KEYS - NYSE

Good day, ladies and gentlemen, and welcome to the Keysight Technologies Fiscal First Quarter 2023 Earnings Conference Call. My name is Jason, and I’ll be your lead operator today. After the presentation, we will conduct a question-and-answer session. [Operator Instructions] This call is being recorded today, Tuesday, February 21, 2023 at 1:30 p.m. Pacific Time. I would now like to hand the conference over to our host, Jason Kary, Vice President, Treasurer and Investor Relations. Please go ahead.

Thank you, and welcome everyone to Keysight’s first quarter earnings conference call for fiscal year 2023. Joining me are Keysight’s President and CEO, Satish Dhanasekaran, and our CFO, Neil Dougherty. In the Q&A session we will be joined by Senior Vice President of Global Sales and Chief Customer Officer, Mark Wallace. The press release and information to supplement today’s discussion are on our website at investor.keysight.com under the financial information tab and quarterly reports. Today’s comments will refer to non-GAAP financial measures. We will also make reference to “core” growth, which excludes the impact of currency movements and acquisitions, or divestitures completed within the last 12 months. The most directly comparable GAAP financial metrics and reconciliations are on our website, and all comparisons are on a year-over-year basis unless otherwise noted. We will make forward-looking statements about the financial performance of the Company on today’s call. These statements are subject to risks and uncertainties and are only valid as of today. We assume no obligation to update them. Please review our recent SEC filings for a more complete picture of these risks and other factors. As a reminder, we are hosting our 2023 Investor Day on March 7th at the New York Stock Exchange. Management is also scheduled to participate in the Morgan Stanley Investor Conference on March 8th. And now, I’ll turn the call over to Satish.

