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Edited Transcript of MKSI earnings conference call or presentation 24-Oct-19 12:30pm GMT

Q3 2019 MKS Instruments Inc Earnings Call

ANDOVER Nov 1, 2019 (Thomson StreetEvents) -- Edited Transcript of MKS Instruments Inc earnings conference call or presentation Thursday, October 24, 2019 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David Ryzhik

MKS Instruments, Inc. - VP of IR

* Gerald G. Colella

MKS Instruments, Inc. - CEO & Director

* John T. C. Lee

MKS Instruments, Inc. - President

* 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

* Patrick Ho

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

* Krish Sankar

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

* Sidney Ho

Deutsche Bank AG, Research Division - Director & Senior Analyst

* Thomas Robert Diffely

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

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the MKS Instruments' Third Quarter 2019 Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions) I would now like to hand the conference over to your speaker today, Mr. David Ryzhik, Vice President of Investor Relations. Please go ahead, sir.

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David Ryzhik, MKS Instruments, Inc. - VP of IR [2]

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Thank you. Good morning, everyone. I am David Ryzhik, Vice President of Investor Relations and I'm joined this morning by Jerry Colella, our Chief Executive Officer; John Lee, our President; and Seth Bagshaw, our Senior Vice President and Chief Financial Officer. Thank you for joining our earnings conference call.

Yesterday, after market close, we released our financial results for the third quarter of 2019. Our financial results and a schedule of 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 the most recent annual report on Form 10-K for the company, and any subsequent quarterly reports on Form 10-Q.

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.

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

This quarter, revenue was $462 million, which was at the high-end of our guidance range. Non-GAAP net earnings for the third quarter was $62 million or $1.12 per share -- per diluted share, which was above our guidance range. This outperformance was driven by stronger demand within our semiconductor market as well as continued operational and financial execution.

While timing of a full market recovery remains uncertain, we have seen improving conditions complemented by strong execution and product differentiation as evidenced by recent design wins.

Our Advanced Markets remain impacted by macroeconomic headwinds, largely the result of trade uncertainty, export restrictions and softening in consumer electronics demand.

While we expect these headwinds to remain an overhang in the fourth quarter, we're excited about the long-term opportunity for Advanced Markets and we believe our broad portfolio positions us well to benefit from key secular trends such as 5G.

While trade, macroeconomics and the semiconductor cycle may be top of mind for many of us, we remain firmly committed to investing in growth and positioning MKS not just for a cyclical recovery in our markets, but more importantly, for the vast growth opportunity we see ahead.

Key catalysts are expected to underpin MKS' growth in the long term include: explosion in data growth, which drives demand for memory and foundry capacity, we are the key solution provider; complex technology transitions across memory and foundry, which can drive higher content for MKS given our market read and differentiation and product expertise; the impact of 5G on the commercial sector, which is expected to stimulate growth even further, as on-premise, edge and off-premise IT environments grapple with the growth in data, the need to store and process it; the impact of 5G on the consumer sector and the ensuing impact on flex PCB, where MKS is a key beneficiary with a market-leading portfolio; as well as other Advanced Markets including solar, life and health science, research, defense and additive manufacturing where MKS is well positioned to drive secular adoption of lasers, optic components and laser-based systems.

In this content, we remain confident in MKS' position to continue to outperform the long-term semiconductor and Advanced Markets growth rates.

Turning to our Q4 revenue and earnings guidance. We estimate that sales in the fourth quarter could range from $445 million to $495 million. Fourth quarter non-GAAP net earnings per share could range from $0.85 to $1.19 per share. Seth will provide the balance of our fourth quarter guidance in his remarks, and 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 [4]

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Thanks, Jerry. MKS remains well positioned to benefit from secular trends across our semiconductor and Advanced Markets, given our broadening product portfolio, our uncompromising focus on innovation, our strong customer relationships and our disciplined operational and financial execution. The explosion of data and its impact on memory and logic chip demand, combined with the increasing complexity of technology transitions places MKS in an attractive position as a key solutions provider in the semiconductor manufacturing ecosystem.

Moreover, 5G is expected to catalyze data growth even further driving additional demand in the semiconductor manufacturing capacity.

