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Nova Measuring Instruments Ltd (NASDAQ:NVMI)
Q2 2019 Earnings Call
Aug 7, 2019, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day and welcome to the Nova Measuring Instruments Second Quarter 2019 Results Conference Call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Miri Segal of MS-IR. Please go ahead.

Miri Segal -- Founder and Chief Executive Officer

Thank you, operator, and good day to everybody. I would like to welcome all of you to Nova's second quarter 2019 financial results conference call. With us on the line today are Mr. Eitan Oppenhaim, President and CEO; and Mr. Dror David, CFO.

Before we begin, may I remind our listeners that certain information provided on this call may contain forward-looking statements. And the Safe Harbor statements outlined in today's earnings release also pertains to this call. If you have not received a copy of the release, please view it in the Investor Relations section of the company's website. Eitan will begin the call with a business update, followed by Dror with an overview of the financials. We will then open the call for the question-and-answer session.

I'll now hand over the call to Mr. Eitan Oppenheim, Nova's President and CEO. Eitan, please go ahead.

Eitan Oppenhaim -- President & Chief Executive Officer

Thank you, Miri, and thank you all for joining our second quarter financial results conference call. I will start the call today by speaking about our quarterly results and performance highlights and conclude by providing guidance for the third quarter of 2019. Following my commentary, Dror will review the quarter's financial results in detail.

In the second quarter, Nova delivered results toward the high end of the guidance range, reflecting our focus therefore to execute our plan in a volatile semiconductor environment. We were able to deliver these results due to the efforts we are making to strengthen our position with leading customers, while efficiently leveraging the operation model we have built to keep firm focus on technical innovation even in a challenging business environment.

We remained committed to the development of our new growth engine, which will continue differentiating our offering, expanding our addressable market and enabling our long-term growth. The results for this quarter are also evidence of the progress we have made in diversifying our exposure to different semiconductor segments, multiple customers and new evolving application in both materials and dimensional process control.

From a business perspective, our performance was highlighted by a balanced customer mix, which included four large customers that contributed more than 10% each to our product revenues. I would like to emphasize two major achievements which are embedded in this outstanding mix. Firstly, the major inroads we are making with the large global memory customer in both NAND and DRAM. And second, a major win in one of the biggest foundries in China. Both milestones reflect the traction our unique portfolio is gaining in the market due to the synergy we have built between the different technologies we offer to our customers.

Following the press release in April when we announced the selection of Nova's VeraFlex in-line materials metrology solution by a global leading memory customer. We are pleased to announce that this win contributes and continue to generate revenue and will proliferate to two other global sites for both DRAM and VNAND applications. This milestone is further evidence for a successful progress in expanding our reach into the growing materials engineering space, which is experiencing fundamental changes that create many fabrication challenges.

We intend to further increase our efforts in this area as we strongly believe that materials control will become increasingly important as new generation devices are developed. Looking at all recent technical inflection points, be it DRAM 1z or 1a or foundry nanowires or multi-dec VNAND, they all represent a growing opportunity for new materials control scheme. The need for tighter materials control drives faster transition from lab slow process control into fast in-line production steps. Like we did with the X-ray transition, we intend to bring other methods from lab environment into the production environment, which will assist our customers to reduce cost and improve yields.

An additional business highlight was the selection of our dimensional OCD methodology by an additional memory manufacturer in China. This competitive selection emphasized our unique offering, which interlaces hardware sensitivity with advanced machine learning and deep training engines. To solve challenging memory application, this can't be solved with traditional techniques. In addition, and following the growing demand for logic devices for emerging solutions like 5G and AI which began to receive orders from the world's leading foundry for its 7- and 5-nanometer expedited ramp up. As previously discussed, Nova's application footprint has expanded in this node to include both front end and back end solutions in multiple steps.

Turning now to our product development and the challenges ahead of us. We believe that there are three major technology inflections for us to address as part of our roadmap. They include 3D scanning in all semiconductor segments, device shrinkage while improving performance, and novel materials introduction to support architectural limitations.