Thank you, Jason. Good afternoon, everyone and thank you for joining us today. Keysight delivered exceptional first quarter financial results, posting revenue and earnings above the high end of our guidance against a backdrop of moderating demand. Our performance and consistent execution demonstrate the resilience of our business, and despite the challenging macro dynamics, we believe Keysight is well-positioned to build on our success and expand our leadership across our end-markets. I’ll focus my comments today on three key headlines. First, we achieved strong financial results. Revenue was a first quarter record and grew 14% on a core basis, driven by strength in both business segments and across all geographies. We again demonstrated the durability of our financial model and delivered $2.02 in earnings per share. Second, we started to see a normalization of what has been a robust and prolonged period of investment by our customers. Over the past two years, significant demand for Keysight’s solutions resulted in a 15% compound order growth rate and a book-to-bill of 1.09. As demand slows in the near-term, Keysight’s exposure to multiple end markets, its differentiated portfolio, and our strong operating discipline positions us well to weather the current macro dynamics. Third, we remain confident in the secular, long-term growth trends across our markets. Our software-centric solutions strategy is well-aligned with the needs of our customers, which we expect will enable us to outperform the market. We look forward to providing you a more comprehensive update on our long-term growth strategies and financial objectives at our upcoming Investor Day. Now let’s take a deeper look at our first quarter results. Orders declined 13% year-over-year against a strong compare of 22% growth in the last year’s first quarter. The slowing demand and business specific headwinds that we anticipated last quarter materialized largely as expected. These included the year-over-year impact of currency, our exit of Russia, and incremental China trade sanctions, which together contributed to a 6-point drag on the compare. We saw customers exercise caution in response to macroeconomic uncertainty. This was most notable among our largest customers in Commercial Communications, who were impacted by sharp demand decline in consumer electronics and computing segments. They are restructuring and reassessing their near-term priorities as the industry digests inventory, while at the same time maintaining investments across key, strategic programs. While the duration is difficult to predict, we expect these dynamics to weigh on our customers for at least the next couple of quarters. Despite macro challenges, revenue grew 10%, or 14% on a core basis. Strong execution and operational discipline resulted in gross margin of 65%, operating margin of 30%, and earnings per share growth of 22%. Turning to our business segments. The Electronics Industrial Solutions Group revenue grew 19% and delivered double-digit revenue growth for the 10th consecutive quarter, which underscores the diversity of our industry exposure. In automotive, we achieved record revenue and strong double-digit growth across all regions. Sales of electric vehicles continued to grow significantly in 2022, further fueling investment in EV and AV technologies and manufacturing. This quarter we secured multiple strategic wins with large OEMS and Tier 1 suppliers across a breadth of applications such as 5G, autonomous driving emulation, battery and charging infrastructure design, and in-vehicle networks. To strengthen our position in this market and capitalize on this growing, decades-long opportunity, we continue to expand our portfolio of solutions. An example is our current collaboration with Jiyun Technologies to develop a high-efficiency, compact battery test system to help accelerate the launch of new electric vehicles. In general electronics, double-digit revenue growth was driven by continued strength in emerging verticals such as digital health and IoT. We also secured wins in advanced research, as R&D investment remains robust in quantum, photonics, and Beyond 5G. Semiconductor solutions revenue growth was driven by continued fab investments in new wafer capacity and advanced nodes. While the inventory adjustments are pacing demand, foundries continue to execute their longer-term plans to globalize their production. We see significant opportunities in this market, and are investing in solutions for emerging semiconductor applications such as silicon photonics, high-power semis, and millimeter wave. Turning to our Communications Solutions Group, revenue grew 7%, with growth across both end markets and all regions. Commercial Communications revenue grew 11% on a core basis, to reach a record Q1, which was driven by ongoing, strategic investments in communications ecosystem. We saw strength in 5G R&D and deployments, Open-RAN, and datacenter networking, with increased focus on 800 gigabit and terabit communications solutions. These programs remain a priority and are driving demand for Keysight’s first-to-market solutions. As a trusted advisor, we remain actively engaged with our customers as they adapt to the current macro environment. We recently announced our collaboration with Qualcomm to accelerate 5G non-terrestrial network communications for broadband in remote areas, and enable device makers to speed development and verification of 3GPP Release 17 compliant designs. We continued to support the progression of standards and submitted the first 3GPP Release 16 protocol conformance test, enabling new use cases such as private and industrial networks, and autonomous vehicles. Investment in early 6G research is underway and Keysight joined forces with 16 organizations to create 6G-SANDBOX, a pan-European testbed for 6G experimentation and validation of 5G-Advanced and 6G capabilities. Nokia recently selected Keysight’s sub-Terahertz testbed to validate D band and E band technology to accelerate R&D critical to 5G-Advanced and 6G use cases in millimeter wave and sub-terahertz frequency spectrum. We also announced industry’s first and highest density network cybersecurity test platform, which provides data center network infrastructure and cloud providers with leading 400 gigabit Ethernet security validation capabilities. These solutions reinforce our leadership across wireless and wireline ecosystems. We are also looking forward to Mobile World Congress in Barcelona next week. Keysight will be engaged with many customers and industry leaders, and showcasing our solutions for advancing 5G standards including Release 17 and early research in 6G and intelligent automation. Turning to our government, defense, and aerospace business, record Q1 revenue grew 9% on a core basis, achieving its second highest revenue quarter driven by increased U.S. government spending, and strength in space and satellite, including new applications for non-terrestrial networks. We recently won a five-year contract with the U.S. Army who chose Keysight’s Field Fox handheld spectrum analyzer for field use. We expect U.S. government budget appropriations to ramp spending in new programs in the second half of this year. We also anticipate an increase in defense budgets worldwide, and growing investment in new technologies such as 5G, space and satellite, quantum, and advanced research. Consistent with our strategy, we continue to expand our software capabilities. We recently completed the acquisition of Cliosoft, whose data and IP management software tools enhance our portfolio of electronic design automation solutions. In addition, Eggplant’s test automation platform was recently recognized as a leader by The Forrester Wave. About one-third of total revenue, the growing mix of software and services is integral to the durability of our financial model. Keysight’s differentiation is a function of our software-centric solutions strategy, collaboration with our customers, and investments we are making to ensure that we address the most challenging technology needs of today, and into the future. We are prioritizing high-conviction growth opportunities to solidify our competitive position for the long-term, while at the same time accelerating initiatives to drive further efficiencies consistent with our financial model. We remain committed to creating long-term value for business stakeholders, and positively impacting the global community. I’m proud that Keysight has been named to the Dow Jones Sustainability Index for the fourth year in a row. I’d like to thank all our Keysight employees for their dedication and relentless execution, which drives our strong track record of performance and is a testament to Keysight’s Leadership Model, our values, and to our people. With that, I’ll now turn the call over to Neil to discuss our financial performance and outlook.