In the third quarter, we benefited from orders arising from our previously announced conductor etch design wins in our power solutions business for 13.56 megahertz RF generators and custom matching networks.

In fact, we've extended our momentum by displacing a competitor with yet another 13.56 megahertz RF power design win, this time for dielectric etch applications. We also secured a number of design wins for our dissolved ozone systems. As we mentioned last quarter, ozone has proven to be an excellent green alternative to chemicals that are used for cleaning in semiconductor and display manufacturing.

MKS has been a leader in this area and our dissolved ozone systems continue to gain traction with key customers. As Jerry mentioned, demand from our Advanced Markets remains constrained due to macroeconomic and trade uncertainty, but we were pleased to secure a series of meaningful laser orders for PCB production as well as across additive manufacturing, solar, OLED applications. In addition, our newest diffraction grating product completed qualification at a large analytical instrument customer, and we've received multiple orders from other life and health sciences customers. Diffraction gratings are used to precisely separate light into distinct wavelengths and are commonly used in many optical instruments.

We remain bullish about the opportunity that lies ahead from laser-based microprocessing applications and are particularly excited about the impact of 5G on flexible PCB, high-density interconnect PCB production, where we expect our optics, photonics, lasers and laser systems to be key beneficiaries. We continue to make excellent progress with our integration of ESI, and in the third quarter, saw continued market acceptance of our flexible PCB laser drilling system. On our prior earnings calls, we highlighted the shipment of beta systems for our new High-Density Interconnect Via Drilling solution to our regional application centers in Taiwan, Japan and China.

The HDI opportunity represents a significant expansion in addressable market for us and we could not be more pleased to announce today that we have received our first HDI purchase order. In addition, we have already shipped beta systems to 2 other customers. Market interest in our offering continues to grow and we remain excited about the long-term growth opportunities for both the flexible and HDI PCB markets.

Before I turn the call over to Seth, I wanted to take a moment to thank Jerry on behalf of everyone at MKS. Jerry, the list of accomplishments while you've been at MKS is impressive to say the least, and I'm fortunate to have been able to serve under your leadership and direction for almost 10 years.

I'm honored to have been chosen to assume the role of CEO starting January 1. You will be missed by everyone here at MKS, but luckily, you're not going too far, and we are excited to work with you in your new role as Chairman.

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. I'll cover our Q3 2019 financial results and discuss our Q4 2019 guidance. Sales for third quarter of $462 million, at the high end of the guidance range, a decrease of 2% sequentially compared to the second quarter. Sales to semiconductor customers were $223 million, an increase of 4% sequentially, as we continue to see the positive signs in the semi market. Sales to Advanced Markets were $239 million, a decrease of 8% sequentially and were impacted by the general slowdown in industrial markets as well as uncertainty caused by global trade tensions. Sales to life and health sciences and research and defense markets remained steady in the third quarter.

52% of our sales were to customers in our Advanced Markets, while 48% were to customers in the semiconductor market, consistent with our long-term goal of achieving a balanced market mix. GAAP and non-GAAP gross margin were 44.3%, [to their] expectations at this revenue volume. Non-GAAP operating expenses were $124 million, which were favorable to the midpoint of our guidance due to the continuing focus of managing our cost structure. Non-GAAP operating margin was 17.6%, which was almost 200 basis points favorable with the midpoint of our guidance range. This continued strong financial performance reflects our ability to effectively manage the company through all phases of the operating cycle.

GAAP operating expenses were $138 million, include $17 million in amortization of intangible assets, $2.1 million in acquisition and integration costs, $1.5 million in restructuring cost and $600,000 in transaction fees associated with the repricing of our term loan. In addition, we recorded a $6.8 million gain from the sale of certain real estate holdings, as we continued to streamline our geographic footprint. GAAP net interest expense was $13.5 million and non-GAAP net interest expense was $10.5 million. Our GAAP tax rate was 14.4% and our non-GAAP tax rate was 15.6%. Tax rates were lower than our expectations due to mix of geographical income, and we expect these rates to return to more normalized levels in the fourth quarter. GAAP net income was $47 million, $0.80 per diluted share and non-GAAP net earnings was $62 million or $1.12 per diluted share.

