Good day, and welcome to the Nova Measuring Instruments Ltd. Second Quarter 2016 Results Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Miri Segal, Investor Relations. Please go ahead. .

Thank you, operator, and good day to everybody. I would like to welcome all of you to Nova Measuring Instruments' Second Quarter 2016 Financial Results Conference Call and Presentation. With us on the line today are Mr. Eitan Oppenhaim, President and CEO; and Mr. Dror David, CFO. .

I'd like to draw your attention to the presentation that accompanies today's call. The presentation can be accessed and downloaded from the link on Nova's website at www.novameasuring.com in the Investor Relations section..

Before we begin, may I remind our listeners that certain information provided on this call may contain forward-looking statements, and the safe harbor statement 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 or News section of the company's website. In addition, the company has prepared a presentation for today's call. It is available on the Investor Relations section of Nova's website, and now would be a good time to download this presentation..

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 Oppenhaim, Nova's President and CEO. Eitan, please go ahead. .

Thank you, Miri, and thank you, all, for joining us today for our quarterly earnings conference call. I will start the call today with the highlights of our second quarter business results. Following that, I will provide some perspective for the industry trends and the market drivers that relate to our opportunities in the market.

Prior to turning the call over to Dror, I will conclude my prepared remarks with the guidance for the third quarter. .

Our quarterly financial results met our expectations and represented sequential growth in revenue and bookings, breaking the momentum for the second half, and support our guidance for record revenue quarter in the third quarter of 2016. .

Our $35.6 million in revenue, along with increased booking level, reflects our growing position in the foundry segment and the inroads we have made into the memory space.

During the second quarter, OCD orders have reached a record of $45 million, covering the entire breadth of our product offerings, including integrated and stand-alone platform as well as modeling and software solution, and spread across multiple customers globally.

These recent bookings improve our visibility, bolstering our confidence in the third quarter performance and reinforce our expectations for a stronger second half. .

In addition to the revenue in booking growth, we also once again demonstrated the solid operational efficiency and agility we have built into our model, with GAAP net income of $3.2 million or $0.11 per diluted share and non-GAAP net income of $4.7 million or $0.17 per diluted share, exceeding the high end of our guidance of $0.15 per diluted share.

With these results, we have now delivered 28 consecutive quarters of profitability, demonstrating our ability to deliver long-term profitability. .

Another major element of our growth is fueled by the value proposition we bring to the customers through the enhancements and increased utilization we offer to our installed base. This value creation assist our customer to better utilize their large fleet of tools, and in return, increases our service revenue across all products and customers.

The outcome of this significant effort, which is beyond only repair and service contracts, contributes highly to the fleet of activity, increasing our served markets and elevating our annual service revenues. In the second quarter, service revenue reached its highest, with over $10 million, suggesting an annual base of about $40 million. .

Let me now extend on my opening remarks in regards to our customer mix during the second quarter and the changes we experienced during this period. As expected, during the quarter, we started to see a significant and long-awaited increase in spending from TSMC and as a result, this customer accounted for 55 -- sorry, 57% of our product revenue.

This shift towards foundry mix will continue in the second half as well, and we expect the investment by the foundry segment in this period to outpace the first half of spending. .

In this environment, our strong foundry exposure along with our growing position in this segment are bearing fruit as our major customer is investing aggressively in the 10- and 7-nanometer production line as well as in the new 5-nanometer development side.

Our technology partnership with this leading foundry allowed us to strengthen our position in the most advanced nodes and support our expectation for a significant growth in TSMC contribution this year and into 2017 as well.

Our position is also allowing us to extend our revenue mix to include not only equipment to the most advanced nodes, but also sell to some other foundries for their matured nodes expansion related to the demand for 28- and 40-nanometer devices. .

Revenue diversification remains a key objective for Nova, and we are delighted to see that Micron also represented a 10% customer for Nova this quarter, reflecting the progress we are making in the memory space to increase our exposure with this customer. .

In addition to the more diversified and evolving customer mix, we also experienced geographical shifts over the course of the last few months, with increased revenues from China.

The opportunities in China are proving to be stronger than we initially thought, with multiple wins that are building up to a significant shift in our early geographical mix, which we expect to be between 15% to 20% from the overall product revenues. .