Thank you, Satish, and hello, everyone. Q1 was a strong quarter and a solid start to the year. We delivered revenue of $1,381 million, which was above the high end of our guidance range, and grew 10%, or 14% on a core basis. As we anticipated, macroeconomic uncertainty moderated demand in the first quarter. Orders of $1.3 billion were down 13%, or 10% on a core basis. Even with revenue outpacing orders by $80 million, we ended the quarter with over $2.5 billion in backlog. Turning to our operational results for Q1, we reported gross margin of 65% and operating expenses of $492 million, resulting in operating margin of 30%. We achieved net income of $363 million and delivered $2.02 in earnings per share, which was above the high-end of our guidance. Our weighted average share count for the quarter was 180 million shares. Moving to the performance of our segments, our Communications Solutions Group generated revenue of $939 million, up 7%, or 10% on a core basis. Commercial Communications revenue of $629 million was up 8%, with double-digit revenue growth in the Americas. Aerospace, defense and government revenue of $310 million benefited from increased U.S. government spending, which we believe will continue to ramp through FY23. Altogether, CSG delivered record gross margin of 67%, and operating margin of 29%. The Electronic Industrial Solutions Group generated first quarter revenue of $442 million, up 19%, or 23% on a core basis, with double-digit revenue growth in automotive and general electronics, demonstrating the diversity of our markets. Growth was strongest in the Americas and Europe. EISG reported gross margin of 61%, and operating margin of 32%. Moving to the balance sheet and cash flow. We ended our first quarter with $2.2 billion in cash and cash equivalents, generating cash flow from operations of $366 million, and free cash flow of $306 million, or 22% of revenue. Shares repurchases this quarter totaled approximately 700,000 shares at an average share price of $176, for a total consideration of $125 million. Now, turning to our outlook. We’re navigating the same evolving macro and industry dynamics that others have noted. As Satish mentioned, we expect it will take at least a couple of quarters for customers to work through their near-term challenges. If the current demand environment persists through our fourth quarter, we would expect to deliver low single-digit revenue and earnings per share growth for the year, achieved through steady backlog conversion, strong cost discipline, and the flexibility of our financial model. Turning to our second quarter guidance. We expect revenue to be in the range of $1,370 million to $1,390 million, and Q2 earnings per share to be in the range of $1.91 to $1.97, based on a weighted diluted share count of approximately 179 million shares. While near-term uncertainties are moderating the demand environment, Keysight’s secular, long-term growth trends remain intact. Our differentiated, first-to-market solutions, durability of our financial model, steady cash generation, and strong balance sheet position us well to deliver on our commitments to our customers and shareholders. We look forward to sharing more with you about the compounding nature of our business at our upcoming Investor Day. With that, I will now turn it back to Jason for the Q&A.

Thanks, Neil. Jason, can you give the instructions for the Q&A, please?

Yes. [Operator Instructions] Our first question is from Mark Delaney with Goldman Sachs.

Yes. Good afternoon. Thank you very much for taking the question. I was hoping, first, if you could elaborate a little bit more on the comments on orders. It seems like it’s particularly impacting the Commercial Communications business and maybe certain other areas are doing a bit better. But if you could offer a bit more on where you’re seeing the orders and where perhaps you’re seeing some moderation from customers?

Yes. Hi Mark. What we’ll do -- first, I want to start by saying our customer engagements remain very strong, robust shipment activity this quarter, and you see that reflected in the strong revenue performance. Second, our backlog is still at $2.5 billion, high-quality, low cancellations to date. And to put this demand normalization in context, I would just point to two things. First, as we said in the last earnings call, we have some business-specific headwinds, roughly 6 to 7 points, that played out. And this quarter, our comps from a year ago, we were up 22%. So putting those things in context, a little bit more deep dive I’ll provide on the end markets could be helpful. In Commercial Communications, we saw the top customer pull back, especially in the wireless part of the business, due to the macro challenges and the inventory digestion that they were going through, especially with regard to the smartphone industry. We also saw equally the activity system pickup on the wireline side as customers are investing in 400 gig and 800 gig Ethernet and terabit and beyond. So, those investments remain strong. In our aerospace and defense business, we’re starting to see a favorable uptick in the U.S. business as budgets are passed and program spends get unlocked. It’s also important to note that the -- that all of the prime contractors had stronger backlog positions, which also gives us a good outlook as we look ahead. And our Industrial business continues to show resilience with the research spend occurring in different countries around the world, automotive with EV and AV and next-gen semi investments remaining strong as well. So, we put all of this in context and say, we remain confident in the portfolio differentiation we have and we’re actively engaged with our customers, which will enable us to outperform this environment.

Thanks, Satish. That’s very helpful. My other question was on the cost controls, and the Company spoke about being disciplined. Were you alluding more to the variable nature of your cost structure, and that will moderate spending depending on what demand ultimately does this year, or are there more specific steps that Keysight is planning to take on cost controls? Thank you.

Yes. Mark, as we mentioned, always that we have this variable cost structure and operating model, that’s the first leg of our resilience from a financial perspective. But we’re always looking for dynamic resource allocation opportunities, especially in a market like this, where we see some of our customers pull back. We redeploy to other customers who need these technologies so that we’re maximizing. So that’s part of that discipline that I referenced. And we always have on deck operational efficiency programs as part of the Keysight leadership model. And we’re remaining focused on that, in some cases, even accelerating that. That should help us offset the inflationary impacts to the P&L as we are all faced with right now.