Integration of ESI acquisition continues to proceed very well and exiting the third quarter, we achieved $12 million annualized cost synergies. We are on schedule to realize the $50 million announced total annualized cost synergies within the next 12 to 18 months. In the third quarter, revenue for the equipment solution division was $49 million, which was also within our expectations.

Now turning to the balance sheet. In September, we successfully repriced our -- we successfully completed our fifth repricing of our term loan, which reduced the interest rate spread on the 2 existing tranches from LIBOR plus 2% and LIBOR plus 2.5% respectively to LIBOR plus 1.75% and combined the 2 tranches into 1 tranche, maturity date in February of 2026. In addition, we made a $50 million voluntary prepayment of principal on our term loan in -- at September 30, with an outstanding balance of $895 million. The most recent voluntary prepayment is our 10th since loan origination in April of 2016.

The repricing and voluntary prepayment reduces our annualized non-GAAP interest cost by almost $6 million based on current interest rates.

Exiting the quarter, we maintained a strong balance sheet liquidity of $475 million of cash investments, $100 million of incremental borrowing capacity under an asset-based line of credit and a modest 12-month net leverage ratio under 1x. Free cash flow for the quarter was $44 million. We continue to demonstrate a balanced approach to capital deployment. And in the quarter, we paid a cash dividend of $10.9 million or $0.20 per share. In terms of working capital, days sales outstanding was 65 days at the end of the third quarter compared to 60 days at the end of the second quarter. The inventory turns were 2.2x or consistent with the second quarter.

Finally, I'll discuss our Q4 2019 guidance. Based upon current business levels, we estimate that our sales in the fourth quarter could range from $445 million to $495 million, and our non-GAAP gross margin to range from 42.5% to 44.5%. The expected gross margin is slightly lower in the fourth quarter due to both seasonally lower volumes and product mix with the equipment solutions division.

We expect our gross margin to return to normalized levels by the first quarter of next year.

Q4 non-GAAP operating expenses could range from $121 million to $129 million. R&D expenses could range from $40.5 million to $43.5 million and SG&A expenses could range from $80.5 million to $85.5 million. Non-GAAP interest expense is expected to be approximately $8.9 million and our non-GAAP tax rate is expected to be approximately 21%.

Given these assumptions, fourth quarter non-GAAP net earnings could range from $47 million to $66 million or $0.85 to $1.19 per diluted share. In the fourth quarter, amortization of intangible assets is expected to be approximately $17.1 million. Integration-related costs are expected to be approximately $1.9 million. Interest income is expected to be approximately $1 million and GAAP interest expense estimated to be approximately $9.1 million. GAAP net income is expected to range from $32 million to $50 million or $0.58 to $0.91 per diluted share or approximately 55.3 million shares outstanding.

I'd like to now turn the call back to Jerry for his final thoughts before we move to Q&A.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [6]

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Thank you, Seth. Before I turn the call over to Q&A, I wanted to share some final thoughts as this will be my last earnings call before I step down from CEO role, effective January 2020 -- January 1, 2020, and then assume the role of Chairman of the Board in May of 2020. As you all know, John will be replacing me as CEO, I could have not asked for a more qualified leader to succeed me. John has been with MKS for over 10 years and has played a significant role in our success. Needless to say, I am very excited about MKS' future.

To comment on the accomplishments over the past 6 years has been astounding, and I'm honored to have led -- had the opportunity to lead such an extraordinary team through this transformation. Over this time, we have tripled our revenue and market cap, delivered a greater than 700% increase in non-GAAP EPS, raised our dividend multiple times, doubled our workforce and acquired 4 companies while aggressively delevering our balance sheet following each major acquisition. If that's not enough, for the third year in a row, MKS was named one of Fortune magazine's 100 fastest-growing companies. I'm also proud to announce that 2 of the 3 winners of the 2019 Nobel Prize in Physics use our proprietary gratings to discover the first planet orbiting a star other than the sun.

This gives new meaning to the term, "Reach for the stars," and I cannot wait to see John take this company to new heights. This concludes our prepared remarks. We'd like to turn the call back to the operator for Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question coming from the line of Sidney Ho from Deutsche Bank.

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Sidney Ho, Deutsche Bank AG, Research Division - Director & Senior Analyst [2]

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Jerry, it's been very nice working with you, so you definitely will be missed. So my first question is as I look at the 4Q guide, what is the relative growth rate by segment baked in your guidance? I think I can guess directionally. But I just want to get a sense about the magnitude and whether there is some more downside in the Advanced Markets.