In order to meet our customer's requirements as a result of these challenges, we are building innovative capabilities in both our traditional OCD and X-ray portfolios, as well as in new technology directions that provide new insights into the fabrication process. In order to deliver sophisticated solutions that will improve yield and cost of ownership, we have established the following fundamentals in our roadmap.

First, interlacing hardware sensitivity with software machine learning solutions to improve learning and prediction. Second, investing aggressively to lead the material process control market that is evolving into one of the major transition this year as customers are moving to complex devices. Third, developing new metrology methods that will enable in-line production measurement instead of slow and expensive laboratory measurements.

The [Indecipherable] of our new portfolio is the recent launch of the PRIZM. This newly designed tool is positioned to solve critical applications in the most advanced manufacturing processes. PRIZM is the first of its kind of metrology platform that combines traditional optical spectroscopy technology with interferometry technology. The technology is an optical method that is currently widely used for imaging and topography measurements. This new technology is capable of extracting unique physical information from the measured device that is inaccessible by either ellipsometry or reflectometry. Combined with interpretation algorithm embedded in our NovaMars and Nova Fleet Machine Learning Solution, PRIZM provides superior sensitivity and measurement accuracy for the most complex, logic and memory device structure.

We have already shipped several tools to multiple customers and are receiving excellent feedback on the value it brings. In addition to this exciting product launch, we continue productising additional platform. We are on track with multiple evaluation and still expect initial revenue in 2019. These technologies reveal unique metrology capabilities for multiple wafer fabrication process steps.

Before I conclude my prepared remarks, I would like to address the market conditions and how they relate to Nova performance. From an overall industry perspective, we strongly believe in the semiconductor fundamental drivers as well as new drivers, which will continue fueling the market beyond the interim challenging conditions. The combination of demand for new computing architectures as well as advanced memories beyond traditional scaling will create more opportunities for us as our customers improve device performance and costs while trying to meet their own customers demand and certification.

As discussed in the previous earnings call, we are aligned with the market expectation for a soft 2019. In our view, the spending environment is largely influenced by a decline in memory spending in both DRAM and NAND. We expect that the current soft demand will be better optimized through 2020 when memory prices and inventory levels will improve. While this remark is consistent with our first quarter comments, we see an improvement in demand for advanced logic devices in foundry. Though this will not necessarily offset the memory decline, we are prepared to increase shipments for 7- and 5-nanometer in the fourth quarter.

Overall, we believe that 2019 is shaping up to be a transition year in several aspects, which will generate more opportunities for Nova to improve its position. We are making significant inroads into major customers, remain focused on delivering our new products and are managing expenses cautiously. We also believe that our widened exposure to multiple segments, customers and geographies, combined with the traction our differentiated portfolio is creating in the market, it positions us well to benefit from the long-term growth potential as the market recovers.

As for the third quarter of 2019 guidance, we expect revenues in the range of $46 million to $54 million, diluted EPS on a GAAP basis in the range of $0.11 to $0.24 per share and non-GAAP basis diluted EPS in the range of $0.20 to $0.34 per share.

Now, let me hand over the call to Dror to review our financial results in detail.

Dror David -- Chief Financial Officer

Thanks, Eitan. Good day, everyone. In my following prepared the remarks, I would refer to both GAAP and non-GAAP results. You can find a detailed reconciliation per item at the end of the earnings press release.

Total revenues in the second quarter of 2019 were $51.1 million at the high end of the company quarterly guidance. Of the company's product revenues, approximately 65% came from Memory and approximately 35% came from Foundry. The increase in the Memory portion of product revenues was also driven by the adoption of the company solutions for high end applications at the global memory customer. Blended gross margin in the second quarter was 55% on a GAAP basis and 56% on a non-GAAP basis within the company target model of 56% to 59% on a non-GAAP basis.

Operating expenses in the quarter totaled $21.3 million on a GAAP-basis and $19.3 million on a non-GAAP basis. On a non-GAAP basis, this is 8% reduction or $1.6 million reduction relative to the previous quarter. The reduction was across all expense items, reflecting management efforts to contain operating expenses.