To date, our tools are installed in each and every new expansion and foundation in China, across all foundry and memory customers. And these installations include our entire product offering with multiple technologies. .

To sum up, our continued business performance is an outcome of our evolving position as a differentiated metrology vendor that offers a much wider and richer portfolio that sets us apart from the competition. This is resonating with multiple memory and foundry customers and was a key driver for our record Q2 bookings.

Our growth drivers today are spread over the most advanced nodes in DRAM, 2 and 1x nanometer; 48 layers and above VNAND devices; and foundries, 10, 7 and 5 nanometers. .

Let me now turn to our product updates. Our stated goal is to continue materializing our technology benefits in the market, targeting the inflection point in the coming years.

To achieve that, Nova is focused on evolving its product portfolio to meet the increasing process control challenges, which are derived from the complex transitions to vertical NANDs, DRAM scaling and foundry next-generation device, combined with new materials. .

Our newly introduced stand-alone and integrated platforms, along with other products we are going to introduce soon, are targeted to focus on this transition in order to strengthen our position in the market.

We believe that our unique portfolio, combining a growing contribution of software modeling solution, along with a synergy between optical and X-ray, sets us apart from the competition and increases our available markets and potential market share gains.

With several growth engines across the optical and X-ray fleet, we are positioned well to benefit from the increasing demand for process control. .

I would like to specifically mention the growing demand this year for our stand-alone OCD solutions, reflecting our expanding position in both etch and CMP.

Our ability to provide our customer a holistic approach, combining several technologies as well as utilizing both the integrated and stand-alone tools in one process control scheme across several process steps, is becoming a great asset that supports our customers' agenda for a tighter control, and in return, increase our opportunity reach. .

As it relates to our X-ray family of tools, our efforts to increase our footprint in the most advanced memory side are bearing fruit, with a repeat order that we recently received from a leading memory manufacturer for our combined XPS and XRS solutions.

The recent order is an outcome of previous successful installations and expands our presence with the customer's most advanced R&D and production sites. Our unique offering provides the customer with the ability to accurately measure parameters not measurable today with other metrology tools. .

Another step in our evolving road map is the progress we have in combining our 2 main technologies.

Our newly introduced hybrid solution combines OCD and X-ray measurement into a new hybrid metrology offering, enabling thin film and material parameters, which are measured by X-ray, to be combined with profile and geometric parameters, which are measured by OCD.

The combined model allows the customer a tighter process control, which can't be achieved otherwise. This new method follows our previously introduced hybrid solution, combining several metrology techniques, and represents Nova's continuous leadership in developing holistic metrology, which is announcing our core capability. .

Another highlight in the quarter was the progress we had in our initiative to focus on partnership program with leading customers and development centers. As we recently announced, following the close relationship we have with Imec, we also formed a program with LETI in France.

This initiative is designed to develop innovative metrology networks to enable leading-edge process control solution for advanced lithography. Based on this advanced program, Nova can today perform measurements on the most advanced logic and memory devices that will ultimately be introduced to the market in 3 to 5 years. .

Turning now to the market trends, while VNAND spending was the main catalyst in H1, we expect a shift in the second half with increasing foundry spending mainly weighted towards 10 and 7-nanometer.

In our view, NAND spending will continue moderately in the second half while the leading-edge customers try to commercialize the next VNAND device beyond 48 layers. Initial investment took place in the recent months, where additional capacity will be added towards the end of the year. .

In DRAM, spending remains focused on 2 and 1x nanometer scaling. The demand for DRAM for servers, PCs and other end-user applications will continue driving the semiconductor market, with high sensitivity to supply and demand trends.

In this aspect, we expect some recovery in this segment towards the end of the year while the market leaders are taking action to sustain their position. .

As evidenced by the growing metrology intensity and the recent technology transition, we are confident that the demand for advanced metrology will increase in the next few years, in order to enable key technology inflictions and faster time to market.

These are translated into a larger opportunity for Nova as we keep investing in our technology and core competency, as well as in bringing holistic solutions and unique software elements to the market.

Our ability to deliver innovative products and key capabilities at scale, directly addressing important technology and market inflictions and remains a key differentiator in this evolving market. .