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John T. C. Lee, MKS Instruments, Inc. - President [3]

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Sidney, it's John. So we are looking at high single-digit quarter-to-quarter growth rate in the semi market. I think that's consistent with probably what you've heard on -- with other customers. And it could be higher than that. But that's what we see right now. And actually, for Advanced Markets, it is down about $10 million, but all of that is due to the seasonality of the E&S division. So their Q4 is usually the seasonal low because of the cyclicality of that market. But the other part of it is the Light and Motion business, the Advanced Markets actually is steady quarter-over-quarter. And we're actually pretty happy with that given all the uncertainty in the tariff wars and the macroeconomic kind of issues. So hopefully, that gives you a little more color on how we look at the Advanced Markets ex ESI, with ESI, and semi.

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Sidney Ho, Deutsche Bank AG, Research Division - Director & Senior Analyst [4]

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That's good. That's great. My follow-up question is, I think last quarter you guys had alluded to some positive discussions with your semi customers, which seems to have materialized. Can you give us a little sense about when you started to see that kind of inflection of demand? How broad-based that demand uptick was? And then finally, it's -- I guess, when revenue started coming down a few quarters ago, you were negatively impacted by your customers cutting inventory. Do you expect them to start building inventory again as the business starts coming back?

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

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Sidney, it's John, again. I think certainly, when our customers see a ramp, they will start building inventory. That's normal. That's part of the nature of the semi industry. We started seeing the uptick in orders probably in the middle of the quarter, middle of Q3. But a lot of it -- and we've thought a lot of it was driven by foundry and logic, and I think that was still consistent with that thinking. I think what we're seeing now is a little bit more additional upside now with a little bit of VNAND as well. So that's kind of what we're seeing today.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [6]

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This is Jerry. I'd like to also, though, go back to amplify the commentary about the Advanced Markets, so I can bring people back to our historical performance, which, to me, is an indication of the future. So for about a 13-year-or-plus period, we had 8% compounded annual growth rate on the Advanced Markets. In '17 and '18, we saw about a 14% growth rate. So we have no -- we still abide by our model of 2x the growth rate of those markets, and we believe that some part of this issue is also reflected in the China trade issue.

We have customers coming to us saying it's not a matter of if, it's a matter of when. Perhaps some of their orders are a bit muted comparative to what they normally would be approaching us with orders. So besides sort of seasonality, we do think there's some impact and with the good news coming out of, hopefully, this geopolitical issue will abate over time. And we expect to see our growth rate to go back to normalized numbers. So I'd just put a little context on Advanced Markets, so as we don't put a pall over that business.

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Sidney Ho, Deutsche Bank AG, Research Division - Director & Senior Analyst [7]

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Wonderful. Last question, if I could. Seth, you guided to gross margin being 42.5% to 44.5% in Q4 and you said things will kind of get back to normal levels in Q1. Just if I look at 2020, how should we think about the gross margin progression?

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [8]

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Yes. So Sidney, what I would say is, again, if you take the midpoint of the guidance in the fourth quarter at $470 million revenue, again, I think normalized that'd be at least a point north of we're currently at midpoint. So I think that's a good jumping-off point. And then what I would say is our model again has been the 50% variable gross margin on revenue increase. That's still the assumption going forward. I think I -- that's what we use internally, obviously.

And the other wild card, which would be -- it's hard to quantify, but it's actually helpful on the upside is, right now, all our factories are running at relatively lower levels based on historical activity. So what happens is business comes back and you start generating more throughput to the factories, the absorption gets better as well. That would be additive to some level to what I just gave you for a model. That's my expectations going forward.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [9]

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And then on top of that, as you know, 6 years ago, we started a team called the profit and cash recovery team, which has led to the increase in the EPS that we talked about earlier. Those teams still exist. They meet every month. John Lee leads them. There's more work that they continue to do to pursue a higher profitability to the company. There is also still a large segment of our business that we are moving to a low-cost region, which, over time, will improve the profitability of the business. So we haven't taken our foot off the pedal of improving the profitability of the company going forward. And John Lee has been leading that charge and he will continue to push forward on things like low-cost country migration, supply chain maximization, all the things we've done in the last 6 years, that will continue.

