Image source: The Motley Fool.
Photronics Inc (PLAB 6.78%)
Q3 2018 Earnings Conference Call
Aug. 22, 2018, 8:30 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good day, ladies and gentlemen and welcome to the Photronics Third Quarter Fiscal Year 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time.
(Operator Instructions)
As a reminder, this conference is being recorded.
I would now like to turn the call over to your host Troy Dewar, Director of Investor Relations. Please begin.
Troy Dewar -- IR
Thank you, Nora. Good morning, everyone. Welcome to our review of Photronics' 2018 third quarter financial results. Joining me this morning are Dr. Peter Kirlin, Chief Executive Officer; John Jordan, Senior Vice President and Chief Financial Officer; and Dr. Christopher Progler, Vice President, Chief Technology Officer and Strategic Planning.
The press release we issued earlier this morning, along with the presentation material which accompanies our remarks, are available on the Investor Relations section of our webpage.
Comments made by any participant on today's call may include forward-looking statements that include such words as anticipate, believe, estimate, expect, forecast. These forward-looking statements are based upon a number of risk, uncertainties and other factors that are difficult to predict. Actual results may differ materially from those expressed or implied and we assume no obligation to update any forward-looking information.
During the course of our discussion, we will refer to certain non-GAAP financial metrics. These numbers are useful for analysts, investors and management to evaluate our ongoing performance. A reconciliation of these metrics to GAAP financial results is provided in our presentation materials.
At this time, I'll turn the call over to Peter.
Peter Kirlin -- CEO
Thank you, Troy, and good morning, everyone. We achieved another quarter of solid growth with a 22% improvement over last year's Q3 revenue and a 4% sequential increase over our strong Q2 results. End market demand is robust across nearly all of our markets, and we are realizing the benefits from successfully repositioning the business to take advantage of growing markets in China and demand from captives.
We have now achieved sequential revenue growth for five consecutive quarters and double-digit year-over-year growth for the last four quarters. It's rewarding to see the company achieve near record performance while stepping up consistently. Year-to-date, revenue is up 18% and we're on track to have the best year in the history of company. Previous two years were challenging and it's taken a lot of work by the entire organization to reach this level again.
I'm extremely pleased with what we've achieved so far in 2018 and the team is focused on continuing to build momentum as we look forward to the completion of our China factories by the end of Q4 and the expected revenue ramp in the second half of 2019.
IC & FPD both achieved sequential and year-over-year growth with high-end IC being the biggest contributor to the improvement. Gross and operating profit improved as we achieved margin expansion through operating leverage and cost containment.
Net income was $13 million or $0.18 per share, at the very top of our expectations. In addition, our cash balance improved on strong operating cash flow. We're at a great point at this time in our China investment trajectory and feel increasingly confident in our ability to finish these projects on time and on budget. Further, as we highlighted during our recent Investment Day, our cash generation should significantly improve once the Chinese facilities are up and running.
This confidence, together with our view that a return [ph] on equity is a compelling investment led to the decision to initiate a share repurchase program, adding another lever to our shareholder value creation strategy. During our recent Investor Day, we described how and why we have repositioned our business. This repositioning provides two benefits.
First, we've been able to grow our top line, despite facing significant challenges with the three of our largest customers reduced their demand for our products, creating a $110 million gap to fill. The second benefit is a more diverse and stable revenue stream with less customer concentration. So, we reimplemented the repositioning with the focus on two strategic priorities.
One was growing our business in China. The second, to increase our business with customers that also make their own masks or those who are referred to as captives. This quarter demonstrates the success we've achieved in executing against both priorities. Revenue from products delivered to China increased 44% sequentially and is up 132% from Q3 of last year.
Year-to-date, China revenue is up 125% and represents 17% of our total revenue, which is a significant diversification of our customer base. This remarkable accomplishment was achieved ahead of the completion of our new facilities in Hefei and Xiamen. Once these facilities are completed, equipped and qualified, we expect our China revenue to accelerate. Especially for FPD, as we will be the first producer of G10.5 plus photomask in the country and the only one with experience of making high-end masks for leading panel producers in China, Korea and Taiwan.
