Q4 2023 MKS Instruments Inc Earnings Call
Participants
David Ryzhik; VP of IR; MKS Instruments, Inc.
John T. C. Lee; President, CEO & Director; MKS Instruments, Inc.
Seth H. Bagshaw; Executive VP, CFO & Treasurer; MKS Instruments, Inc.
James Andrew Ricchiuti; Senior Analyst; Needham & Company, LLC, Research Division
Joseph Michael Quatrochi; Senior Equity Analyst; Wells Fargo Securities, LLC, Research Division
Krish Sankar; MD & Senior Research Analyst; TD Cowen, Research Division
Steve Barger
Presentation
Operator
Good day, and thank you for standing by. Welcome to the MKS Instruments Fourth Quarter and Full Year 2023 Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded.
I would now like to hand the conference over to your speaker today, David Ryzhik, Vice President of Investor Relations. Please go ahead.
David Ryzhik
Good morning, everyone. I am David Ryzhik, Vice President of Investor Relations, and I'm joined this morning by John Lee, President and Chief Executive Officer; and Seth Bagshaw, Executive Vice President and Chief Financial Officer.
Yesterday, after market close, we released our financial results for the fourth quarter and full year 2023, which are posted to our investor website at investor.mks.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 annual report on Form 10-K for the year ended December 31, 2022.
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.
During the call, we will be discussing various financial measures. Unless otherwise noted, all references to combined company financial measures reflect the 2022 combined results of MKS and Atotech Ltd, which MKS acquired on August 17, 2022. Also, unless otherwise noted, all income statement-related financial measures will be non-GAAP other than revenue.
Please refer to our press release and the presentation materials posted to the Investor Relations section of our website for information regarding our combined company results, non-GAAP financial results and a reconciliation of our GAAP and non-GAAP financial measures. For a detailed breakout of reported and combined company revenues by end market and division, please visit our investor website.
Now I'll turn the call over to John.
John T. C. Lee
Thanks, David. Good morning, everyone, and thank you for joining us today. MKS delivered solid results in 2023 against a challenging market backdrop. For the full year, we delivered revenue of $3.6 billion, adjusted EBITDA of $863 million and net earnings per diluted share of $4.43.
Our performance highlighted the resilience of our business. We faced headwinds from a softer demand environment in our Semiconductor and Electronics and Packaging markets, but we generated solid profitability due to a combination of prudent cost controls and the underlying strength of our broad portfolio of proprietary solutions.
We appreciate the continued support of our customers, who rely on MKS to solve their toughest challenges, and on our employees who worked relentlessly to deliver on the MKS promise.
Our results also reflect our first full year operating with Atotech as a combined, more capable global company. The addition of Atotech's industry-leading chemistry and plating equipment solutions have expanded our broad range of capabilities and provided us with a higher mix of consumables and services revenue. We are on track to achieve our targeted cost synergies from the Atotech acquisition.
I'm also encouraged with the progress we made in 2023 in positioning for future revenue opportunities as our Electronics and Packaging teams are actively engaged with key customers on their next-generation designs for advanced package substrates, a critical enabler for new applications such as artificial intelligence.
Most industry observers expect a recovery in our end markets to slowly unfold in the second half of this year. We have established ourselves as a critical enabler of advanced electronics, with our foundational solutions for the semiconductor and electronics and packaging markets.
By staying focused on our innovation roadmaps, controlling costs, managing our balance sheet and driving design wins with key customers, we are positioning MKS to generate attractive growth and value creation in the years ahead.
Now let me discuss our fourth quarter results in more detail. We delivered revenue of $893 million, adjusted EBITDA of $218 million and net earnings per diluted share of $1.17, all above the high end of our guidance range.
Revenue from our Semiconductor market exceeded our expectations, as we saw better-than-expected demand in certain product categories such as plasma and reacted gas and analytical controls solutions. That offset a continued muted demand environment for our vacuum solutions for deposition and etch applications, due to the industry downturn in NAND equipment spending, which remains at historically low levels. Demand for our photonic solutions for lithography, metrology and inspection applications remained robust. In 2023, this business grew on a year-over-year basis and exited the year at more than 20% of our overall semiconductor revenue. Photonics Solutions remain an important area of investment for MKS, and we expect it to be one of the key growth drivers for our semiconductor market in the years to come.