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Operator [10]

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And our next question coming from the line of Amanda Scarnati with Citi.

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Amanda Marie Scarnati, Citigroup Inc, Research Division - Semiconductor Consumable Analyst [11]

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The first question is on the ESI side of the business. Can you talk a little bit about what normalized revenues look like in this business now that they've come down a little bit? And how much of the revenue today are you seeing already from 5G? And how should that kind of track going forward?

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John T. C. Lee, MKS Instruments, Inc. - President [12]

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Amanda, it's John. So ESI will probably end the year pro forma around the $200 million and as I think we've talked about in the past, 2019 was a low year because of the overcapacity over by 2 of the primary markets meaning flex and the MLCCs in 2018. So going forward, I think we would expect that to be a bit higher. It all depends on, I think, a little bit about how much more inventory burn off there is in flex. But we're excited about the fact that our new flex tool, CapStone, is -- continues to receive very favorable results from our customers. Our HDI business, we -- as I mentioned on the call, we have some very positive results today, and we expect that to be additive since we have no market share in that business.

With respect to your question on 5G, I think some of the phone makers that are making 5G phones obviously have their subcontractors using our tools to make flexible PCBs for 5G. I think as 5G continues to grow in market share, we know that the content of flex PCBs and MLCCs in 5G is significantly higher. And so we expect that to continue to grow. I think there is a tailwind. I think everybody's a bit surprised that 5G looks like it's going to be adopted at a faster pace in 2020 for sure than the industry had thought maybe even just 90 days ago. So I think that's a nice tailwind for us. Going forward, we expect that to continue to be more adopted by our customers of ESI.

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

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And then on the semiconductor side of the business. Can you just remind us what your percentages are of revenue to the memory side of the business, NAND and DRAM versus logic and foundry, if you've broken that out in the past? And just sort of what you were seeing in terms of orders this quarter? You saw some nice revenue in the semiconductor business. And was that mostly tied to that sort of foundry CapEx boost that we saw over at TSMC?

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John T. C. Lee, MKS Instruments, Inc. - President [14]

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Yes, Amanda, this is John, again. I think for sure, we thought that the Q3 bump that we started seeing the pickup, that was pretty much tied to the foundry -- logic and foundry picking up their CapEx spend and then that flowing through the OEMs. It's been difficult for us to figure out how much is memory, how much is logic because we're sending tens of thousands of all kinds of parts to the OEMs and then they're put on all kinds of tools going forward. But I think from a macroeconomic standpoint, we could see that the pickup in Q3 was foundry-driven, and we are guiding to be a little higher, obviously, in Q4 because foundry will continue to be strong, but we also, as I said, see that VNAND, at least some initial buys of VNAND could also be -- will be an upside to the CapEx spend.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [15]

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I think to add a little additional color to that too, is one of our largest customers surged with us over the last several years and they're very well positioned on the memory side of the business. We're then surging into the #2, then the #1 spot, would give you a good indication of the position MKS has in memory when NAND comes back. So expect to see acceleration through the foundry work and then once memory continues to accelerate, that should be a good positive effect for MKS over time.

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Amanda Marie Scarnati, Citigroup Inc, Research Division - Semiconductor Consumable Analyst [16]

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I just want to clarify, John, one thing that you said that NAND then could be upside in December quarter, so you're not sort of building that into expectations at this point that any sort of a [strand] is coming back?

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John T. C. Lee, MKS Instruments, Inc. - President [17]

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No, we have built it in. So we already have built in the upside in -- on NAND.

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Operator [18]

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And our next question coming from the line of Patrick Ho with Stifel.

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Patrick Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [19]

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First off, I want to just take a moment also to congratulate you, Jerry, for the work at MKS for many years, but, particularly, the last 5-plus years as CEO, I think, the company has really transformed itself and obviously as the leader of the company, you should get a lot of credit for that.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [20]

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Thank you. I have a great team, by the way, just to let you know. Same people that will be here after I'm gone. But thank you, Patrick, I appreciate that.

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Patrick Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [21]

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Just like the Patriots, I assume, right?

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [22]

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That's -- yes, it's Belichick and Brady, not just Belichick, just to let you know. Everybody else does a good job.