Looking forward, during this interim volatile period, we plan to continue our efforts to contain expense levels. In parallel, the company continues at full force its focus on continuous customer penetration and new product development as was evidenced by the recent new tool of record wins and the recent introduction of a new optical 3D platform.

Operating margin in the quarter was 13% on a GAAP basis and 18% on a non-GAAP basis. The effective tax rate of the company in the quarter was approximately 15%. Earnings per share in the quarter was $0.23 per diluted share on a GAAP basis and $0.32 per diluted share on a non-GAAP basis at the high end of the company guidance for the second quarter. As previously communicated, the company is transitioning its main offices in Israel and the US to new locations. As a result, during the office transition period, the company is bearing duplicate office lease costs. In the second quarter of 2019, these costs amounted to $827,000 and were adjusted for non-GAAP representation purposes either the [Phonetic] item facilities transition costs. The distribution of these costs across the company expense items in the profit and loss statement is detailed at the end of the company's quarterly press release. We expect similar facility transition costs of approximately $800,000 in the third quarter of the year, which will mark the finalization of the company's facility transition process.

On the cash flow front across the first half of 2019, the company generated $16.5 million from operating activities and invested $7.7 million in property and equipment, mainly in the new facilities. In parallel, the company continued to execute its previously announced share repurchase plan and concluded the second quarter of 2019 with approximately $180 million in cash reserves, slightly higher than the beginning of the year.

Regarding the company outlook for the third quarter of 2019, at the midpoint of the company guidance, we expect the following. Blended gross margin is expected to be approximately 54%. This result is lower than the previous quarter and the company target model due to a combination of factors, including an unfavorable product mix, the sale of newly introduced products which bear higher costs during the initial adoption cycle, the lower general business volume and cost related to the new facilities.

Operating expenses are expected to be approximately $22 million on a GAAP basis and approximately $19.8 million on a non-GAAP basis. On the tax front, we expect the effective tax rate in the third quarter to decrease to approximately 5% due to the finalization of tax reporting processes and the different distribution of profits between the different territories. Effective tax rate in the fourth quarter of 2019 and in future years is expected to normalize at 15%.

With that, I will turn the call back to Eitan.

Eitan Oppenhaim -- President & Chief Executive Officer

Thank you, Dror. And with that, operator, we'll take the questions.

Questions and Answers:

Operator

Thank you. [Operator Instruction] And we'll take our first question from Quinn Bolton with Needham & Company. Please go ahead.

Quinn Bolton -- Needham and Company -- Analyst

Hey, guys. Wanted to start with the new PRIZM tool and the new technologies. Your comments around gross margin, talked about some new products, wondering if the third quarter guidance includes any revenue from new technologies or the PRIZM tool that might in part be driving that lower gross margin for the third quarter?

Dror David -- Chief Financial Officer

Hi, Quinn. So, actually not practically the comment which was related to new products related to products which we announced earlier in our already in, I would say, extensive process of adoption in the market. So it does not include these new products [Indecipherable].

Quinn Bolton -- Needham and Company -- Analyst

Okay. Second question. You talked about the sort of Foundry strength acceleration at 5 and 7-nanometer. Can you talk at all directionally about how you see that strength continuing into 2020? I think your largest customer seems to be on a pretty aggressive build of of their 5-nanometer plans and has pulled in some 7-nanometer. Do you think that strength continues into the first half of 2020?

Eitan Oppenhaim -- President & Chief Executive Officer

Quinn, thanks for the question; it's Eitan. S,o the way that I look at that and used [Phonetic] couple of times that the way that this customer has build the capacity, usually they have it by phases. The first phase took place in the first quarter of 2019, actually started in the fourth quarter of 2018 and continued to 2019. And what we look right now on the expedited ramp is for the second phase that's supposed to start somewhere toward the end of the third quarter. And in the way that I look on the capacity and the amount of capacity, it will continue at least toward the first quarter of 2020.

Quinn Bolton -- Needham and Company -- Analyst

Okay, great. And then, just lastly, over the last quarter, it seems like the Memory outlook has continued to deteriorate, the logic Foundry business has uptick. How do you see your mix between Memory and Foundry trending in the third quarter from that 65%-35% split in Q2? Thank you.