The construction of our two facilities in China is progressing and we are in track to complete both facilities by the end of Q4. After that, we will begin to move in tools and other systems to support our operations. Once the tools are operational, we will begin the process of qualification, which will take two to three months for FPD and several months for IC. Based on these timelines, we expect to begin to realize revenue from our China facilities in the second half 2019.
On the subject of China, I would like to offer a few thoughts on the recent and ongoing trade discussions between US and China. By the very nature, geopolitical events like these are very unpredictable. That said, I believe the impact of Photronics to be minimal and manageable. On the tier front, we do not export any products from China into the US and do not plan to when our China facilities ramp. Therefore, US tariffs should not directly impact our business.
Regarding potential restrictions on transfers from the US into China, this could impact our IC business. FPD is largely immune as essentially none of the technology or tools used to manufacture display photomasks originate in the US. Within IC, there are some possible, but I want to emphasize, not currently implemented restrictions that has the potential to impact our ramp. To this end, we have contingency plans developed such as moving technology or assets from another global location or from our partner, that give us confidence that we will be able to manage this risk, should it arise.
Furthermore, once our facilities ramp, our China -- our presence in China as a strong local merchant supplier should provide us with a competitive advantage over mask makers outside the country, enabling us to meet all our customers' mask needs, so they can focus on making semiconductors and displays to advance their respective businesses.
On the second strategic front, we have also done a tremendous job of increasing our IC revenue with Captives. Some of these operations can be large and comprehensive. For example, one of our customers operates the largest IC mask making facility in the world, while others are more limited in scope.
Regardless, we have worked very hard to turn this challenge into an opportunity. There are several reasons why a customer with their own mask shop may outsource masks, including business continuity concerns, capacity constraints or product [ph] outsourcing so they can focus internal resources on the most advanced nodes. We have positioned Photronics as the supplier of choice for Captives when they choose to outsource mask production.
Our revenue this quarter, with IC Captives increased more than 2.5 times compared to the same quarter last year. We're now at annual run rate in excess of $120 million to these customers. This is a clear demonstration that we can work together to meet their requirements, while also improving our financial performance.
As I stated earlier in the call, we are on track to have the best year in the history of our company. Our business is growing both top line and bottom line. We are generating cash to further strengthen our balance sheet, providing more options in how we increase shareholder value. We are meeting our strategic objectives to increase our China revenue and our business with Captives. And our China investments are on budget and on schedule. I'm very excited about the direction of the company and look forward to updating you as we move forward.
I will now turn the call over to John for more details on our Q3 performance and Q4 outlook.
John Jordan -- CFO
Thank you, Peter, and good morning everyone. Third quarter 2018 continued the resurgence of the business after repositioning the company during 2016 and 2017. Operating results improved over our strong second quarter and positioned us to hit record revenue levels for this fiscal year. Revenue of $136.4 million is the second highest quarterly revenue in the company's history with growth in both IC and FPD.
Sequential revenue growth over what is typically a seasonally strong quarter was boosted by strong industry demand and our successful repositioning of the company to take advantage of unique and strategic opportunities in the market. Revenue recorded by our existing Photronics operations for product delivered into customers in China, as Peter mentioned, has increased significantly during the past year.
The costs recorded by our new China start-up operations, nearly entirely independent of those revenues, are increasing as we hire resources and begin paying operating expenses when the new facilities are completed. The effect of those costs on Q3 results was inconsequential. I'll discuss the anticipated effect on Q4 results when I discuss guidance later.
IC revenue improved 26% year-over-year and 5% sequentially, drove by strengthened high-end up 94% year-over-year, primarily due to our customers' new designs for logic chips particularly 28-nanometer and 14-nanometer. We're also seeing the positive results from targeting China and Captive producers.
IC revenue from deliveries into China has increased threefold since last year and now represents 16% of IC revenue. Revenue with customers with captive mask shops has increased 2.6 times and represents 29% of total IC revenue. We believe these trends are sustainable and as we assess Q4, we anticipate that demand will keep revenues at least at current levels.