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Patrick Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [23]

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Let me start off first on the semi side of things. Some of the share gains that you talked about on the call, particularly in the power solutions, but other areas, I think I've seen in press releases and the mass flow controller side of things, are these applicable to tools that are being delivered in volume today for this upcoming up-cycle or are these more on future nodes where you'll see the higher volume adoption?

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

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Patrick, it's John. So let me just speak to the RF power part. We talked about several design wins over the last few quarters on conductor etch and what we said today was that some of those initial design wins are now turning into volume orders. So and some other design wins have not yet and so it's a mix, but this is the first hopefully ramp where some of our conductor etch design wins that we've talked about over the last 6 quarters are turning into volume. And we expect that the other design wins that have not turned into volume will eventually, perhaps the next cycle or this cycle, but this is the first quarter we're seeing those volume orders for conductor etch design wins in the past.

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Patrick Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [25]

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Great, that's helpful. And maybe following up on the Light and Motion business that you mentioned was holding steady. Can you just remind us about some of the differentiation in that business and the markets you serve relative to the broader industrial market where there is clearly weakness, say, in the fiber laser market in terms of the industrial segment? Can you just, again, remind investors about, I guess, the diversification and some of the different marketplaces your types of lasers serve?

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John T. C. Lee, MKS Instruments, Inc. - President [26]

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Sure, Patrick. So we've talked about in the past, when we talk about industrial lasers, we're talking about microprocessing. So the powers are lower. This is in contrast to macroprocessing, where the power -- the laser power is in the tens of kilowatts. But just because the power is lower, it doesn't mean it's easier to do. It's actually more difficult because we're actually pulsing. And so this is the kind of finesse manufacturing that is allowing people to, for instance, make next generation of flexible PCBs for iPhones or to use these lasers to get another 1% efficiency of solar cells or to cut OLED displays. And so this is the kind of broad-based microprocessing -- industrial laser microprocessing market that we address. And so the other part of it was the high-power macroprocessing market, and we do participate in that with power meters and diagnostics, but we do not make those lasers.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [27]

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Patrick, also I think the other thing I'd like to add to that is more of the thesis and strategy between a Newport Light and Motion and ESI, is that we are excited about the technical collaboration between some of the best laser development minds and people who use them in the systems side of the business. And the fact that we can understand the applications in the systems side of ESI and we can develop lasers that will help them differentiate themselves as well as they can provide technical feedback back to the Light and Motion laser equipment group and the people that have developed those lasers to create more technical operation differentiation to the other providers of lasers. So beyond just the current set of business that we see, we're excited about the collaboration and the opportunity to continue to differentiate both companies with collaboration on the design and application of lasers. I don't want that to get lost, that's a key point of that -- both of those companies.

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Patrick Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [28]

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Great. That's helpful. And maybe as a final follow-up question for John, I know earlier this year, at Photonics West, you talked about some of the introduction of new complementary products, especially for the Light and Motion business and how you, "We're going to surround the workpiece." One, can you give us an update on the traction of some of those products as well as some of the, maybe qualitatively, what else you're working on that you plan to introduce to further, "Surround that workpiece?"

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John T. C. Lee, MKS Instruments, Inc. - President [29]

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Yes, I think one of the biggest gaps we had in completing the Surround the Workpiece strategy was our laser portfolio. So while we've seen a lot of success in our laser group, we still did not address the picosecond segment of lasers. And so we've talked about 2 releases of the picosecond lasers this year, one at 25 watts and one at 50 watts. And so those are gaining good traction right now and so that's another area that we'll probably be able to talk about more going forward, especially as Photonics West rolls around again.

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Operator [30]

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(Operator Instructions) And our next question coming from the line of Krish Sankar with Cowen and Company.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [31]

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Jerry, congrats on a terrific career. As everybody else mentioned, you'll definitely be missed.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [32]

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Thank you.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [33]

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I had three questions. All three on market share, either for Jerry or John. You guys spoke about how December quarter semis is going to be up sequentially like high single digits. How much of that is driven by the conductor etch market share? Is there a way to segment it by saying, we thought that when you'd be flat or down, is there any kind of color on that?

