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Ultra Clean Holdings (NASDAQ:UCTT)
Q4 2018 Earnings Conference Call
Feb. 21, 2019 4:45 p.m. ET

Contents:

Prepared Remarks:

Operator

Good day, everyone, and welcome to the Ultra Clean Technology's fourth quarter and full-year 2018 earnings conference call. [Operator instructions] Please note that today's event is being recorded. So I would now like to turn the conference over to Rhonda Bennetto, investor relations. Please go ahead.

Rhonda Bennetto -- Investor Relations

Thank you, operator. Good afternoon, everyone, and thank you for joining us. With me are Jim Scholhamer, chief executive officer; and Sheri Savage, chief financial officer. Jim will begin with some prepared remarks about the business and Sheri will follow with the financial review, then we'll open up the call for questions.

The press release we issued earlier this afternoon, along with the information about the webcast and how to access the replay of this call can be found on the Investor Relations section of our website at www.uct.com. Today's call contains forward-looking statements. Investors are cautioned that those statements involve risks and uncertainties that may cause actual results to differ materially from those discussed on this call. Information concerning these risks and uncertainties is contained in our periodic filings with the SEC, including our most recent Form 10-Q and 10-K and in the press release relating to today's call.

All forward-looking statements are based on management's estimates, projections and assumptions as of today and UCT assumes no obligation to of update them after today's call. Also on today's call, we will be referring to non-GAAP adjusted financial measures, and reconciliations to GAAP can be found in today's press release. And with that, I'd like to turn the call over to Jim. Jim?

Jim Scholhamer -- Chief Executive Officer

Thank you, Rhonda, and good afternoon, everyone. Thank you for joining us for our fourth-quarter and full-year 2018 conference call and webcast. First, I'm going to highlight a few financial results that Sheri will expand on in her commentary. I'll follow this with an overview of how we see the short and long-term semiconductor market landscape and outlook and conclude by outlining some deliberate actions we are taking to become more profitable and increase the value we deliver to our customers and our shareholders.

With the addition of Quantum's first full quarter of revenue, we were able to post top-line results for the fourth quarter of just over $257 million, at the high end of our guided range. These results capped off a strong year for us, with 18.6% revenue growth year over year, despite an uncertain and dynamic second half. Acquiring Quantum has proven to be an extremely valuable contributor to UCT and the diversified and complementary capabilities have already begun to transform our financial profile. In the fourth quarter, UCT's non-GAAP gross margin improved 300 points over the third quarter.

Operating margin improved slightly from 6.4% to 6.5% quarter over quarter, indicating there is work to be done, and I'll expand on exactly how we plan to accelerate our profitability in a moment. First, I'd like to talk about the semiconductor landscape in general, and describe what we are seeing from our position in the value chain, both short and longer term. Then, I'll describe what we are doing to offset industry uncertainty by elaborating on cost improvements we are undertaking to rightsize our business. I'll start with the IDMs, where our service business plays a significant role.

The semiconductor business is defined by rapid technological changes and the need to maintain high levels of investment for new materials and innovative manufacturing processes for increasingly complex chip design. Top-tier IDMs admitted they did not foresee the magnitude of the economic deceleration in the second half of 2018, especially of China, resulting in IDMs posting year-end results well below expectations. Intensifying competition in the smartphone business, mounting macro uncertainties and lackluster demand for memory chips was cited as the primary reason for the slowdown and have resulted in a softer outlook for 2019. Despite this, Quantum holds a very distinct competitive advantage and is expected to grow mid to high single digits in 2019, even though wafer fab equipment spending is expected to decline.

We benefit in two distinct ways. First, we receive a recurring revenue stream from our ongoing service within the growing installed base, where we hold a leading position. Second, we work with our top-tier IDM customers as they invest in new fabs, requiring highly technical cleaning and analytical solutions. We add value by partnering closely with our customers, helping them extract increased technical capability and higher productivity from existing and new assets within advanced products.