Eitan Oppenhaim -- President & Chief Executive Officer

So we still expect Memory to be relatively strong in the third quarter. But evidently, given the extensive ramp up of 5-nanometer the significant customer of the fourth quarter, in the end of the year, there will be transition toward Foundry.

Quinn Bolton -- Needham and Company -- Analyst

To Memory, more than half...

Eitan Oppenhaim -- President & Chief Executive Officer

Quinn, I would like to -- so, Quinn, it's Eitan here. I think that the mix in the third quarter will stay at around 60% Memory. I think that besides the fact that the traditional memory providers are seeing some decline in their revenue and as well they are reducing the capex, but if you're looking right now on the macroeconomic situation, we do see some increase in Memory in China. As I said in my remark, it is a big win for us in the Memory. And there are couple of customers that are building faster the VNAND capabilities as well as the DRAM. So if you look right now on the mix, I think that it will be less of the Korean providers, but it will be more on the Chinese memory customers, but the mix will stay 60%-40% roughly.

Quinn Bolton -- Needham and Company -- Analyst

Great. Thank you.

Operator

We will take our next question from Patrick Ho with Stifel. Please go ahead.

Patrick Ho -- Stifel -- Analyst

Thank you very much. Eitan, maybe as a follow up to some of your prepared regarding China, especially the Foundry business over there, are you seeing increased, I guess, demand and interest in your product portfolio for some of the trailing edge, given that there are several nodes behind or are they evaluating a lot of the work at their very leading edge?

Eitan Oppenhaim -- President & Chief Executive Officer

So, I think that when I'm looking right now on China in the last two quarters, and I think that it's in line with other companies report, we see that due to global economy situation, we see increase both in the Foundry as well as in the Memory. And when you are looking right now on those customers, there is one leading non-provider that is not so behind the Korean and others. And he actually expedites capacity on the VNAND side. Regarding DRAM, there is one customer that is building very aggressively the capactiy and it's been expedited a bit in the last few quarters. Regarding Foundries, we have two local Chinese manufacturers that we see also some expansion in the trailing nodes. So without getting into the details, if you have those four customers investing, two in Memory and two in Foundry, we obviously enjoy those those expansions.

Patrick Ho -- Stifel -- Analyst

Great. That's helpful. And maybe a question also for you. The advanced foundry (Technical Difficulty) it's not a surprise given some of the commentary, customers like TSM have said on their earnings call. How do you see intensity trends rising potentially as the industry goes 5 to 3 nanometres? Because we saw quite a bit of the jump when we went from 16, 14 to the current 7 and 5 see the evaluation work you're doing at 3 nanometres helping know from a capital intensity standpoint.

Eitan Oppenhaim -- President & Chief Executive Officer

If I concentrate only on the logic side, if we're looking right now on the transition from 16 to 10, 7, 7-plus and then 5, all of them will be on a scaling FinFET devices. So even if we're looking right now on 5-nanometer, by the way not only in TSM but in others, it's publicly announced that it's going to be FinFET and it's just scaling down. If you're going beyond that, there are a couple of architectural changes that probably they will have to make and choose if it's going to be a regular dimensional FinFET device or it's going to be changed to something else.

One of the major discussion in the industry is the move from FinFET devices into nanosheet or nanowires, it can be vertical. It can be horizantal. But looking on 3-nanometer, we think that it's a major inflection point. You can't just scale. You need to change materials in order to get to keep the performance. You need to move to a different dimensional shape because otherwise performance will go down. And therefore, we do see that moving form from 5 to 3. It will be a major inflection point technology wise. And therefore, if we have a combination in the foundry where both the dimensions and the materials keep on changing, it's the combination itself. It's very good to the mix that we're offering to the customers.

Patrick Ho -- Stifel -- Analyst

Great. Thank you very much.

Eitan Oppenhaim -- President & Chief Executive Officer

Thank you, Patrick.

Operator

We'll take our next question from Jaeson Schmidt with Lake Street. Please go ahead.

Jaeson Schmidt -- Lake Street Capital Markets -- Analyst

Hey, guys. Thanks for taking my questions. Just curious if -- how we should think about thesservice revenue growth this year? I think last time you still expected that to grow 10% in 2019. Is that still the case?