As we look to the first quarter of 2024, we expect revenue in our [semiconductor] market to be down sequentially from our better-than-expected fourth quarter, as overall demand remains muted. While customer inventory levels of some of our product categories have eased, we expect continued drawdown in categories tied to memory spending.
Turning to our Electronics and Packaging market. Revenue was slightly better than expected due to the lumpiness of certain laser drilling equipment sales. Overall demand remained stable but muted, consistent with PC, smartphone and server production volumes. That said, the long-term growth drivers for our Electronics and Packaging markets remain as strong as ever.
We frequently discussed how the trends of miniaturization and complexity are moving from semiconductors to other critical components of advanced electronic devices, including packaged substrates, which are a key building block of advanced packaging architectures.
There are many packaging architectures enabling today's cutting-edge applications of which TSMC's chip-on-wafer-on-substrate architecture or CoWoS is one. Let me walk you through about MKS, as a foundational enabler to that architecture.
For the COW, which represents a chip-on-wafer, we have a leading portfolio of critical subsystems across deposition, etch, lithography, metrology and inspection applications that are integral to the manufacturing of individual semiconductors as well as bonding these individual semiconductor chips to each other. We also have a small but growing chemistry business for this application.
These stacks of chips are then packaged on top of a silicon interposer, which is the W or wafer, which is then integrated on a package substrate. This last step represents the O and the S in CoWoS.
MKS has leading expertise in laser drilling, chemistry and plating equipment that addresses more than 70% of the critical process steps to manufacture these package substrates.
Similar to transistor scaling for semiconductors, the lines, the spaces and the interconnecting views of a package substrate are getting smaller. The size of the substrate is getting larger, the number of layers in each package continue to increase. All of these creates more complexity and miniaturization, and MKS is uniquely positioned with the broadest portfolio to help our package substrate manufacturing customers meet these challenges.
As we look to the first quarter of 2024, we expect revenue from our Electronics and Packaging market to be down slightly on a sequential basis, primarily due to typical seasonality associated with the Chinese New Year.
Turning to our Specialty Industrial market. Revenue was slightly weaker than expected, primarily due to modest softness in demand for research and defense applications. As we look to the first quarter, we expect demand trends in our Specialty Industrial market to remain stable, with revenue to be relatively in line with fourth quarter levels.
As a reminder, we leverage our R&D investments in our Semiconductor and Electronics and Packaging markets to drive incremental revenue opportunities in our Specialty Industrial market, which is a more stable business with good margins and cash flow.
Wrapping up, I want to thank the entire MKS team for their passion, dedication and resilience this past year. In addition to weathering a softer end market backdrop, the MKS team worked tirelessly to resume normal production and deliver for our customers, as we recovered from the ransomware event in the first quarter of 2023. The strength of our team and our culture is reflected in the industry accolades we received during the year, including being named to U.S. News and World Report's inaugural Best Companies to Work for in the industrials and business services industry list, as well as being named by Newsweek and Statista as one of America's most responsible companies for 2024.
Finally, before I hand the call over to Seth, I want to thank him for his dedication and service to MKS, and to congratulate him on his upcoming retirement. Seth has a long and distinguished career at MKS. He has been instrumental to our growth and transformation. Seth's foresight, financial stewardship and ability to navigate complex financial landscapes have earned him the admiration and respect of all who have had the privilege of working alongside him.
Our search for his replacement is well underway. We look forward to updating you when we have named our next Chief Financial Officer.
And now I'd like to turn the call over to Seth.
Seth H. Bagshaw
Thank you, John. Before I discuss our results and outlook, I just want to say a heartfelt thank you to the entire MKS team, as well as our shareholders for their support and partnership in the past 18 years. It has been a privilege to serve as Chief Financial Officer of MKS. I am proud to have been a part of the company's substantial growth and transformation over that period.
MKS has strong operating model and a unique position to capitalize across a number of attractive secular growth opportunities, leaves me very excited about the company's future and I look forward to following MKS' continued success.