As wafers start to increase, so does our service business. This gives us great confidence in our ability to sustain stronger performance than our peers who rely solely on WFE spend. Taking a step down the value chain, OEMs are struggling with the trickle-down effect from the pushouts announced by the IDM. Industry fundamentals, especially within the memory segment are showing weakness, as both NAND and DRAM spending continues to contract, resulting in excess inventory in this business.

We anticipate these elevated inventory levels to normalize over the next few quarters, which bodes well for a more favorable 2020. Non-memory sentiment is slightly more optimistic and is predicted by some to grow in 2019, albeit slightly. Regardless of these near-term headwinds, industry investment remains rational and disciplined and poised to deliver very attractive long-term growth opportunities. And that brings us to our product and solutions business.UCT delivered highly integrated one-stop end-to-end solutions for our OEM customers.

Unlike the majority of Quantum's business with the IDMs, UCT's custom manufacturing offering are driven primarily by WFE capital equipment spend. Our direct visibility based on customers' order is limited and can change significantly even within a quarter. Based on what we've seen and heard so far this year from IDMs and OEMs, together with our internal marketing intelligence, the industry is taking a much more muted tone, and we believe we could see weakness continue throughout the year. While we hope that we are wrong and that recovery does materialize in the second half of this year, we are restructuring our business now to be more profitable in either scenario.

With that summary as a backdrop, we felt it was imperative to initiate a series of rigorous cost-improvement initiatives to increase profitability, without compromising or constraining our capacity to react quickly when industry growth resumes. While we did reduce expenses in the second half of last year as the equipment market softened, they were not sufficient to take us through what we now believe is an extended period of reduced demand. Our products and solutions business and our services business are designed to drive operational excellence companywide, both underwent an exhaustive analysis and brought forward a list of objectives that they must meet to improve profitability and drive higher returns for our shareholders over the longer term. Our restructuring plan includes consolidating and eliminating sites, moving additional production to Asia, the elimination or postponement of certain planned capital expenditures and a meaningful reduction of workforce.

While some of these initiatives are under way, others will be rolled out over the coming quarters. We anticipate cost improvement along the way. However, the majority will be realized in the second half of the year. Expected annualized cost savings from the restructuring plan will be in the $15 million to $20 million range once completed.

UCT has successfully managed through several industry cycles, as recently as late of 2016 and has emerged a much stronger company than when those disruptions began. We are working very closely with our customers to position us for significant growth when the industry rebounds. As we navigate these short-term uncertainties, we are confident that we will be in a much stronger position to benefit from the multi-year technology inflections and leading-edge logic, foundry and memory as well as the increased requirements in semi more broadly. The semiconductor industry is set to benefit from ongoing, next-generation innovation and development in home and industrial automation systems, wearable devices, advanced software, data center, cloud computing, Internet-connected devices and artificial intelligence just to name a few.

Increasing consumption of electronic components in our ever-expanding automated and connected world will further contribute to growth in the industry. For comparative purposes, our non-semi business was approximately 7% of total revenue in the fourth quarter, of which display made up roughly half. We are seeing display investment timing delays resulting from a softer market outlook. Although we believe spending in display equipment will remain muted over a longer period, the display market remains appealing as technology transitions accelerate, creating meaningful opportunities during the coming years.

In summary, we are very confident in the long-term prospects of the semiconductor industry with ever-increasing applications. We view the current downturn as an opportunity to materially improve our bottom line while ensuring that we protect our revenues and optimize our capabilities to secure long-term growth. I would like to thank our employees and our shareholders for their continued support. And I look forward to updating you on our next call.

With that, I'll turn the call over to Sheri.

Sheri Savage -- Chief Financial Officer

Thanks, Jim, and good afternoon, everyone. Thanks for joining us. In today's discussion, I will be referring to non-GAAP numbers only. I'll begin with the short recap of 2018, then dive into our fourth-quarter results.

For the full year of 2018, total revenue was $1.1 billion, an increase of 18.6% over the prior year. Gross margin averaged 16.5%, compared to 18.1% in 2017. Operating expenses, as a percentage of revenue, increased by less than 1% over the prior period, totaling $94.9 million. Operating margins came in at 7.8%, compared to 10.3% in the prior year.