Eitan Oppenhaim -- President & Chief Executive Officer

So I think that in general what we experienced in the recent months is that given the situation, the high volume manufacturing of DRAM and also some NAND -- VNAND, some customers are actually idling portions of the fab or the tool. So we have more challenge in that front, but we do expect to see service revenues grow quarter-over-quarter across the coming quarters.

Jaeson Schmidt -- Lake Street Capital Markets -- Analyst

Okay, that's helpful. And then, I understand the headwinds gross margin here in Q3. When should we expect that to alleviate? Is that more of a first half 2020 story or Q4 of this year?

Eitan Oppenhaim -- President & Chief Executive Officer

So obviously this depends, I would say, mainly on the level of business volumes. And I think that under the assumption that there is a stronger quarter looking beyond Q3, then gross margin should return to the normal level.

Jaeson Schmidt -- Lake Street Capital Markets -- Analyst

Okay. Thanks a lot, guys.

Dror David -- Chief Financial Officer

Thank you.

Operator

We will take our next question from Mark Miller with The Benchmark Company.

Mark Miller -- The Benchmark Company -- Analyst

Good morning. I was just wondering if you can provide a little more color on what's your X-ray business?

Eitan Oppenhaim -- President & Chief Executive Officer

Mark, can you repeat please?

Mark Miller -- The Benchmark Company -- Analyst

I was wondering if you could just give us a little more color on what's going on with X-ray in terms of orders and sales?

Eitan Oppenhaim -- President & Chief Executive Officer

Okay. So, as you know, we don't break it on the revenues between the optical and X-ray since both tools today can measure dimensional end materials. So therefore it's an information that we don't give for competitive reasons. Nevertheless, I can tell you that today, if I'm looking right now on the progress that we did in the last three years on bringing the X-ray from left to that used to be very slow and measure only a few applications, today we can say probably that most of the customers that are buying these tools buying it for production and some of them for [Indecipherable]. The reason, by the way, following the -- to further market that I made or commented that there's no way to continue scaling devices in semiconductor without referring into materials as a major element or major driver to improve performance. And if you're looking right now both on DRAM going to 1z, 1a, you're looking on VNAND multi-dec and the next embedded memory. And you look even for a foundry or logic going to 5-nanometer and 3-nanometer, changing the device itself from an architectural point of view or dimensional point of view will not give the fine results.

And therefore, if you look right now on the amount of material that has been used in a device, it actually doubled itself in the last few years and it will continue to be evolving in the next coming years. Combined with making the [Indecipherable] from what they used to be, the combination of that film structure as well as an extra novel materials that are being introduced is presenting a big opportunity for Nova. And we were able to materialize that in the last few years. The business of the X-ray has continued growing in the last few years and we assume it will continue growing in the next coming year as well.

Jaeson Schmidt -- Lake Street Capital Markets -- Analyst

Thank you. That was helpful. That was my point for the question. Could you provide breakdown -- sales breakdown by region?

Quinn Bolton -- Needham and Company -- Analyst

Yeah. So, in general, I would say, the following -- China was around 25% of the revenues, Korea was around 30% of the revenues, and the rest was placed mainly between US, Japan and Taiwan.

Mark Miller -- The Benchmark Company -- Analyst

Thank you.

Operator

This concludes our question-and-answer session. I would now like to turn the call back over to Eitan Oppenheim, President and CEO.

Eitan Oppenhaim -- President & Chief Executive Officer

Thank you, operator, and thank you all for joining our call today. By that, we conclude our second quarter 2019 earnings conference call.

Operator

[Operator Closing Remarks]

Duration: 32 minutes

Call participants:

Miri Segal -- Founder and Chief Executive Officer

Eitan Oppenhaim -- President & Chief Executive Officer

Dror David -- Chief Financial Officer

Quinn Bolton -- Needham and Company -- Analyst

Patrick Ho -- Stifel -- Analyst

Jaeson Schmidt -- Lake Street Capital Markets -- Analyst

Mark Miller -- The Benchmark Company -- Analyst

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