters. And then the smaller chips are driven a lot by phones. And so we had that overbuild and now we're in a digestive period. But we're certainly very positive because smaller chips will continue to be put into phones, especially with 5G. You'll need a lot more of these MLCCs per phone. And so that's why longer term we are positive on both small chips and large chip testing.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [37]

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We've gotten external input that the MLCC could be a double-digit CAGR for about a 5-year period over time due to the applications John talked about, automotive, personal devices. So the short term, there is a bit of a oversupply. But the long-term prospect and relatively [short] appears to be very bright for that. I think it gives us a chance to do those, look at the legacy tools and perform value analysis and the cost structure of those tools. So sometimes, you have a little bit of a repeat unless you do things on the cost side that you can't do when you're going for war. So we expect to be able to work on the margin of those products over time as well.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [38]

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Got it. Got it. And then a last question for Seth. Did I hear you right, the taxes -- tax is going to be 22%, seems pretty high, and how do you think about it longer term?

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [39]

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Yes, yes, so you're right. Our normalized real long-term [is more like] 19%, is our view coming into the year. And what happens is the way the mix of income rolls outs, slow down, just sort of drives up the rate amount dramatically. So I think that this year, the full year '19, 22%, our expectations when volumes pick up and again sending the piece of that uptick leaving, looking forward 2020 for sure. Revenue picks up then, range should come back down to 19% rate, back to historical norms.

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Operator [40]

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Our next question comes from Mark Miller with The Benchmark Company.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [41]

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Just wondering, there's been some speculation that both Samsung and SK hynix might be moving up their 128 layer ramp. And I'm just wondering have you heard that? And if that be the case, what do you interpret that for you, for MKS?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [42]

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Yes, Mark, it's John Lee. So we certainly can't comment on those rumors since we don't know. But I would say that, when the industry goes to the 128 layer, those will be only enabled by the most advanced VNAND hole etch provided by the one large OEM who has that share. And that OEM is using the power supplies that we provide. And so when that happens, we'll be very positive about that. That should drive our power business. So we would love them to start that sooner than later.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [43]

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Have you seen any change? There was a power outage at the Toshiba fabs, and Western Digital and Toshiba lost a lot of wafers and estimated it could be a significant part of the output for the industry. Has there been any ramifications of that? Have you seen with anybody?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [44]

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No, not yet, Mark. I mean in terms of wafer starts, we read the same reports that you read about VNAND and DRAM. It does look like VNAND pricing has stabilized, and the debate now is whether that's a short-term blip because of that outage or whether it's just because the supply is catching up to -- demand is catching up to supply. So we haven't seen any direct impact for ourselves.

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Operator [45]

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(Operator Instructions) Our next question comes from Weston Twigg with KeyBanc Capital Markets.

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Weston David Twigg, KeyBanc Capital Markets Inc., Research Division - MD & Senior Research Analyst [46]

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First just wanted to touch base on the HDI product opportunity. You said you shipped some beta tools out to several geographies. And I'm wondering, if you could give us an idea of when that might translate into revenue. And what kind of revenue that could look like maybe through 2020?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [47]

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Wes, it's John. I'll take a stab at that. So we have shifted 3 regions, and they -- usually what happens is they go into our application centers. And those local customers can come by and literally bring their panels for -- and try the different recipes. And so Taiwan, Japan, and China are the biggest markets for HDI. So the next 3 to 6 months, what will happen is these major customers will be testing them, improving processes in. And then usually what happens in this kind of cycle, similar to flex, they will start ordering in the first half of the next year to put the tools into their factories to make the next-generation PCBs for the consumer product cycle. And so we expect that if we're successful, then volume orders should be occurring in the first half of 2020. So to how much? The market is $400 million, $500 million, of which we have 0. And so if we can gain a couple of design wins with 2 key customers, I think we'd be pretty happy. Then once that gets out, then over the years we would build that market share.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [48]

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The initial feedback though was extremely positive on the tool -- actually that we have won an award for the technology for that HDI tool based on cost of ownership in terms of speed and accuracy. So the -- and that's independent of MKS thing. It's a great tool. So right now, the start of this is extremely positive. We're also going to have a summit in the early fall. We are bringing customers to be involved with the tool directly. So we're looking forward to inviting large swathes of customers directly to see the tool and operate the tool with us.

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Weston David Twigg, KeyBanc Capital Markets Inc., Research Division - MD & Senior Research Analyst [49]

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Okay. That's very helpful. And then likewise I was just wondering. You mentioned the new higher powered laser that would address some of the manufacturing opportunities in solar and batteries and advanced displays. And I'm wondering if for this market you could help us size it and also maybe discuss the competition that you're facing in that market.