Diluted earnings per share was $1.66 on net income of $64.7 million, compared to $2.34 and $80.3 million in 2017. And lastly, for the full year, we generated cash from operations of $45.4 million, compared to $48.9 million in the previous year and exited 2018 with $144.1 million of cash and cash equivalents. Now let me turn to fourth-quarter results. Our semiconductor services business performed better than expected, offsetting the same weakness in our products and solutions business.

This resulted in total revenue of $257.4 million, up 10% quarter over quarter and at the high end of our guided range. Total semiconductor revenue was $239.7 million, which included $58.4 million from Quantum. Non-semiconductor revenue, which includes display, generated $17.8 million or 6.9% of revenue. Total non-GAAP gross margin rose to 18.7%, a dramatic improvement from 15.7% in the third quarter.

This increase reflected a full quarter of our high-margin services business. As we've shared before, margins can be influenced by a number of factors, including customer concentration, geography, product mix and volumes, and you should expect to see variances quarter to quarter. Operating expenses, as a percentage of revenue, increased to 12.2%, as expected, due to the Quantum acquisition. Operating margin for the fourth quarter was 6.5%, up slightly from 6.4% in the prior quarter.

While heading in the right direction, it is clearly not where we want to be. The restructuring that is under way will improve efficiency and further reduce costs. By taking decisive action now, we are preparing UCT to manage through an unpredictable environment, while improving longer-term results and increasing our value for the customers and shareholders. Based on 39 million shares outstanding, earnings per share for the fourth quarter were $0.23 derived from net income of $8.7 million.

This compares to $11.9 million net income and $0.30 per share last quarter. Our tax rate for the quarter was 17.2%, compared to 14.6% last quarter. Going forward, we expect our tax rate to be in the middle to high teens as -- but as always, you can expect to see variances quarter to quarter. Turning to the balance sheet.

We ended the quarter at $144.1 million in cash and cash equivalents, a decrease of $16.2 million over the prior quarter. We used $30 million to pay off joint-venture debt related to the Quantum acquisition. Cash from operations was $30.1 million, an increase of $2.8 million over the prior quarter. Inventory decreased by $12.5 million during the quarter, and we will continue to optimize our inventory level to closely match customer demand.

Our first-quarter outlook reflects what a lot of our peers and customers have reported already, a continued softening in our semi-conductor products and solutions business. However, we do expect to see slight increase in our services revenue. We are assuming total revenue for the first quarter to be between $230 million and $250 million. While we expect to see upside on our bottom line as a result of the aggressive restructuring strategy we are undertaking, the benefit of that process will take some time to flow through and be fully realized.

For the first quarter, we are projecting non-GAAP EPS to be between $0.09 and $0.19. And with that, I would like to turn the call over to the operator for questions. 

Questions and Answers:

Operator

Thank you. [Operator instructions] Our first question comes from Quinn Bolton of Needham & Company. Please go ahead.

Quinn Bolton -- Needham and Company -- Analyst

Hi, Jim, Sheri and Rhonda. First, let me offer the -- congrats on the nice gross-margin improvement in the fourth quarter. I guess, first wanted to start with your outlook for 2019. It sounds like you're taking a fairly conservative approach and not expecting any sort of recovery in WFE throughout the year.

I just wanted to one, confirm that, that's the way you're thinking about it. The second question I have is, where do you think we are in the inventory reduction process? And when do you think we would sort of potentially come back to levels of underlying consumption in 2019?

Jim Scholhamer -- Chief Executive Officer

Yeah. Hi, Quinn. I'll take the first part and I'll turn it over to Sheri for the second. So 2019, you know, the outlook.

I think, it's obviously -- the second half is uncertain, as I mentioned on the call. We don't have visibility for the second half. I think, in this situation, we don't know if the second half is going to recover like the initial consensus was out there a few months ago. And I think, given the uncertainty instead of banking on a recovery, I think, it's in our best interest.