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John T. C. Lee, MKS Instruments, Inc. - President [34]

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Krish, it's John. No, I don't think we'd say the conductor etch market share win is driving all that. I think it's really the broader base -- the broader base industry, semiconductor industry moving up because, as you know, we have a -- the broadest portfolio of products. So pressure is going up, flow is going up, valves is going up, plasma is going up, and power is going up. So it's not driven all by one particular segment.

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

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Got it. Got it. And then just as your customers drew down their own inventory or the recent down cycle, do you expect they're going to start building up inventory? And if so, is that imminent? Do you think it's a Q4, Q1 event? Or do you think they're going to be more cautious in their approach building up inventory as the cycle approaches?

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

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Yes, well, the history says, Krish, that they always build up inventory fast and to your point, we believe that will happen in Q4 and Q1 because of some of the end-user announcements of what they expect to spend CapEx, and that's pretty much all the visibility we can have. Now of course, some folks think that the first half will continue into the second half, but as you know, predicting semi CapEx is a fool's errand. So we'll just be fast, but we do expect that there will be a buildup of inventory to support shipments in Q4 for our OEM customers and shipments in Q1 for our OEM customers.

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

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And customers have signaled that to us already.

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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. Just two quick questions. One on ESIO. The HDI PCB, you spoke about a new order. If I remember right then ESI will stand alone, the HDI market share was under like 2% or 3%. Is that still the case? And where do you think your HDI market share for PCBs would be exiting a year from now? Then I have a quick follow-up.

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John T. C. Lee, MKS Instruments, Inc. - President [39]

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Yes, Krish, so it was probably under 2%, how's that for market share of HDI? So we kind of look at it as 0 because they had an older tool addressing HDI that's been obsoleted a while ago -- many years ago. So it was really legacy stuff. This is a new tool, addressing the $500 million HDI market. So we today have 0 market share. And that new first order, by the way, was with a customer that didn't even take a beta site. Usually, you take a beta site, you try it for a while and you pay for it and you order more, and we have 2 of those customers. So there's 2 separate individual customers in Asia that we have already shipped beta tools to. So they'll be trying it out in their fabs for the next 3 to 6 months.

By the way, we also have line of sight to a few more this quarter, beta shipments, and we'll update you on that at the next quarter's call. But this other customer, quite unique. I'll give you a little more color. So they give us a PO, we'll be shipping them the tool soon, but they're a materials developer. Meaning, they are developing materials for next-generation HDI PCBs. And for us, that's very strategic because, if and when they're successful, when other customers say, okay, let's use your material, they're going to ask how do you process it? How do you drill holes in it? Well, obviously, they will have a recipe and proof with our tool at that point.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [40]

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Got it. Got it. That's very helpful, John. And then just the final question on the Newport industrial laser business. Is that recovering? Is the business going to be driven primarily by macro China recovery? Or are there any market share-related headwinds or competitive challenges we need to worry about?

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John T. C. Lee, MKS Instruments, Inc. - President [41]

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Well, there's always competitors, Krish. But we've actually been taking share over the last couple of years in our lasers for that microprocessing industrial. So I think it's -- our view is that it's mostly constrained by the geopolitical issues and the trade war.

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Krish Sankar, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [42]

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Congrats, again, Jerry.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [43]

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Thanks, Krish.

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Operator [44]

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Our next question coming from the line of Tom Diffely with D.A. Davidson.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [45]

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Jerry, it's been a pleasure working with you and good luck in your next role as Chairman. But I'm guessing it's not going to be a hands-off role.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [46]

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Well, you'll have to ask this team. That's why when John said, I'll be missed, I said, yes, probably by some people, not by a lot of others. So we'll see.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [47]

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Yes. John, I wanted to ask one more question on HDI. It seems like a really big opportunity here. What is driving -- what drove your win and what do you think is going to drive your wins going forward? Is it speed, accuracy? What does your tool have?