FPD growth was driven by displays used in mobile applications, specifically LTPS and AMOLED. We classify LTPS as mainstream due to the mask size even though the circuit geometries are similar to AMOLED. Our LTPS revenues are on the rise because of LTPS' recent widespread adoption by smartphone manufacturers. This technology currently offers most of the performance at one-third the price of AMOLED, and as a result, has gained significant market share.
We believe that as the price gap between LTPS LCD and AMOLED narrows, LTPS equipped phones will eventually transition to AMOLED. Meanwhile, our deliveries of AMOLED for mobile also increased as that market showed signs of growth and we began to ship products from our new P-800 mask writer fortifying our technology leadership in this sector. Despite improved AMOLED revenue, high-end was down sequentially as we pivot away from G8.5 panels used for large format TVs.
Gross margin improved to 26.1% and operating margin expanded to 15%; as operating leverage and cost control enabled us to grow earnings more quickly than revenue. Below the operating line, other income was lower due to less foreign exchange gain, tax expense decreased primarily due to a one-time tax benefit of $2 million or approximately $0.01 per diluted share, and minority interest increased due to strong earnings at our JV in Taiwan.
Net income attributable to Photronics shareholders increased to $13 million or $0.18 per diluted share, continued improvement over previous comparable periods. We ended the quarter with $333 million in cash and $58 million in debt, consisting of the convertible debt issue that matures next April.
Operating cash flow improved from the Q2 level to $49 million. We spent $20 million on CapEx, $6.8 million on share repurchases, and received $6 million capital contribution from our China JV partner. Year-to-date CapEx is $64 million and we're adjusting our full year CapEx guidance down to $135 million to $150 million.
This does not reflect any change in the schedule of the China products -- projects or the amount of investment, but merely reflects the timing of cash flow payments for the buildings and tools. A significant amount of cash outflow that we expected to occur in Q4, 2018 has been deferred to Q1, 2019.
Total estimated costs on the China projects remains unchanged. As a result, our CapEx for Q1,2019 is expected to be $135 million to $150 million, which will be in the preponderance of our CapEx spend next year.
Before I provide fourth quarter guidance, I'll remind you that our visibility is always limited as our backlog is typically only one to two weeks and demand for some of our products is inherently uneven and difficult to predict. Additionally, the ASPs for high-end mask sets are high, and as this segment of the business grows, a relatively low number of high-end orders can have a significant impact on our revenue and earnings for a quarter.
Given those caveats, we expect fourth quarter revenue to be in the range of $133 million to $141 million. End market demand, especially for high-end products, should remain positive during the quarter, and we will continue to focus on growing our business in China and with Captives.
Based on this revenue expectation and our current operating model, we estimate earnings for the fiscal 2018 fourth quarter to be in the range of $0.14 to $0.19 per diluted share. As we ramp the China operations hiring qualified resources and paying operating expenses, the negative effect of those start-up operations included in the Q4 guidance is approximately $0.03 per share.
In our current model, we anticipate the lowest point in China operations to have a negative effect on quarterly earnings of approximately $0.06 per diluted share and anticipate China to be accretive to earnings by the end of fiscal 2019.
We are on pace to have one of the best years in our history and are very pleased with the performance and the company's positioning. We are growing our China business ahead of the completion of our operating facilities there and our construction projects are on time and on budget. We are growing our business with Captives, effectively expanding our servable market.
Our cash generation and balance sheet are strong enabling initiation of a program to return cash to shareholders as we complete the China investments. This is a very exciting time for Photronics, and we are glad, you have chosen to join us.
I will now turn the call over to the operator for your questions.
Questions and Answers:
Operator
Thank you. (Operator Instructions) Our first question comes from Tom Diffely of D.A. Davidson. Your line is open.
Tom Diffely -- D.A. Davidson -- Analyst
Yes, good morning, nice to see all these -- some of you [ph] starting to work now on the same way. So first question on the cost, John, you just alluded to the impact on the cost side to the margins for China expansion. Is that evenly shared between flat panel and IC?