Let me now cover our fourth quarter and full year results and provide some thoughts on our first quarter of 2024. Starting with the fourth quarter, we delivered revenue of $893 million, above the high end of our guidance range, primarily due to [than] expected revenue from a Semiconductor and Electronics and Packaging markets.
Revenue was down 4% sequentially and down 18% year-over-year.
Turning to our end market results. Fourth quarter semiconductor revenue was $362 million, declining 1% sequentially and 28% year-over-year. Fourth quarter electronics and packaging revenue was $226 million, a decrease of 7% sequentially and 15% year-over-year. Excluding the impact of foreign exchange in palladium pass-through, fourth quarter revenue declined 9% on a year-over-year basis.
Moving to our specialty industrial market. Revenue in the fourth quarter was $305 million, down $0.05 sequentially and down 3% year-over-year. Excluding the impact of foreign exchange in palladium pass-through, fourth quarter revenue declined 3% year-over-year. In the fourth quarter, consumables and services revenue across our 3 end market categories comprised 41% of our total revenue.
Turning to our margins. We reported fourth quarter gross margin of 46%, exceeding the midpoint of our guidance range. The more favorable gross margins were a function of unexpected volumes as well as favorable product mix. Our healthy gross margins reflect the value of technological capabilities and the complex problems we solve for our customers.
Fourth quarter operating expenses were $229 million, below the low end of our guidance range, due to strong cost control, even though we had better than expected revenue. Fourth quarter operating margin was 20.3%, well above the high end of our guidance range due to higher revenue, favorable mix and prudent cost control, resulting in robust operating leverage.
We continue to work toward our cost synergy targets with Atotech. We exited the fourth quarter, delivering almost $50 million of annualized run rate cost synergies, on track to achieve our cost synergy target of $55 million exiting the second quarter of 2024.
Fourth quarter adjusted EBITDA was $218 million, also above our guidance range. Adjusted EBITDA margin was 24%. Net interest expense for the fourth quarter was $76 million, lower than anticipated due to more favorable interest rates relative to our expectations.
Our tax rate for the fourth quarter was 16%. Net earnings for the fourth quarter was $78 million or $1.17 per diluted share.
Turning to our balance sheet and cash flow. We exited the fourth quarter with more than $1.3 billion in liquidity, including cash and short-term investments of $875 million and an undrawn revolving credit facility of $500 million. We exited the quarter with gross debt of $5 billion. And last month, we successfully completed the refinancing of our $744 million secured Tranche A term loans by raising incremental secured U.S. dollar in euro Tranche B term loans.
As a result of the refinancing, we extended maturity of the refinance debt to 2029, consistent with our existing Tranche B term loans. It eliminated the financial maintenance covenant that applied, while our Tranche A term loan was outstanding.
Based on current interest rates, we also expect the refinancing result in modest interest savings.
In addition, we made a voluntary debt prepayment of $50 million earlier this month, following the $100 million voluntary debt prepayment we made in the fourth quarter. We continue to prioritize deleveraging our balance sheet while managing the cash and investment needs of the business.
In this context, it's worth noting that the first quarter typically has lower free cash flow due to timing of variable compensation payments. Our net leverage ratio exiting the fourth quarter was 4.7x based on trailing 12-month adjusted EBITDA of $863 million. For the fourth quarter, free cash flow was $146 million and unlevered free cash flow was $194 million.
Consistent with prior quarters, we made a dividend payment of $15 million or $0.22 per share.
Moving to full year 2023 results. Revenue was $3.6 billion, down 19% year-over-year on a combined company basis. Semiconductor revenue totaled $1.48 billion, declined 28% year-over-year due to a decline in global semiconductor capital equipment spending. The largest driver of that decrease was a significant decline in NAND spending, where we are a key enabler with certain subsystems such as RF power generators for high aspect ratio etching.
Electronic and Packaging revenue was $916 million in 2023, down 19% year-over-year compared to combined company results in 2022. Excluding the impact of foreign exchange in palladium pass-through, Electronics and Packaging revenue declined 13% on a year-over-year basis.
Within Electronics and Packaging market, total chemistry sales declined 10% year-over-year on a combined company basis. When excluding the impact of foreign exchange in palladium pass-through.