Our next question comes from Mehdi Hosseini with SIG.

I want to go back to booking a backlog. You guys have been very clear for a couple of quarters that post-COVID we’re going to have to go through a backlog normalization. And I want to get some more color from you is, is there any way you can separate or differentiate the backlog normalization from end market demand weakness, especially in the smartphone area that you highlighted?

Yes. Maybe I’ll just start, and then Neil can add. I’d say that if we look at our end markets and if you take a look at the commercial comps, especially in the wireless side, the top customer pull back is definitely macro related and related to the inventory exposure that they have, which has been widely talked about. But if we look at the base customer spend, it remains pretty strong. So, that’s as far as that end market is concerned, but we start to look at aerospace defense and our industrial exposure, which continues to provide us top line diversity. And I think that will play out as we go through the year as well. Neil, specific to our backlog position?

Yes. I mean, the only thing I would add to that is maybe starting with the supply chain, we still have areas where we are supply chain constrained. But in other areas, we’ve seen a pretty rapid improvement in terms of availability of product and kind of the trend towards normalization of lead times. And so what we are seeing, and I’ve talked about this is something we expected. In many cases, we have products for the -- or customers for those products that have scheduled shipments now out an additional quarter and beyond. And as our lead times have come in, they don’t now, at this time, need to place new orders until they get delivery of the product that’s already sitting in backlog. And so, the -- if you’re around 6 or 8 months, there was this tendency to place orders early to get in line to adjust for those long lead times. Now that we’re seeing lead times normalize and coupled with macro uncertainty, there’s no longer that incentive to get in line early and that is creating a little bit of additional pressure on the order line.

Sure. And just a follow-up here. You did $1.3 billion of new orders. Is there any way we could think about the R&D portion of that order or the strategic investment that were reflected in the $1.3 billion from production? And I’m just trying to better understand how we should think about the downside risk in booking activity from here? Is there like a -- is $800 million a quarter the worst-case scenario, or anything in that nature that you can offer would be very helpful.

Yes. Thank you, Mehdi. Again, it remains a highly uncertain environment as you know. What we’re seeing is customers typically firm up demand and budgets at the beginning of the year because of the concerns they have, they’re pushing out those decisions to later in the year. So, the uncertainty definitely remains. But as we look at the spending environment, especially even in commercial comms, we see more pullback around manufacturing expansions relative to the R&D plans of customers. So that’s generally the trend. And if you look in the ISG business, I’ll say, in the semiconductor as an example, customers are not pulling back on next-gen semi capacity, right, whether it’s 5-nanometer or 3-nanometer, they’re actually maybe cutting back on some of the 7-nanometer work they were planning on. So, the focus on next generation remains very strong. I may -- I will ask Mark to provide some color on the customer dynamics that he’s seeing in the -- from a sales perspective.

Yes. And I would -- Mehdi, I would -- just to directly answer your question, the mix during the quarter was still very predominant R&D. And Satish mentioned, the pullback was much less there and especially in commercial comms than it was on the manufacturing side. The other factor that we’ve talked about in the past on other conference calls is our funnel. We have a six-month funnel that gives us a strong indication of the forward-looking demand. That has been factored into our guide. It has normalized with the effects that we saw pretty acutely here in the first quarter. And looking out six months, the demand signal looks to be fairly consistent, in line with what we saw in Q1.

Mehdi, the other point with regard to your comment on the downside risk, right? I’ll say that we’ve done a lot of work to enter into more of the R&D markets of our customers. That still remains a priority for us. We’ve also done quite a bit of work to diversify this business to expand into industrial end markets, aerospace defense and auto in particular. And finally, through our sales footprint, we’ve done work to attract new customers, and that remains a critical priority for us, and we -- which I remain confident that all of these actions will enable us to outperform in this environment as well.

Our next question is from Meta Marshall with Morgan Stanley.

Just a couple of questions. I mean, maybe you spoke to kind of Open-RAN millimeter wave and kind of some areas of investment. I guess as we think about the communications business, could you just give us a sense of like what are the strongest revenue driver is growing in - moving into kind of calendar year 2023? Is it Open-RAN? Is the millimeter wave? Is it 6G? Just kind of some -- what is the general strength of that business coming from? And then, maybe as a follow-up question, you guys mentioned some kind of cost discipline, stronger cost discipline that you are balancing out kind of the lower demand indications from. But just a sense of where investments are still being made, just what degree of those cuts are we kind of talking about as we move throughout the year? Thanks.