We'll be able to manage recovery in the second half. But given that we have at least two quarters of runway, it's a good time for us to embark on some of the longer-term cost reductions that take some time to implement in the lower period. I guess, I'll continue on with the inventory. We've been aggressively working on the inventory down.

We're not yet at the levels that we like to be. We'd like to get our turns up, one or two more turns a year, but I think as we finally -- as the revenue declines have slowed down or stopped on the equipment side, we'll have some time to catch up. We've been reducing the inventory. But we haven't been able to reduce it as fast as the revenue has been dropping.

But now that things have stabilized, I think, over the next several quarters, we'll be able to recover to normal levels.

Quinn Bolton -- Needham and Company -- Analyst

Sorry, Jim, my question on the inventory was really meant more for where do you think your customers inventories are? Are they buying sort of at a rate lower than what they're actually shipping? Or do you think your shipments are fairly well aligned with an underlying demand at this point?

Jim Scholhamer -- Chief Executive Officer

Right, right. OK. Yeah, sorry about that. Yeah, the inventory between us and our customers, the OEM customers is generally not as large of a concern as it is between -- the original part manufacturers are making more standard on the shelf items.

So we did see some of that impact in Q4 of customers finished goods inventory in some of the major modules. I think, a significant portion of that has been worked out.

Quinn Bolton -- Needham and Company -- Analyst

Great. And then for Sheri, I think, you mentioned annualized cost savings of roughly $15 million to $20 million, as you implement these cost-saving programs. Can you give us some sense, how much of that hits the OPEX line? How much of that comes into cost of goods?

Sheri Savage -- Chief Financial Officer

Most of it is actually cost of goods, but we will see some small increments in OPEX. So I would say probably 70% to 80% will go through COGS, and then the rest of that will go through OPEX.

Quinn Bolton -- Needham and Company -- Analyst

Great. I'll stop there and get back in the queue.

Sheri Savage -- Chief Financial Officer

Great. Thanks.

Operator

Your next question comes from Karl Ackerman of Cowen and Company. Please go ahead.

Karl Ackerman -- Cowen and Company -- Analyst

Hi. Good afternoon. Jim or Sheri, just going back to that last question on OPEX. Looking at March OPEX, I think is a touch higher than perhaps what I would've thought.

But following the implementation of the $15 million to $20 million of cost-realignment actions you are taking, how should we think about the absolute level of OPEX spending for the balance of 2019? And secondarily, as you seek to improve manufacturing utilization, how should we think about gross margins for the balance of the year?

Sheri Savage -- Chief Financial Officer

So from an OPEX perspective, obviously, we're not forecasting out. I think, we've mentioned last quarter that we thought we'd be in about the 12% range. Now that QGT is part of our overall company, they have a certain level of OPEX as well as we do. So they drove our percentage up a little bit.

That's something that we're going to continue to optimize over the course of the year with these cost reductions as well as just obviously, optimizing in general, that's what we intend to do. So I would expect that we would be, depending upon revenue, be in the 11% to 12% range as we have been and then continue to drive down, if possible.

Karl Ackerman -- Cowen and Company -- Analyst

Got it. That's helpful. As a follow-up, while the services business of QGT is obviously much more insulated from the year-over-year WFE drop in 2019, I would think that a pullback in wafer starts would likely affect kind of growth this year, at least, near term. And so I guess the question is, does the growth of your services business more mid to high single-digit growth in 2019 imply a massive hockey stick ramp in the second half of this year? Or would you expect it to be relatively flattish off March levels? Thank you.

Jim Scholhamer -- Chief Executive Officer

Yeah, in the service business, we actually have a lot more visibility. Our bottoms-up forecast is extended quite a bit more than it is in the equipment side. And that's due to the nature of putting the facilities in place near the fabs and being very tightly bound with the fabs, particular fab start-up. So we're well-positioned and there's been some fab ramp-ups that have been announced and are -- and we now see that they're going especially in Israel, for example.