John Jordan -- CFO
No, it isn't Tom, and as you know, the IC facility is a joint venture. So it's a mix and share of the loss with the joint venture partner. So it's a little more complicated than an even share.
Tom Diffely -- D.A. Davidson -- Analyst
Okay. I guess my question then was, if it is on the joint venture side, does some of that get offset by the non-controlling interest? Will we see that dip down due to that increasing cost?
John Jordan -- CFO
Yes. And we have some of that actually in this quarter, a small amount. In Q4, it gets a little bigger. So the minority interest that we share for the Taiwan facility gets reduced somewhat by the minority interest and the loss in the China facility.
Tom Diffely -- D.A. Davidson -- Analyst
Okay. And the $0.06 impact, the maximum impact is going to be the quarter before revenue started, I assume?
John Jordan -- CFO
Well, we haven't actually disclosed which quarter it is, but it could be.
Tom Diffely -- D.A. Davidson -- Analyst
Okay. And then, maybe a question for Chris on the, the high-end flat panel tool that you just started (inaudible), is this tool more aimed at the leading players in Korea or is in situation where this tool works very well with the new Chinese customers because it increases their real window, so to speak on the production, that help them increase yields.
Christopher Progler -- CTO & Strategic Planning
Thanks, Tom. Yes, really it's both. It's still the only one of a kind in the field, so it's giving us a real competitive advantage and we're getting broad interest among both of those groups you mentioned for capability of this tool. And we have shipped masks to both of those groups for the highest end application. So I think it's pretty broad based and we're leveraging it for PoRs and new products, as we speak.
Tom Diffely -- D.A. Davidson -- Analyst
Okay. And then it seems like, perhaps the biggest news or the most exciting part of the business is with the Captives right now, you've had 29% of the business. How stable do you see that business or how volatile do you think it will be on a quarterly basis?
Christopher Progler -- CTO & Strategic Planning
Yes, I think, if you look at how that business has evolved over the last year. It's been a consistent ramp quarter-by-quarter. I think now where we sit with the Captives; we've reached a period of stability for the next quarter or two. But having said that, I think we see more room to run in that marketplace as we move into the early part of next year or next fiscal year.
Tom Diffely -- D.A. Davidson -- Analyst
Okay, great. And then finally, John, it looks like the R&D spending has come down a little bit in recent quarters. And I would have expected that to go up with some of these new programs overtime. Where do you think it -- kind of the steady state is for R&D overtime?
John Jordan -- CFO
You know that, Tom, I'm not sure if there is a steady state. It depends on the qualifications that we do. So, in those periods when we're doing more qualifications, you're going to see higher R&D expense and then the following periods benefit from those qualifications on the revenue line. So it will vary. And even at its highest point, it's still a pretty low percentage of revenue comfortably.
Tom Diffely -- D.A. Davidson -- Analyst
Yes. Okay, thanks for your time.
Operator
Thank you. (Operator Instructions) Our next question comes from Patrick Ho of Stifel. Your line is open.
Patrick Ho -- Stifel -- Analyst
Thank you very much. Maybe as a follow-up to Tom's question regarding the Captives. Given that you're obviously helping them to support some of their IC ramps. Peter, maybe if you could just give a little color of what happens when -- I guess from a capacity standpoint, internally for them, when they kind of see demand go down, they'll start bringing stuff back in-house to keep their fabs full. How do you adjust with those forecasts potentially down the road?
Peter Kirlin -- CEO
Yes. So, I guess the first point I would make is, before the Micron JV ended, our revenue to Captives was really dominated by Micron and the affiliates. Today, effectively that similar revenue stream is split across a number of Captives. So as any one adjust their plans, the impact to our business is significantly muted. So we have the benefit of diversification with that customer base. The other thing that we can't discuss in great detail, but in some circumstances, we have actually contractual commitments from them that extend over a multi-year periods to act as a second set of shock absorbers against a downturn in the business. And then, I think, the final thing I would say is the other source of revenue diversification. If you look at our business and you do the math around the commentary, you will see that our revenue to Captives was about $30 million and our revenue to China was about $30 million. So that $60 million is a significant chunk of our overall top line. And as far as China goes, as everyone knows, they're operating with a different set of criteria regarding any industry downturn. Would there -- our customers there have objectives that go beyond the normal profit and loss statement in the business. So we see the combination of diversification of the Captive customer base, the contracts where we've been able to get them in place, and then finally, the fact that the ramp in China should more or less be downturn proof as three significant shock absorbers now on the business, should the industry rollover.