Yes. Meta, thank you. So first of all, we remain intensely focused on continuing to innovate and strengthen our portfolio. So from an R&D perspective, the collaborations we have with our customers informs where we invest, and we feel pretty good about it. At best, some of these pullbacks are short-term delays for R&D spend, and we expect those to recover as our customer deals with these inventory dynamics that we mentioned. With regard to 5G, I think I would say that the R&D roadmap remains in place, right? Our customers have a multiyear roadmap, and they continue to invest to realize that roadmap. And at the big picture level, I would say while substantial progress has been made in terms of 5G deployments, we still have about roughly 1 billion subscribers in the world, and the roadmap is to take it from $1 billion to $5 billion in the next five years or so. So clearly, there’s more deployment activity occurring that’s in front of us with India and other parts of the world leading that effort. The standards progression, which really is a basis for R&D business with Release 16 and Release 17, moving into Release 18, which will be 5G advanced, is pretty strong. And those innovation vectors around non-terrestrial networks, new features such as RedCap for IoT applications -- proliferation of 5G into new verticals remains areas of opportunity for us that we’re investing in to continue to differentiate along with Open-RAN as well, which we have talked about. But the industry roadmap remains solid, and our differentiation remains strong in these markets.

And then, Meta, I’ll just address the cost discipline question. So, first and foremost, I’d like to just emphasize that we are continuing growth-oriented investments that are going to drive this business forward in the future. We’re very clear about what those priorities are internally and we’re keeping our foot on the gas with regard to our most important growth-driven investments. That being said, I like the way Satish characterized it, right? We always have onset a tap of efficiency gains that we’re looking to that we’re looking to operate on as part of our continuous improvement culture. And given the environment that we’re in with pressure on the top line, coupled with not just inflation, frankly, but signs that the dollar is going to backtrack on some of the strengthening that we saw last year, which will also put pressure on our foreign currency spending. We felt it was prudent for us to take actions to accelerate some of that efficiency. So, it’s across the P&L, but we are not putting future growth investments at risk.

Our next question comes from Samik Chatterjee with JP Morgan.

I guess if I can just start with orders. And if you can comment on the linearity of orders through the quarter based on your expectations for seeing some of this digestion from customers for another couple of quarters, so just you had more deterioration maybe as you exit the quarter. But just wanted to check if sort of what’s the trend through the month in the quarter that you saw. And the comment that you made about electronics orders holding up better than communication overall. Now, I hate to sort of generalize EISG overall, but it’s seems a bit counterintuitive because my impression was that communication is a bit more R&D aligned for you than EISG in general. But maybe if you can sort of correct me there or why -- explain why that’s happening if R&D is most protected? And I have a follow-up. Thank you.

Sure. Samik, this is Mark. I’ll take the first question on linearity of orders. And it was -- we had about two-thirds of our orders after the second month. We had a big finish to the end of FY22 and our fourth quarter. So, we had a nice rebound in December and the last quarter was about 34% of the total orders of bookings for the quarter. So, it was a pretty linear flow of business. On the electronic industrial side, what we see, as Satish mentioned, is continued demand around next-generation process technologies for our semiconductor business, very long-term secular growth drivers that we’ve been talking about for a long time. The activity level and focus around the next-generation auto, EV in particular, is continuing to ramp. Again, this is a decade-long transformation. The number of EVs sold last year as opposed to ICE vehicles continues to grow. So, I see this as a long-term trend. And what I was particularly surprised with was how our general electronics business held up, particularly around some of the verticals that we’re focused on, digital health care, advanced research and education. Obviously, some of this is exposed to broader GDP kind of markets, and we saw the PMI stay below 54. I think it was five or six months in a row. But in general, the three segments below EISG continued to show resilience and, overall, continued investments in these next-generation technologies.

For my follow-up and maybe to just change gears here a bit, there’s a competitor of yours who is going through a strategic review process with interest from multiple parties for an acquisition. I’m not asking you to comment on the interest in that company in itself. But how should we think about benefits to Keysight from scaling the business in a step function from here on? And the level of -- leverage -- debt leverage on the balance sheet you would be comfortable with if attractive opportunities did come through that are more visible?

Yes. Thank you, Samik. I’d say you’re right. We don’t comment on any specific opportunity. I would just say that we remain confident in the business that we run, its cash generation potential. You’ve seen the strong free cash flow performance of the business. And so congruent with that, we have a consistent capital allocation discipline, which is around organic growth and M&A where it makes sense and return of capital. And with regard to M&A, you’ve seen us be incredibly patient and disciplined with regard to the opportunities we pursue. We look at hundreds of companies after having done market assessments on them. And then we’ve done about 20 to date. And we’ve been -- and we’ve done them with a view of the strategy and what scale that we can bring to the target and how we see the -- first, the strategic fed, but second and equally important is the return to our shareholders. So, I think those hurdles will continue to remain in place, and we remain very disciplined.