And so we're pretty confident in where we're positioned in the wafer fab starts, as we've got a pretty solid forecast in that area.

Karl Ackerman -- Cowen and Company -- Analyst

Perfect. I'll see the floor. Thank you.

Operator

Our next question comes from Patrick Ho of Stifel. Please go ahead.

Patrick Ho -- Stifel Financial Corp. -- Analyst

Thank you very much. Maybe first off for either Jim or Sheri, with regard to the restructuring. Can you give a little bit more color what -- where the restructuring is going to come from, whether it's from your core UCT business systems and products side or on the QGT front? And the reason I'm asking is, if a lot of it is on the core UCT side of things, could this have been done earlier before the acquisition close, so you could get kind of the cost structure and some of the rationalization does [Inaudible] that kind of makes sense on a going-forward basis?

Jim Scholhamer -- Chief Executive Officer

Yeah. To answer your question, yes, it is on the core equipment side or SPS side is what we call it. Obviously, we have been making adjustments to that side of the business, incrementally as we went along through the year of '18. Back in the fall, we had a major customer, called the bottom, and at that time, we believed that there would be a pretty quick recovery after only a quarter or so.

And we took steps back then. But now that this appears to be an extended period of time, we can do the types of restructuring, moves that take a longer period of time and that are more easily achieved when the factories aren't running at high levels of capacity. So it really -- in order to do a lot of things that we're doing, we needed the kind of runway that we now see that we have.

Patrick Ho -- Stifel Financial Corp. -- Analyst

OK, fair enough. And then maybe as a follow-up to that given how -- I mean, you've been in the equipment industry for a long time now, and it's an extremely volatile business -- maybe it's less cyclical than it's been in the past. With these restructuring moves, how confident are you, if WFE in the future gets back to that 50 or -- $50 billion or higher level, that you can turn it on and be able to ramp quickly for your customers in those future times? I understand the rationalization today, but if they go back to the high levels that we saw just a few quarters ago, I guess, what [Inaudible] we should have that it can be turned very quickly?

Jim Scholhamer -- Chief Executive Officer

Yeah. Our confidence level is very high without going into too much detail about the types of restructuring that we're doing. We are very confident we'll be able to have a very similar, if not improved capacity at the end of the restructuring. It will be much more efficient.

We have a lot of duplication of capabilities, both within the region and then globally. And so there's an opportunity to really get scale in certain areas that make sense and remove duplication from site to site.

Patrick Ho -- Stifel Financial Corp. -- Analyst

Great. And final question for me, on the services front. It's a business that you're projecting to grow again this year. It's got obviously different market dynamics from the product side of things.

How are you looking at offering, I guess, different types of services, analytics? And I guess, maybe more -- even stickier solutions than the traditional parts cleaning business. How are you looking at new offerings for your customers that will drive incremental revenues over time?

Jim Scholhamer -- Chief Executive Officer

Yeah. Actually, that is definitely a part. We're not just doing cleaning, we're actually doing a lot of contamination control and analytics already with the ChemTrace segment of the cleaning division. So that actually is one of the key strategic elements of the service that Quantum business that we bought.

And we're definitely looking at how to leverage that and improve that. That is definitely one of the selling points of that capability. And second, there's also a lot of activity technology-wise on surface treatments and surface coatings and texturing. A lot of engineering that goes along and a lot of work is being done on handling a lot of the strange, new materials being taken off of periodic table and put into chips.

And so we're definitely, as a combined entity, we're -- the main focus is how to put resources in that area and leverage that, because it's already an effective arm of the service business and definitely something we want to grow.

Patrick Ho -- Stifel Financial Corp. -- Analyst

Great. Thank you very much.

Sheri Savage -- Chief Financial Officer

Thanks, Patrick.

Operator

[Operator instructions] Our next question comes from David Duley of Steelhead Securities. Please go ahead.

David Duley -- Steelhead Securities -- Analyst

Yeah, thanks for taking my question. Just, I guess, a couple of clarifications. What -- you mentioned that your Quantum business is going to grow, I think, high single digits. What is the base level? What was Quantum's revenue in total in '18?