In summary, we believe that our growing focus on executing our strategic plan, combined with our operational efficiency and our differentiated offering, along with growing customers' partnership, presents a multiyear opportunity to continue our long-term profitable growth. .

With that, I would like to share our guidance for the third quarter of 2016. We expect record revenue in the third quarter in the range of $42 million to $44 million. Diluted GAAP EPS is expected to be between $0.16 to $0.19, and non-GAAP EPS is expected to be between $0.24 to $0.27. .

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

Dror?.

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

Total revenues in the second quarter of 2016 were $35.6 million, up 4% quarter-over-quarter. Product revenue distribution in the quarter was 75% from the foundry segment and 25% from the memory segment. During the quarter, the company had 3 10% customers.

Of the company's overall product revenues, TSMC accounted for 57%, Micron accounted for 12%, and SMIC accounted for 11%. .

Blended gross margin in the quarter was 53% on both GAAP and non-GAAP basis, at the low end of the company's target model of 53% to 55%. Product gross margin came in at 60% due to favorable product mix in the quarter, which also included elevated software revenues.

Service gross margin came in at 35% and was lower than the previous quarter, mainly due to higher usage of materials and repairs to support the company's existing install base. .

Operating expenses in the quarter came in at $15.4 million on a GAAP basis and $14.2 million on a non-GAAP basis. This level was lower than expected, mainly due to a combination of lower R&D expenditures and higher R&D income at the same quarter. Operating margins in the quarter were 10% on a GAAP basis and 14% on a non-GAAP basis. .

Tax expenses in the second quarter were $0.6 million on a GAAP basis. On a non-GAAP basis, which exclude adjustments to deferred tax assets, tax expenses were $0.4 million. .

GAAP-based net income in the quarter was $3.2 million or $0.11 per diluted share, at the high end of the guidance for the second quarter. Non-GAAP net income in the quarter was $4.7 million or $0.17 per diluted share and exceeded the high end of the quarterly guidance by $0.02. .

The company generated $3.5 million of positive cash flow from operating activities in the quarter and concluded the quarter with approximately $95 million in cash reserves. .

On the balance sheet front, inventories increased by approximately $2.7 million as the company prepares for a major business ramp in the second part of the year. .

Before concluding my prepared remarks, I would like to give some additional insights regarding the company's guidance for the third quarter of 2016. As Eitan mentioned, we expect revenues in the third quarter to be between $42 million and $44 million, which is an all-time record quarterly revenue level for the company.

Blended gross margins are expected to be approximately 54% in the third quarter of the year, in the midpoint of the company's target financial model for gross margins.

Operating expenses in the third quarter of the year are expected to be between $16.9 million and $17.2 million on a GAAP basis and between $15.6 million and $16 million on a non-GAAP basis. .

We have previously communicated that the company's target financial model is aiming at operating margin of approximately 15% on a GAAP basis and 18% to 20% on a non-GAAP basis. We have also communicated that this model is expected to be achievable at an annual revenue level of $175 million or $44 million quarterly revenues. .

At the midpoint of the revenue guidance for the third quarter, we expect operating margins to be very close to the targeted financial model, approximately 14% on a GAAP basis and approximately 17% on a non-GAAP basis.

These operating margins are very close to the target financial model and increase our confidence that we will be able to meet this financial model on an annual basis, if the company's revenues continue to scale up. .

On the tax front, we expect third quarter tax rate to be approximately 20% on a GAAP basis and approximately 7% on a non-GAAP basis. .

All these elements together lead to a significant increase in the earnings per share in the third quarter of the year, which are expected to come in between $0.16 and $0.19 on a GAAP basis and $0.24 to $0.27 on a non-GAAP basis. .

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

Thank you, Dror. With that, we will be pleased to take your questions. .

[Operator Instructions] And we'll take our first question from Patrick Ho with Stifel, Nicolaus. .

Eitan, can you give a little bit of color on the sustainability of the current market trends you're seeing, particularly with the foundries? And I guess, what I'm trying to get at is, you're going to have a record quarter in September in terms of revenues.

Do those trends kind of sustain themselves as we look into the December quarter?.