Patrick Ho -- Stifel -- Analyst
Great, that's helpful. And maybe, as my follow-up question for either Chris or John, with EUV in high volume manufacturing, sort of on the horizon over the next year or so, how do we look at both your investments and qualifications related specifically to EUV? I understand a lot of the CapEx right now is obviously due to the China initiative, but how do we look at EUV and potentially bringing on new tools for that as some of those customers begin to go into high volume manufacturing?
Christopher Progler -- CTO & Strategic Planning
Hi Patrick, this is Chris. I can take that one. We have made a few incremental investments for EUV in our Boise nanoFab. They've been relatively small and they're kind of dual-use platforms 193 and EUV. And as we had announced, we do have a joint development program with IBM and we are working on some advanced logic tape-outs. As far as when we would need to or want to do a turnkey -- fully turnkey EUV line, we're still quite a few years out from needing that. Most of our initial EUV work is going to be hybrid flows where we'll do some steps, maybe a Captive will do other steps, and then we will do kind of early production, early prototyping. But I think the full turnkey line; the kind of investment you're talking about is still quite a few years away. So we're stepping up, we have a lot of development going on, we're making smaller incremental investments, but we wouldn't really project any large CapEx expenditures to support our EUV strategy right now. But we're definitely in the game, and we have a great product and we're shipping samples to at least three or four different customers.
Peter Kirlin -- CEO
Yes, and just going back to our Investor Day, right. This call, there was a lot of commentary about the repositioning of the business, right, a significant component of the repositioning was to build and continue to build our book of business in China as we ramp our facilities there. So the next, jeez, think may be three years, right, China should provide a nice growth trajectory for the company, coupled with the -- basically the mobile display shift, right, into AMOLED. So we're trying to take advantage of what we described as technology dislocations, China, the mobile display shift into AMOLED and the large panel shift from G8.5 to G10.5. So three technology dislocations, we're actively trying to manage to grow our business over the next two to three years. I think EUV lines up pretty nicely beyond that time window for the leading merchant to ride another technology dislocation. And as Chris said, we are prudently investing, and again, the investors don't see this, but we have to develop the customer relationships and the -- do the business development we need to support the investment when it becomes time to do it. So EUV for us is now sitting as the next leg of potential growth in our business, but it's, in our view right now, sitting beyond the China ramp.
Patrick Ho -- Stifel -- Analyst
Great. Thanks again and nice work on the quarter.
Christopher Progler -- CTO & Strategic Planning
Thank you, Patrick.
Operator
Thank you. Ladies and gentlemen, there are no further questions at this time. I'll now turn the call over to Mr. Peter Kirlin for closing comments.
Peter Kirlin -- CEO
Thank you, once again, for joining us this morning. We are very pleased with how the company is performing and optimistic that 2018 will be one of the best years in our history. And at 2019 we'll be even better as we launch production in China. Thank you for your interest and your support.
Operator
Ladies and gentlemen, that concludes today's conference. We thank you for your participation and ask that you now disconnect. Everyone have a wonderful day.
Duration: 31 minutes
Call participants:
Troy Dewar -- IR
Peter Kirlin -- CEO
John Jordan -- CFO
Tom Diffely -- D.A. Davidson -- Analyst
Christopher Progler -- CTO & Strategic Planning
Patrick Ho -- Stifel -- Analyst
This article is a transcript of this conference call produced for The Motley Fool. While we strive for our Foolish Best, there may be errors, omissions, or inaccuracies in this transcript. As with all our articles, The Motley Fool does not assume any responsibility for your use of this content, and we strongly encourage you to do your own research, including listening to the call yourself and reading the company's SEC filings. Please see our Terms and Conditions for additional details, including our Obligatory Capitalized Disclaimers of Liability.