Specialty Industrial revenue was $1.23 billion in 2023, down 4% year-over-year on a combined company basis. Excluding the impact of foreign exchange in palladium pass-through, sales declined 2% year-over-year.
In 2023, the revenue split between our Semiconductor, Electronics and Packaging, Specialty Industrial markets was 41%, 25% and 34%, respectively. For the full year, gross margin was approximately 46% and operating margin was approximately 20%. Again, that performance is a reflection of the value of our proprietary and differentiated technology as well as disciplined cost management. We are pleased with execution on margins, given the lower level of revenue due to broader industry softness.
Turning to cash flow. We generated operating cash flow of $319 million and free cash flow of $232 million. Furthermore, we generate unlevered free cash flow of $473 million or [30%] of total revenue.
We are pleased with the strength of the underlying cash generation in our business, despite a challenging demand environment in our end markets, as well as the ransomware event in the first quarter of 2023. As our end markets recover, we expect cash generation to improve, which will enable us to accelerate our debt paydown.
Now let me turn to our first quarter outlook. We expect first quarter revenue of $840 million, plus or minus $40 million. By end market, our outlook is as follows: revenue from our semiconductor market of $330 million, plus or minus $15 million. Revenue from electronics and packaging market of $210 million, plus or minus $10 million; and revenue from our specialty industrial market of $300 million, plus or minus $15 million.
Based on anticipated product mix and revenue levels, we estimate first quarter gross margin of 45.5%, plus or minus 1 percentage point. For the first quarter, we expect operating expenses of $240 million, plus or minus $5 million. Sequential increase was due to typical increase in fringe expenses, so we'll continue investments into the business.
While operating expenses can fluctuate due to underlying business levels, we believe a $240 million to $250 million quarterly run rate is a reasonable estimate to think about OpEx for the balance of 2024. We'll also continue to manage our cost structure carefully.
For the first quarter, we estimate adjusted EBITDA of $182 million, plus or minus $22 million. For the first quarter, net interest expense expected to be $78 million, reflecting current interest rates, our recent refinancing and the $50 million voluntary prepayment we made earlier this month.
For the first quarter, we expect our tax rate to be approximately 24%. However, for the full year, we expect our tax rate to be approximately 20%. We are very pleased with execution optimizing our tax rate following the close of the Atotech acquisition in August of 2022. In fact, absent any tax -- any change in tax legislation, we now expect our long-term tax rate to be approximately 19% to 21% compared to a tax rate of 25% to 27% represented in our long-term financial model at our 2022 Analyst Day. Given these assumptions, we expect first quarter net earnings of $0.72 per diluted share, plus or minus $0.25.
In closing, we performed well navigating through sickle softness in our end markets by focusing on what we can control. We maintained strong gross operating margins. We prudently manage our cost structure, while remaining aggressive on product innovation. We significantly lowered our tax rate through a series of tax planning initiatives. We optimized our balance sheet by extending certain debt maturities, and simplified our debt structure by eliminating the financial maintenance covenant that applied to our existing debt. We reduced our cost of debt through repricing our USD Term Loan B. We maintained strong liquidity as we manage through a sickle down -- slowdown. And finally, we deployed more than 80% of free cash flow to debt paydown.
All these actions have made MKS a stronger company. We're well positioned to capture long-term secular growth opportunities we see across our portfolio and translate that into attractive value creation for our shareholders.
With that, operator, you can now open up for Q&A.
Question and Answer Session
Operator
(Operator Instructions) Our first question comes from Joe Quatrochi with Wells Fargo.
Joseph Michael Quatrochi
Maybe first, just to start, as we kind of think about total revenue and your guidance for the first quarter and think about the seasonality for some of the businesses your end markets, how should we think about, I guess, the rest of the year, do you view the March quarter as kind of the low point of revenue for the year?
John T. C. Lee
Joe, it's John. I'll take that. As you know, we only guide one quarter out. Visibility is limited as usual. But we certainly read the same things you do, and we're certainly in constant contact with our customers. And I think our view is consistent with the industry, meaning the first half is kind of consistent with current levels, kind of with our guidance. And then certainly, the industry feels that the second half can be a little better. And our focus is really to continue to do the R&D for the future projects with our customers.