So Patrick, thanks for the question. Beyond that -- beyond the fact -- basic fact that we don't guide beyond one quarter ahead and with still next few weeks to close the fourth quarter and the year, I would like maybe to speak specifically on the market environment and the business drivers going forward.

So we said and we comment from the last conference call and also this one that the second half is going to be stronger than the first one, and the third quarter is the first milestone in that -- materializing that comment.

Looking on the market drivers for Nova in the fourth quarter, which we also will also continue in 2017, probably will be the continuous foundry spending in 10 and 7, majorly on fees unpaid this year. We definitely see that it will continue on the fourth quarter and also on the -- at least on the first half of 2017.

Besides that, on the foundry side, and it's basically coming from China, is the foundry spending in 28- and 40-nanometer that we started to see in the first quarter and definitely, we'd see it all over the year. It's actually higher than initially thought and will become, as I said, around 15% to 20% of our product revenue.

And the third one is the inroads that we are making into the -- specifically into the VNAND space that we will start to see also some growth, more significantly than we saw before, in the coming quarters. So those, majorly, the 3 elements that we will see.

And it's -- as we see it right now, we are still expecting that the second half will be stronger than the first one. .

Great. That's helpful. And maybe going to your hybrid metrology offering that you detailed, combining X-ray and OCD metrology capabilities. Two-part question there.

Can you detail, I guess, the initial customer traction base you're getting, whether its foundry, memory? And secondly, what kind of applications are they being used for? And are they primarily on the R&D and engineering front? Or are they applicable on the production line as well?.

So I'll -- so Patrick, I'll try to get into as much details as I can without revealing any competitive information. I think that in an overall, if I'm looking from my level, we look right now on our fleet on the combination of X-ray and OCD as a combined offering that we give to the -- or we offer to the customer.

There are some application that actually we can sell better with X-ray and actually taking part of the OCD application. And therefore, I don't want to go into the details.

The fact that I can share is what we shared publicly is the applications on the front end were unique combination of thickness measurement, along with material measurement and some general CD parameters. And it's majorly happening in the front-end application.

Now regarding the customer traction, our exposure in foundry actually is bigger than memory, so the first traction came from foundry. And those applications are aiming both on R&D and production. And we have those applications working in production already. .

[Operator Instructions] And we'll take our next question from Edwin Mok with Needham & Company. .

So first question is -- just want to talk a little about the DRAM space. We have heard from multiple people talk about potentially how we recover in DRAM spending as well as fourth quarter and beyond.

Just curious, how do you kind of think about your position in DRAM? And if there is a recovery, what could help drive -- would that help benefit your business?.

So Edwin, thanks for the question. So looking right now on the progress that the company did in the memory, starting from 2015 and then continued in 2016, part of the strength came from the DRAM space. I think that our position in the DRAM is becoming stronger and stronger.

And actually, looking right now on the drivers that we see in 2017, and as I said will recover a bit by the end of 2016, are coming from 2 major elements. One is the technical transition or the inflection point in moving to 2x and 1x nanometers, and there's a lot of technical investment in that. And secondly is the capacity.

As I mentioned in my prepared remark and I will not get into a specific customer, I think that the leading customers in DRAM will have to spend by the end of the year in order to keep supplying DRAM to their end-user applications that actually believe the demand for that is increasing.

So as we see that, from our expectation, somewhere by the end of the year, both the supply-demand scheme as well as the inflection point and the technical investment that is needed will trigger some moderate spending in DRAM by the end of the year. And of course, we will enjoy that. .

Okay, great. That's helpful. And then, I guess, a question for you, Dror. Product gross margins are very strong last quarter, over 60%. And thinking about the comp, I did the math on the guidance. You guys are implying that this quarter may be 59% or something like that. Just want to kind of get a sense of where that comes from.

Is that more software? And should we expect the 60% comp growth on gross margin sustainable beyond this quarter?.

Yes. There were 2 elements favorable for the second quarter in terms of product gross margins. One is elevated software revenues in the second quarter, and the second was the overall product mix, which included, I would say, higher ASP products.

In terms of the third quarter and forward in the year, we do expect gross margins for products to return to their normal levels, which would be around 58%. .