Sheri Savage -- Chief Financial Officer

I don't have the -- I have -- the '18 is about $235 million.

David Duley -- Steelhead Securities -- Analyst

OK, great. And then as far as the size of the WFE market in 2019. For planning purposes, are -- what level are you planning for? It was roughly $50 billion last year. How far down do you think it's going to be this year?

Jim Scholhamer -- Chief Executive Officer

Yeah. I don't think we really backed out or I would want to get -- be the lone guy, predicting WFE, not ahead of everyone else. But definitely not $50 billion. But we did a mixture of the bottoms up and the tops down kind of analysis that led us to believe that it's going to be down in a similar range that it's been now.

And we believe the major movements down from current revenues are kind of over with. But we don't -- I think, more of what we see than any further major deterioration is just lack of sign of recovery in the second half, which may happen. But at this point, we don't see it.

David Duley -- Steelhead Securities -- Analyst

What -- I guess I'm asking this is -- generally, I think, it's kind of consensus that it might be down around $42 billion from $50 billion, or roughly down the high end of that 20% range that people are referring to. But if there's no second-half recovery, then it would be down more than that. And I guess, that's kind of what I'm wondering is, if you don't have visibility into a second-half recovery, one way or the other, then -- just trying to figure out what level of planning you are kind of gearing toward the industry?

Jim Scholhamer -- Chief Executive Officer

Yeah. Again, without trying to bridge down to a new WFE number, I think, those are reasonable assumptions to make. And I think you could -- we could do our planning from there.

David Duley -- Steelhead Securities -- Analyst

OK. And then going forward, what gross-margin expectation should we have for your cleaning business there?

Sheri Savage -- Chief Financial Officer

Well, for the cleaning side, they are about double what our typical core UCT business has been. So from a combined-company standpoint, we really see us being at the higher end of our range, if not beyond that, as we move in through the course of the year, depending upon how the course of the year goes from a revenue perspective. But we're going to see that we're at the higher end of our range as you saw in our financials for Q4.

David Duley -- Steelhead Securities -- Analyst

I'm sorry. I didn't -- was there a gross-margin percentage for the company -- for the business?

Sheri Savage -- Chief Financial Officer

Yeah. We haven't -- we're not providing that at this point. Really, we're -- we are going to be doing segment reporting starting in Q1. So you'll start seeing the op margin for that future business going forward when we get into 2019's reporting.

David Duley -- Steelhead Securities -- Analyst

OK. Final question for me is, as far as the cost-savings goal, I think, you mentioned that they really don't hit to the second half of this calendar year, just given the timing of things. As far as the $15 million to $20 million would we be, kind of, guess on a quarterly basis in the second half, how much we might have achieved by the end of Q3 and the end of Q4, let's say?

Jim Scholhamer -- Chief Executive Officer

Yeah. Obviously, we don't want to do a full-year forecast. Some of the actions have occurred as of very recently. So the actions are recurring as we speak, and they'll continue through the year.

There will be no real material effects, really, that we believe until the second half of the year. And they'll -- and obviously, if you spread the cost savings over the second half and maybe some of them going into the first quarter, I think, you can just make some assumptions on how that might spread out.

David Duley -- Steelhead Securities -- Analyst

OK. Thank you.

Sheri Savage -- Chief Financial Officer

Thanks.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Jim Scholhamer for any closing remarks.

Jim Scholhamer -- Chief Executive Officer

Yeah. Thank you for joining us, and we look forward to speaking to you again in April.

Operator

[Operator signoff]

Duration: 33 minutes

Call Participants:

Rhonda Bennetto -- Investor Relations

Jim Scholhamer -- Chief Executive Officer

Sheri Savage -- Chief Financial Officer

Quinn Bolton -- Needham and Company -- Analyst

Karl Ackerman -- Cowen and Company -- Analyst

Patrick Ho -- Stifel Financial Corp. -- Analyst

David Duley -- Steelhead Securities -- Analyst

More UCTT analysis

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