And so as you know, MKS has always been very lean and able to react very quickly to any changes in those assumptions. So we are looking at a first half that's kind of consistent with what we just talked about and guided for Q1.
Joseph Michael Quatrochi
Got it. That's helpful. And then just as a follow-up, I think in the past, you guys have talked about the number of MKS plus Atotech opportunities in your pipeline. And I think a lot of them have still been kind of driven by Atotech. But just kind of curious just as we turn over the new calendar year, if there's any update there on the number of opportunities there? And then maybe any color on just the number that are being driven by MKS?
John T. C. Lee
Yes, sure, Joe. So we've kind of alluded to double-digit numbers of customer opportunities at different customers, double digit. And that's remains the same. As you know, the development and work with the customers takes time, because we're working on the next-generation package substrates with these customers.
As you know, Atotech has leading industry market share in that space and the top 30 customers are their customers. So the majority of it is the synergy of Atotech and those relationships, bringing over the laser groups. But our laser group also has had market share leadership in flex drilling. And there are examples there as well and customers there where the laser group is bringing the Atotech opportunity into that customer.
Operator
Our next question comes from Krish Sankar with TD Cowen.
Krish Sankar
Seth, thanks for all your help through the years. You'll definitely be missed. John, my first question is, last year, your semi business underperformed WFE. This year, arguably, WFE is expected to be flat, although the second half biased. Kind of curious how to think about your business? Because historically, it seems like in the years when WFE improves, you should outperform WFE. But how to think about your business in the year when WFE is actually flat?
John T. C. Lee
Yes. That's a good question, Krish. Certainly, we look at our performance relative to WFE over the long-term because, as you know, during the cycles, it varies when you're going up or going down. Many industry analysts are thinking of 2024 being flat, as you said, for WFE.
I think the only characteristic I'd say that's a little different is when it's flat that long, the inventory burn down eventually finishes. And so even if it's flat, because there's just less inventory burn down, that should be beneficial to those of us in that part of the supply chain.
And in our prepared remarks, we did call out that there have been many product categories where inventory burn down has completed, and we're kind of seeing a balance between what our customers are shipping versus what we're shipping to them.
But it's not done yet. And we called out that memory -- specific product categories tied to memory. There's still, we believe, some inventory burn down that has to happen. And that is certainly going to be a function of how fast that part of the semi market turns up.
Krish Sankar
Got it. And then on the Atotech side, I guess I should say the PCB part of your business. Is this fair to assume that the material side, which is your legacy Atotech business, that is really going to be driven by smartphone volumes? And on the PCB drilling side, one of the questions I get is, even if smartphone units grows this year, they're still below the peak pandemic levels. So there is really no need to buy PCB drilling equipment. So I'm just kind of curious, can you help answer those 2 parts of the PCB question?
John T. C. Lee
Yes. I think there's no real change. The dynamics are very much determined by utilization versus capacity expansion. So no change there. And to your point, as utilization rates increase, we'll see that in the consumables part immediately and first.
And just like in semi, once the utilization rates hit a certain level, our customers would then be making plans for capacity additions. And the CapEx then would follow, not just in laser drilling, but also equipment for chemistry plating. So what we're focused on now is making sure that we're designed in. So that when those volumes of CapEx occur, we're going to see that volume. But the characteristics of the consumable part of our business versus the CapEx part haven't really changed.
Operator
Our next question comes from Jim Ricchiuti with Needham & Company.
James Andrew Ricchiuti
I wanted to go back to the comment about the E&P business and what you described as lumpiness in the laser systems business. So in other words, where did you see some strength? Was it in the -- that legacy flex drilling? Or are you -- did you see some momentum in the HDI laser systems business and the Geode too?
John T. C. Lee
Yes, Jim. Yes, we can give you a little color on that. CapEx for lasers is a little lumpy in the packaging business. And the better-than-expected result in Q4 was really driven by laser drilling for the flex market.
James Andrew Ricchiuti
Okay. And John, how would you characterize what you're seeing for the HDI portion of that business?