Okay, great. That's helpful. Last question I have, just in terms of competition. Obviously, it has been a 3-player space in general, right, for the OCD space. But it has been a nice strong space, so I imagine your competitors are pretty aggressive in trying to win traction there.

Where do you see the biggest competitive threat, I mean, given especially your strong position in TSMC? Do you see that being attacked by a competitor? And how do you kind of see your competitive position in the space?.

So Edwin, that's a great question. And I try to elaborate with that on our position in the market currently and also, as we see that right now what happens in the customer. And I will start first with the customer's position.

I think that looking right now on the consolidated spending that happens in the market by leading memory and foundry customers, you can imagine that each one of those customers has some options to decide from as part of his -- 2 out of 3 product nodes or other things that they can choose each one of the metrology when you the fleet is set.

So looking right now on the competition, the competition right now is happening on each one of the customers. Nevertheless, now I'm coming to the first thing is the position that we have in the market.

Looking right now, the way that we came out from 2017, and according to the -- and also the official announcement that was made by Gartner, is another -- actually Nova grew in the market share and outpacing the industry and actually outpacing the competition.

So I assume that looking right now on the combination of 2015 and 2016, we're actually making progress in both foundry and memory. Looking right now on our numbers and the exposure to customers, moving from 15% in 2014 to 30% exposure in 2015 actually show the progress that we did.

And lastly, looking right now on the intensity, which we experienced from TSMC ramp, which actually composed the majority of the $45 million that we just announced, we can imagine that on a yearly basis, TSMC contribution to the company will be much higher than the previous year.

And this one coming from, actually, from market share positioning and market share gains, because we were looking right now on the capacity that we've added. And looking right now on the significant volume that we got in order, it's actually reflecting the position that we actually were increasing in TSMC.

And this supposed to be the answer to what position we have in TSMC. I can also imagine that once companies like us that's exposed to TSMC showed such an increase coming from foundry, I assume that if you're looking on our competitors' spread, you should have seen that as well. But actually, we did, so that's my answer. .

We'll take our next question from David Wu with Indaba Global Research. .

I have some questions about your Micron wins. Are those Micron wins related to 3D RAMs or are they related to DRAMs? And also, Hynix used to be one of your top 10% customer.

Is that tied to DRAM or is it tied to NAND?.

So David, we don't break down the numbers in memory for the DRAM and VNAND. We can assume that looking right now on the traction that we have in memory, when it started in -- started, I think, a year ago, when we started to show the growth, it's actually pacing the market trends. So we showed some growth last year when DRAM spent most.

And if looking right now in this year and our exposure to the memory customers according to the VNAND trend that we see right now, actually we can imagine where it comes from. And I don't want to go into the detail exactly on each application and segments for competitive reasons. .

Okay. Talking about competitive reasons, the reason I'm curious about Micron is that the Intel 7 dial-in is also using the same 3D NAND technology as Micron.

Is that part of a potential business for you? And when I look at your competitors, the only one that has very big exposure to 3D NAND is Nanometrics, and they claim to have Micron as their largest memory customer as well. So I was thinking whether you must have win some applications at Micron 3D NAND.

And is the Intel fab, is that part of Micron's orders?.

So David, the answer is yes, okay? But there are 2 kind -- there are 2 types of answers I would like to give to this particular question. One, the -- we are selling, as I said, in China, to every foundation and every expansion happening. One of the expansion that we are seeing is Dalian in China, and part of Micron is that.

But the majority part comes from other memory applications outside of China. So we are seeing exposure both in Intel in Dalian as well as in other Micron fabs.

By the way, David, the reason that we brought this 10% customer and emphasized that is because of the competitive information that we saw in the last few months, and it actually assured our position in Micron as well. .

[Operator Instructions] With no other questions at this time, I'd like to turn the call back over to Eitan Oppenhaim for any additional or closing remarks. .

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Thank you, operator, and thank you, all, for joining our call today. I would also like to thank our committed employees that contribute to our success day in and day out in supporting our vision with passion and dedicated hard work. With that, we conclude our quarterly conference call. Thank you. .

And that does conclude today's conference. Thank you for your participation, and you may now disconnect..