Our next question is from Chris Snyder with UBS.

So back on the conference call in November, the Company talked about book-to-bills approaching a more normalized 1.0x. The quarter came in a bit below that at 0.94. So, were orders in the quarter softer than you would have expected back in November? Or [Technical Difficulty] for book-to-bills to improve as the year goes on and kind of reach that more normalized average of 1.0x for the full year?

Yes. I mean, if you go back to the November quarter, we talked about 8 points of specific headwinds that we were facing from currency and from China, Russia, those things, and that we expected that we were also recognizing macro on -- softness on top of that or anticipating macro softness on top of that. So, by and large, I’d say the quarter came in largely in line with our expectations. It’s obviously hard to put a quantification on macro. I mean, looking forward, as Satish has said, it’s very difficult to call at this point. We’ve attempted to give you some parameters with which to think about the business. Mark has commented that in our funnel, which looks out over the next couple of quarters would indicate demand that’s more or less in line with what we just saw in the first quarter. And then, I did state in my prepared comments that if that kind of order trend remain in place for our entire remainder of our fiscal year, we’d expect to still be able to deliver a low single-digit revenue and EPS growth. So, we’re taking it one quarter at a time, but that should hopefully give you some guardrails with which to think about the business.

Thank you. I appreciate that. And then just kind of staying on orders for fiscal Q1, is there anything or color you could provide around how orders in China did during the quarter, given a lot of the disruption over there? And also government and defense business orders, just given some of the budgeting resolution processes going on? Thank you.

Sure. This is Mark. I’ll comment on both of those. So we faced, as everyone did, the unanticipated breakout from COVID, and there were some incremental trade restrictions that happened in the month of December. We did see orders decline in China. They actually increased sequentially. So, that kind of indicates the unusual seasonality that we faced. But it was -- relative to what we were expecting to face with some of the declines, I was pleased with our response. And it really continues to be in line with what we’ve talked about in the past, which is our ability to pivot to new opportunities and the breadth of our customer base in China, which continues to be an area of strength for us. And that includes automotive, where the business was up. Some of the private networks, which is a new use case for 5G from an industrial standpoint, continue to show signs of growth for us. Mature process technologies for semiconductor. So, as we go forward and the economy begins to normalize there and maybe reopen into the second half, we’ll keep a close eye on that as well. Aerospace defense, as Satish noted in his opening comments and otherwise, we saw a strong growth -- order growth, in the U.S. That’s a direct byproduct of the budget being approved much earlier this year than last year. And what we see happen in Q1 was not new program starts, but rather multiyear programs that were stalled because of continuing resolution turn back on and some of that spend continue to flow. So, as we get through the next several months and quarters, and the record high RDT&E budget flows through the process, we hope to see some additional tailwinds there. Outside the U.S., with the geopolitical situation, we expect to see continued long-term demand for defense modernization. So, we’re positioned well to capture that as well.

Yes. Just maybe to add a comment to Mark, the space and satellite also continues to inflect for us in the aerospace defense business, and is showing some momentum there with customers, too.

Our next question comes from Aaron Rakers with Wells Fargo.

I’m going to go back to kind of the order and backlog dynamics. Neil, I think last quarter, you had mentioned that you were maybe about four or five weeks of kind of inflated or elevated backlog relative to normal. I’m curious where that stands right now? And does your low single-digit assumption assume -- growth-wise assume kind of back to normalized backlog levels through the course of the year?

Yes. It’s a great question. So obviously, revenue outpaced orders by about $80 million within the quarter. You can do the math on it. But if we see a similar environment persist for the remainder of the year, which is, again, in line with the guardrails what I put out there, we’d burn $300 million plus of that kind of abnormal backlog. So, it may not get us all the way home, but it would get us a significant chunk of the way towards normalization of the backlog over a multi-quarter period. We always knew it would take multiple quarters to normalize the backlog. And while this is just one scenario, I think it’s not out of line with our expectations.

Okay. And that’s helpful. And then, a quick follow-up. Just on the semiconductor business, you continue to perform well. And I don’t know the answer to this question, but I’ll just put it out there, is that -- is there any kind of disruptions? I think there’s been a supplier in the semiconductor supply chain that had seen, I think, some cyber attack issues. Is that at all impactful to your business or not?

No, not at all. For us, we serve the wafer stage, which is on the front end. It takes a longer lead time from our fabs to put capacity. And we see customers sticking with their plans for 5-nanometer and below. And equally, we’re also quite pleased with the progression we’re making to further add more applications into our solution stat, whether it is high-power applications for certain chips or silicon photonics or millimeter wave. So we continue to build that portfolio out.