John T. C. Lee
Yes. I think it's still muted, Jim. I think you can see the utilization rates of many of our customers. And as you know, that's driven a lot by smartphones, PCs and servers. And so some of our substrate customers publicly -- public companies have been down 30% year-over-year. So when those utilization rates pick up, then as my answer to Krish's question, we'll see that chemistry go up. And then as that continues, we'll see that CapEx investment happening. But right now, HDI CapEx seems still a little muted.
James Andrew Ricchiuti
Got it. Just a follow-up question. On the Photonics Solutions Division, the PSD, we saw some a little bit more of a sequential decline in Q4. I'm trying to understand that a little better. Is that the semi portion of that business may be catching up with some of the weakness you've seen in other areas in semi business? Or is it just possibly a case of weakness in some of the other markets that's overall impacted the Photonics PSD revenue?
John T. C. Lee
Yes, that's a good question. The PSD division, the semi part of PSD, that has continued to be strong as we -- as we mentioned in the prepared remarks. And that's, as you said, is going to be one of the bigger long-term drivers of our outgrowth in market share in WFE because of the exposure to lithography, metrology and inspection. And so the slight downtick in PSD was really some muted demand in research and defense relative to what our expectations were.
James Andrew Ricchiuti
But that's not suggestive of any, maybe change in the market in that non-semi portion of the business? Or do you think it's -- is it more of a timing issue, Joe? Have you seen any change in dynamics in the market?
John T. C. Lee
No. In fact, -- we -- the specialty industrials is made up of many markets, and some can be a little lumpy up and down. But in general, it's been a pretty steady business. And some of the industrials, for instance, like automotive, have actually been very, very steady. So this particular quarter, we're just calling out a little bit of research and defense. That was a little lower than our expectations. But the rest of the specialty industrial markets were very steady, actually.
James Andrew Ricchiuti
Yes. And I just actually segue to the last question about automotive. Are you seeing any impact from all of the headlines we're seeing in automotive as it relates to the Atotech business?
John T. C. Lee
Yes, we see the same things you see a lot of the chip companies, right? That is playing automotive guiding down. But we really haven't seen that, Jim. It's been a very steady, steady business throughout the year. And kind of our expectation, at least in Q1 as well.
Operator
And our next question comes from Steve Barger with KeyBanc Capital Markets.
Steve Barger
My first question is related to the cycle. In the past, you've talked about how semi and E&P are likely to recover in a similar timeframe, but at different magnitudes. Do you still expect a more or less simultaneous recovery? Or is there any scenario where one segment or the other would lag or not participate as the market recovers?
John T. C. Lee
Yes. Thanks, Steve. It's a good question. I think in general, they are correlated. Because if you're making more chips, you're going to have to package them. I think -- so our view is that they are continuing -- going to continue to be correlated.
The difference for MKS is that our exposure to semi is really about CapEx and our exposure, most of our exposure to E&P is consumables. So as we talked about earlier in the earlier question, we'll see that sooner E&P just because of the consumable nature of the business. And then CapEx there would follow as well.
Steve Barger
Right. Got it. And free cash flow has been in the $140 million range in the last couple of quarters. Do you feel like that's stabilizing to the point where it could be more predictable around these levels as you go through the year and think about working cap and inventory?
Seth H. Bagshaw
Yes, Steve, this is Seth. I'll take that question, obviously. So I think the -- it's hard to get cash flow in any one quarter. But the inventory levels, as we talked before, has been really sticky because of the supply chain constraints. So we started to see inventory level sort of peak in the last quarter, that will be helpful going forward as well.
But fundamentally, as you brought -- outlined here, at certain revenue levels, which we're hitting right now, the cash flow becomes quite robust. Q1 is a little more working capital requirements because of variable compensation payments. But Q4, we're very pleased with cash flow, very strong execution on margins and on OpEx. That continued through 2024 as well. So it's hard to be exactly cash flow each quarter. But I would expect cash flow to be more robust going forward as the revenues pick up.
Operator
Thank you. I'm showing no further questions at this time. I would now like to turn it back to David Ryzhik for closing remarks.
David Ryzhik
Yes. I'd like to thank everyone for joining the call. And operator, you can close the call.
Operator
This concludes today's conference call. Thank you for participating. You may now disconnect.