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John T. C. Lee, MKS Instruments, Inc. - President [48]

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Tom, I think what we already -- what we had designed the tool for was a 20% to 30% increase in productivity, so speed at the same accuracy, relative to what was already out there. And so I think that's why we're seeing this initial strong interest for it. Additionally, though, as you get into developing recipes, we're starting to see there could be other advantages to how we drill a hole. So -- but the primary differentiator is a 20% to 30% improvement in throughput. So that's a huge cost of ownership for our customers. And then over time, it seems like we'll be developing new recipes with the flexibility that we have in how we've designed the laser and that should allow us perhaps other advantages going forward. And as you can imagine, we're not stopping there. There are other ideas and things being tried already in our development labs to move the HDI process forward even faster or to smaller dimensions or more accuracy than what's already out there today.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [49]

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Well, to add to that too, Tom, the -- our competing tool on HDI is about 8% lighter than the competing tool and about 1/3 less square -- area of square foot in the factory environment. So as John has mentioned, it's also faster and a lower cost of ownership, it's actually smaller and lighter, which is helpful as well.

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

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Yes. And when people ask what's weight got to do with it, we have a large operation in China and you don't really get to expand horizontally. You have to expand vertically. And having a tool that's significantly lighter in weight means that you don't have to have just go on the first floor to install, you're now talking about second and third floor of main fashion operations, which is, believe or not, a big deal in terms of the square footage that's allowed in China.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [51]

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Okay. And what are the buying cycles like in that space? I mean is -- do you have to wait for capacity needs to open up? Or is it technology-driven? How -- when do your customers become right for you to have an insertion point?

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

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It's -- I think it's a similar buy cycle as flex PCB because you can imagine a lot of consumer products use both, right? And so we look at as the first half of a year is usually when the end-users, the iPhone maker, the other smartphone makers start awarding contracts to the subcons. And that's when the subcons know how much capacity they're going to need and that's when they start ordering. So usually we see orders kind of end of Q1 then through Q2 and then there's certainly some follow-on in Q3 for any extra capacity and that's the kind of cyclicality. And then Q4, as we talked about, it is a PCB cyclical low and that's why we talked about that earlier.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [53]

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Okay. And one more question on the flex side. We've heard from other suppliers that there's 2 big drivers, there's moving to the most advanced technologies, which increases complexity, but there is also the kind of the tail of the older phones moving to the more advanced phones, that upgrade cycle. Even though they're not new technologies, it's a higher use of the technologies. And so that's also a pretty good driver. I'm curious on your flex side, over the next couple of years, do you see that second point as being a nice driver of capacity for you?

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [54]

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It could be, but probably in a secondary fashion. So a secondary supplier of PCB is maybe using some of the older tools that they had been using for advanced smartphones, for instance, now. Maybe 2 or 3 years from now, they'll be using it for the older phones. And then that does open up capacity for more advanced flex PCBs for the newest phones. So we haven't really thought about that as precisely as you've thought about it, Tom. So that could be a tailwind, but we haven't analyzed that quantitatively yet.

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Thomas Robert Diffely, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [55]

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Okay. And then Seth, finally, just on the R&D side, guys, going forward, is the gap in R&D based on something like beta sites or tools going out the door? What's the $3 million difference there?

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Seth H. Bagshaw, MKS Instruments, Inc. - Senior VP, CFO & Treasurer [56]

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Just -- it could be just normal fluctuations in R&D spending, Tom. It's nothing that's uniquely tied to any particular product or R&D effort. It can bounce around a little bit. It's -- a fair amount of R&D spending is material-based, which, kind of, comes in lumpy fashion. So that's probably what's driving the difference, quite honestly.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [57]

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Yes. Sometimes, Tom, we will be building a lot of new units, let's say, for our power, there would be materials charged to R&D. You ship it and then, of course, then they kind of rolls into cost and that can be very lumpy.

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

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Congratulations, Jerry.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [59]

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Thank you.

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Operator [60]

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And I'm not showing any further questions. I would now like to turn the call back over to Jerry Colella for any closing remarks.

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Gerald G. Colella, MKS Instruments, Inc. - CEO & Director [61]

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Okay. Well, thank you. We are pleased with our results for the third quarter of 2019 with another quarter of strong operational and financial execution, which drove our top and bottom line outperformance. And we're confident that our exposure to diverse end markets and the strategy that we've put in place have positioned us for long-term success. Lastly, I want to thank you for joining us on the call today and for your interest in MKS. I have enjoyed working with many of you as CEO. I look forward to watching the company reach new heights as Chairman. We look forward to updating you on our progress when we report our fourth quarter 2019 financial results. Thank you.

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Operator [62]

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Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.