Our next question comes from Jim Suva with Citigroup.

The first part of my question is, Neil, you made the question that are the statement as the year plays out, if it does according to plan, you’re looking at kind of sales growth. I think I heard you say low mid-single digits, and then you said -- and EPS growth. Did you mean the EPS growth to be positive or like in that same range of sales growth? Because typically, earnings per share grows at a bigger or a magnitude about sales growth. Then I’ll have a follow-up. Thank you.

Yes. So what I said, first of all, we weren’t guiding the year. What we said is, it’s a highly uncertain environment, it’s difficult to know. But if the demand stays consistent with where -- what we saw in Q1 through the remainder of our year, we would expect to deliver in that scenario low single-digit revenue and low single-digit EPS growth. Obviously, our model calls for higher revenue growth than that with 40% operating leverage, which enables us to get to double-digit EPS growth. So, in a scenario where revenues are growing at a lower level, coupled with this inflationary environment, which is a bit abnormal, we’d be looking at low singles for both revenue and EPS. Again, under that specific scenario where our orders remain more or less in line with what we saw in the first quarter.

Great. And then my follow-up question is, I believe it was in the month of December that had the incremental trade restrictions against China. I think that’s right. And so when we think about your commentary for 2023, if things are consistent, how much of sales impact is that incremental restrictions? Is that what you’re referring to in your prepared commentary about the kind of 3 to 4 points -- or 6 to 7 points of growth impact, or can you just help me flesh out the impact of the trade restrictions? Thank you.

So, the new China trade restrictions that came about in December is an additional 1 to 2 points of headwind for us over the longer term. The comment about 6 to 7 was -- on the call last quarter, I outlined what at the time we thought was going to be 8 points of headwind coming from China, Russia and FX. As we got to the end of the quarter, what we thought was going to be 8 was more like 6.5, so call it 6 to 7, and that’s largely because the dollar backed up a little bit. So, the FX impact was less than originally expected. The China impact was slightly less as well.

Our next question is from Matthew Niknam with Deutsche Bank.

Maybe just a follow-up on that last one. On the Analyst Day, I’m just wondering any initial thoughts on what we could expect on March 7th in terms of just updates to longer-term targets? And then just on the M&A backdrop, I’m just wondering, what’s the latest you’re seeing in terms of opportunities and valuations. And I know in the past you’ve been focused on some smaller size software deals. I’m just wondering if that’s still the focus or maybe whether you’re open to larger deals, just considering the pullback in private market valuations. Thanks.

Yes. Thank you. I look forward to sharing the forward-looking view on the market fundamentally at the Investor Day. Across our end markets, we have -- we see innovation accelerating. And I think we’ll lay out Keysight’s strategy to go into set those exciting long-term opportunities. So that’s number one. But I think with regard to M&A, clearly, if you look at how we’ve grown, we’ve been disciplined in actioning M&A of all sizes. You’ve seen us do Anite and Ixia, slightly larger scale and then a lot of technology tuck-ins, which have helped us complete the workflow and actually create greater value for customers and also expand our margins in the process. So from that perspective, we remain active in exploring new markets and targets as well. But again, as I mentioned before, we have strong strategic and financial hurdles that we have to meet as gates before we go ahead and transact the business. On the valuation front, on the margin, we think the valuations are likely to come in as more of the market reality sets in with a number of the firms, so. And with the strong balance sheet and cash position, we remain active in exploring opportunities.

Our next question is from Adam Thalhimer with Thompson Davis.

Congrats on the Q1 beat. First question on cancellations. You said that they’ve been low to date. I guess I just wanted to gauge your level of concern that that could get worse.

Yes. We’ve had no increase in our cancellation rate. So we continue to believe the quality of our backlog is very high.

And then I guess I’m just curious, how does this downturn and what you’re seeing so far compare to prior downturns? Because amazingly, you guys have been public almost 10 years, but we haven’t had a prolonged recession during that period.

Yes. I think I’ll take this. Satish here. Every recession, the environment is different. And I would say that after having a couple of very strong growth years, some normalization was inevitable. And what we’re seeing is pull back from some of the customers in response to some of the inventory excesses in specific markets. But I go back to our portfolio position is the strongest it’s ever been because of our emphasis on solutions. Our business model today is much stronger because we have -- over 33% of our business is software and services, which gives us additional resilience. And we have a strong operating model at the Company that allows us to tide over some perturbations in the marketplace. And we also enter the year with a strong backlog position as well. So from those perspectives, it’s different. I also think if you look at the gross margin at the Company level, we continue to stay strong at 65%. And I think with the operational model in place, we remain confident about our ability to demonstrate that resilience.