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John T. C. Lee, MKS Instruments, Inc. - President & COO [50]

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Yes. So this category of laser is defined by the pulse width, and that's picosecond. So prior to the first announcements of the 30-watt version, we had no participation in the picosecond market. And we participate in nanosecond market and femtosecond. So we've kind of surrounded the picosecond, but we didn't have an entrance there. And so this market is arguably -- could be as big as nanosecond, and those are large numbers, because people are moving to shorter pulse widths to get more precision in different materials. So we're just beginning to participate there. We see a lot of customer interest, demos already out there by the way for the first solar power version, and we just announced a 50-watt version. So we expect that this will add substantially to our laser revenue going forward.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [51]

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Maybe I can give a little historic perspective on it, though, Wes. So in 2016, our laser business was sub-$200 million. In 2017, it was $227 million. And in 2018, it was $282 million for a growth rate of over 24% from '17 into '18. So this is a huge opportunity for just the laser business in general, based on microprocessing in the light industrial space. And the more and more we released these newer applications, the greater the opportunity is.

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John T. C. Lee, MKS Instruments, Inc. - President & COO [52]

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Wes, maybe a little more about the differentiation versus -- so there are other people out there with picoseconds waiting for us for sure. But we're trying to leverage what we did in nanosecond. Nanosecond laser we released about 5 years ago, Talon was a change in the industry in terms of cost for the performance. And that's why the Talon's been very extremely successful in nanosecond, took a lot of share from incumbents. And we're using and leveraging that same architecture for the picosecond laser. So we're not just going out there with something that's me-too. We're going out there with something that is much better from a cost performance standpoint.

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Operator [53]

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Our next question comes from Tom Diffely with D.A. Davidson.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [54]

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So we've talked a lot about the inventory levels with the OEM customers. I'm curious though what the inventories look like at the Advanced Market customers? And what are they typically holding in terms of inventories?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [55]

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Tom, it's John. In terms of inventory -- your question is about inventory for Advanced Market customers?

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [56]

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Correct, yes.

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John T. C. Lee, MKS Instruments, Inc. - President & COO [57]

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Yes. Now typically they don't hold kind of inventory that semi OEMs do. Usually, they -- when they have the business, they buy. It's pretty fast turn. There's less of the copy exact issues there. So they can change quickly. So you don't have that motivation to hold a lot of long-term inventory because you're going to have this copy exact effect. So no, we don't actually see a lot of inventory issues with the Advanced Markets customers, industrial customers.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [58]

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Okay. It sounded like post the Huawei ban, you saw a big slowdown in that space. Just curious, have you seen projects being canceled or are they just kind of put on hold or shelved for a bit?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [59]

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No, that's a good question. No, the projects that we were working on prior to the ban are continuing. Just the magnitude of the orders are less, just because our customers are being more careful. So instead of ordering $10 million of lasers, for example, they might order $3 million for now and waiting until the clarity of the markets gets better before they order the rest. So it's really about tempering down how much they'd order rather than counseling. That's been our experience so far.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [60]

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Okay. That's helpful. And then when you look at the new power supplier for the conductor etch market, you mentioned VNAND. I'm curious if that was specifically a VNAND product or is that also applicable to DRAM foundry and logic?

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John T. C. Lee, MKS Instruments, Inc. - President & COO [61]

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It's actually applicable to DRAM. It's a high aspect ratio type of etch conductor. So -- but as a result of that, obviously, you can do low aspect ratio as well if they so choose to, to win design win -- applications there.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [62]

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Okay. And then finally, Seth, it sounds like you're about halfway through the cost reduction program on the synergies for ESI. What do you expect the timing to be on the second half? Is it more 2 years outwaited? Or is it kind of be evenly spread through that period of time?

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [63]

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Yes, good question, Tom. There's a whole series of things in play, so again with 18 to 36 months. Our goal is kind of like -- for Newport we announced same thing, 18 to 36 months, and you get that approximately done in a 20-month period. So I would say 20 months is [difficult] for ESI for sure, but we're trying to pull as best as we can. So I will say we'll update everybody on a quarterly basis at this point. But we're ahead of schedule. For $15 million, we're very strong about achieving the total cost synergies, but I think we'll have to roll it out as when we do the earnings calls going forward.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [64]

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And historically, we beat the synergy target that we put out there. We put $35 million for Newport. I think it was $40 million we finally achieved, Seth?

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [65]

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Yes, correct.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [66]

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And so historically, we've come over the top of our synergy number, Wes (sic) [Tom]. We don't like to justify a deal with a big synergy number. We don't think that, that is a good message to -- internally and to the shareholder of the company. We feel comfortable with the $15 million, and hopefully, we can do better now what we've done historically.

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Operator [67]

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At this time, I'm showing no further questions. I'd like to turn the call back to -- for closing remarks.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [68]

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Sure. This is Jerry Colella. We're pleased with our results for the second quarter. It was another quarter of strong operational and financial execution, which drove our non-GAAP operating margin and non-GAAP net earnings above the midpoint of our guidance. Our diversification strategy continues to drive growth in our Advanced Markets. We are confident that our exposure to diverse end markets and the strategy we've put in place have positioned us for our continued long-term success. Thank you for joining us on the call today for your interest in MKS. We look forward to updating you on our progress when we report our third quarter 2019 financial results. Thank you.

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Operator [69]

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Ladies and gentleman, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day.