Our next question is from Rob Mason with Baird.

Satish, frankly, I’ll follow up your comment with a question just around the software orders in the quarter. I kind of inferred that they remain resilient. But as you think about where you’ve seen some challenges in Commercial Communications, to the extent that there’s a slowdown in renewals, or is that something that hits your radar screen as you see some of the headcount reductions take place in the tech sector? Just how you defend against that?

Yes. I think we have an incredibly sticky business with our customers, and we’re not seeing them pull back on renewals. Obviously, new purchases are taking longer, as Mark alluded to earlier. But I think even in the Commercial Communications sector, we have two businesses, right, wireless and wireline. We’re seeing stronger pullback from customers in the wireless side of the equation. The wireline customers continue to innovate. You see some of the trends in data center and cloud that are playing out. Need for faster data rates is important. Also in lieu of all of the activity that’s going on around AI, there’s a greater need to optimize the workflows of our customers. So, that part of the opportunity continues to remain stronger on a relative basis. I’ll just have Mark make any comment on...

Yes. Rob, just to answer -- yes, that was -- Satish did a great job. And I’ll just let you know we didn’t see the pullback in software like we did in other parts of the business. As a matter of fact, our renewals were up and our growth from subscriptions and enterprise agreements remained steady, which is what you would expect from a sticky business, something that has kind of a continuous flow of value in a subscription model. So that really worked for us this quarter.

Sure. Sure. Is that -- maybe just as a follow-on question, is that the influence that -- there seems to certainly be maybe a trend with -- two quarters, two years make a trend, where the first quarter gross margin is a good bit stronger in the Commercial Communications segment and then maybe steps down, moderates in the second quarter. Is that still the expectation or the dynamic at play there?

Could you repeat that? I’m sorry.

Yes. Just essentially, your communications -- CSG group gross margins tends to have a much stronger first quarter gross margin, at least going by the last couple of years, than it does the remainder of the year. Is that -- would that be the expectation this year as well?

Yes. I mean I don’t think you can draw any conclusions looking at historical sequential gross margin data as to what to expect. At least as I would think about it, any perturbations that may have appeared to have repeated have to be more coincidental than systematic.

And our final question is from David Ridley-Lane with Bank of America.

The typical seasonality is for a nice sequential uptick in EISG in the second quarter. Lot of the commentary on the call has been that ESG remains pretty strong. I mean, within your second quarter guidance, should we expect kind of that historical sequential pattern in EISG?

Yes. I mean all I would say is our sequential guide right now takes a look at our large backlog, looks at the schedule of shipments, looks at the incoming funnel. And obviously, we’re going to rely on a portion of incoming orders to turn into revenue within the quarter. And so. we have a high degree of confidence in our ability to deliver to the number that we’ve put out.

Got it. And then also IE -- on EISG, excuse me. The trend in gross margin has been a little bit softer over the last couple of quarters. Is there -- that being said, margin expansion -- operating margin expansion has continued to be quite good. But I’m just wondering, is there something in the mix or other dynamics that you could call out to sort of explain that gross margin trend there?

Yes. Across the businesses, we’re obviously looking to create value for our customers and that value expectations go up with time, greater solutions, content, greater -- software obviously increases the gross margin. You see that in our CSG business, 67% gross margin. So, we’ll continue to drive that up. On the EISG business, slightly lower software content, higher mix of manufacturing offerings traditionally. But equally, our emphasis on creating solutions is not diminished. We’re in fact, adding more software content, even to our semi manufacturing test systems, we’re providing more analytics capabilities, and we have strong customer uptake for those. So, over time, as we come off this inflationary impacts of the supply chain and other things that we’ve talked about, I would continue to expect more margin upside and look forward to sharing some of that with you at the Investor Day.

There are no more questions, so I’ll pass the call back over to the management team for closing remarks.

Yes. Thank you, and thank you all for joining. Keysight delivered another strong quarter, revenue up 10%, strong gross margins at 65%, operating profit 30%, free cash flow of greater than $300 million. And we continue to remain focused on actively collaborating with our customer -- customers across the multiple end markets we serve as they navigate these dynamic conditions, which gives us the confidence in our ability to outperform. Again, we have a diversified end market exposure, strong solutions portfolio that’s growing, strength of backlog, strong cash position and a strong balance sheet. And all of these enable us to invest to realize our long-term growth strategies. But we’re doing so with the fiscal discipline and prudent operational initiatives that we have in place. We look forward to seeing you all in New York on March 7th. And I’m excited to share the future growth strategy moving forward. Thank you.