Troy Dewar - Director, IR Peter Kirlin - CEO John Jordan - SVP and CFO Christopher Progler - VP, Chief Technology Officer, and Strategic Planning.

Edwin Mok - Needham & Company Brian Chin - Stifel Nicolaus Thomas Diffely - D.A. Davidson & Co..

Good day, ladies and gentlemen, and welcome to the Photronics First Quarter Fiscal Year 2018 earnings conference call. [Operator Instructions]. As a reminder, today's conference is being recorded Wednesday, February 14, 2018. I would now like to turn the call over to Mr. Troy Dewar, Director of Investor Relations for Photronics. Sir, you may begin..

Thank you, Chelsea. Good morning, everyone. Welcome to our review of Photronics' 2018 first-quarter financial results. Joining me this morning are Dr. Peter Kirlin, Chief Executive Officer; John Jordan, Senior Vice President and Chief Financial Officer; and Dr. Christopher Progler, Vice President, Chief Technology Officer, and Strategic Planning.

The press release we issued earlier this morning, along with the presentation material which accompanies our remarks, are available on the investor relations section of our webpage. Comments made by any participant on today's call may include forward-looking statements that include such words as anticipate, believe, estimate, expect, forecast.

These forward-looking statements are based upon a number of risk, uncertainties, and other factors that are difficult to predict. Actual results may differ materially from those expressed or implied and we assume no obligation to update any forward-looking information.

During the course of discussion, we will refer to certain non-GAAP financial metrics. These numbers are useful for analysts and investors and management to evaluate our ongoing performance. A reconciliation of these metrics to GAAP financial results is provided in our presentation materials.

Before turning the call to Peter, I would like to remind you once more that Photronics will host an Investor Day on May 23, 2018, in New York City. Details will be coming forward soon and I hope to see you all there. At this time, I will turn the call over to Peter..

Thank you, Troy, and good morning, everyone. Photomask demands were very positive during our first quarter. And we benefited by achieving sequential revenue growth, countered the typical seasonal headwinds, led by overall improvement in FPD and another strong quarter of high-end IC. Year-over-year growth was 12%.

This was our third quarter of sequential revenue growth and yet further confirmation that our business has shifted into growth mode. For FPD, demand for LCD mask improved as our customer released new designs in an effort to improve factory utilization. As we stated before, photomask demand for FPD often runs countercyclical to panel demand.

During last quarter, demand for LCD panels started to moderate and pricing weakened. Our customers responded by introducing new panel designs to gain market share, creating demand for new mask sets. We expect to see the same dynamics play out in the AMOLED market in the coming quarters, especially as our customers bring additional new capacity online.

High-end IC was up once again, led by strong logic demand from foundries in Asia. Memory was down slightly on a sequential basis, but we believe this to be a timing issue rather than a change in overall market dynamics. And we expect our memory business to deliver incremental revenue growth in Q2.

Gross margin improved sequentially, but higher operating expenses resulting in lower operating margin. There were also several items below the line that impacted net income, which John will discuss in a few minutes. As a result, net income was $5.9 million or $0.09 per share.

Our balance sheet got even stronger this quarter as we once again generated good operating cash flow. Additionally, we also received the initial capital contribution from DNP in China for the new JV we established there.

This places us in an even stronger position to make the significant CapEx investments later this year, which will be required to equip our two new manufacturing facilities once their construction has been completed. The momentum we created at the end of 2017 is continuing.

For the second quarter, we believe that most of our high-end markets should grow. The exception being high-end logic, where we expect a pause, given the uptick in business that we have enjoyed during the last two quarters. For example, PDMC achieved record revenues and operating income in Q1.

Beyond the near term, there are several factors that should drive our growth over the next few years. For us, growth is all about the high end. Mainstream is important. It is profitable and it generates cash and we will continue to strive to maintain our preeminent market position in this market segment. However, it is largely a mature market.

In order to grow, we must develop the right high-end technologies and capabilities and then place them in front of the appropriate customers at the correct time. If we do this well, we gain market share, which is manifest in higher revenues, earnings, and cash flow.

This uptick in financial performance then enables us to launch the next investment cycle. Historically, we have executed these cycles with successively higher revenue peaks in 2006, 2011, and 2015.

These peaks were driven by share gains in G8.5 FPD transition in Korea in 2006, our penetration of the high-end market with a nanofab in 2011, and our JV's ramp in high-end logic market share in Taiwan in 2015.

Moving forward, one high-end area we anticipate growth in FPD is display technology used for mobile devices in transitioning from LCD to AMOLED. There are several reasons for this. AMOLED has superior visual characteristics, lower power consumption, enables flexible and foldable formats for further innovation and product design.

Samsung developed this technology and has been using it in their mobile phones for the last few years. Last fall, Apple made its first move to AMOLED with their premium phone adopting the technology. Even with this move, the majority of smartphones are still using LCD screens.

Most industry observers anticipate the adoption rate to grow significantly in the coming years. Within this transition, there is another story. Each generation of smartphone AMOLED display uses higher resolution.

For example, the iPhone 5, which was released a few years ago and uses LCD technology, has a resolution of 300 pixels per inch or approximately 300 pixels per inch. Whereas Galaxy S8 and iPhone X has screen resolutions of more than 500 pixels per inch.

And the next generation of mobile displays is expected to increase screen resolution by approximately another 100 pixels per inch. Both of these factors, the move to AMOLED and the move to higher resolution, are good for mask demand. They mean more masks per set and more critical masks to generate the higher resolution.

As the technology leader in display photomasks, we are well placed to benefit from these trends. To this end, we will begin installation of our new P-800 at the end of Q2. We will be the first photomask player to install this tool.

This mask writer, coupled with our process technology, should allow us to manufacture photomasks to enable our customers to make AMOLED screens with 1,000 pixels per inch or greater resolution so that they can grab more share of the critical smartphone market. The other trend we are seeing in display is growing TV sizes.

And along with this, growing substrate size to improve glass efficiency. The last major change in substrate occurred when G8.5 was introduced nearly 15 years ago. At that time, the sweet spot in large-format TVs was 42 inches. As TVs have now grown to 65 inches and 75 inches, G8.5 is no longer optimal.

To address this operational inefficiency, the industry is adopting G10.5-plus substrates. The number of manufacturers capable of making displays of this size is still small but growing. And most of this growth is occurring in China.

The most significant investment we are making to take advantage of this growth in display substrate size is in the new facility we are constructing in Hefei, China. Once complete, we will be the premier display manufacturer in the country and the only one capable of producing G10.5-plus photomasks. A few weeks ago, we held our groundbreaking ceremony.

In attendance were all the Chinese display manufacturers that are ramping G10.5-plus panel fabs. Needless to say, they are very excited to have a domestic source of supply for these very large format photomasks. Not only are we investing in display, but we are also constructing an IC facility in Xiamen, China.

This facility, which is part of our new JV with Dai Nippon, will be capable of producing 14-nanometer photomasks and would be a leader in China's IC photomask industry. Combined, we will be the clear mask market and technology leader in China. This is important because the merchant photomask market is growing in China.

Even before we have completed these factories, our Chinese bookings, both FPD and IC, have been growing. In Q1, deliveries into China generated 15% of our total revenue. I'm very excited about the growth opportunities that we are developing.

The technology inflection in display plus the geographic expansion into China shall allow us to grow nicely over the next few years. In fact, we believe that in three years' time, Photronics will be approximately 40% larger than we are today. This only considers the organic growth opportunities.

Additional growth could be achieved through M&A in the photomask space or attractive adjacencies. 2018 is off to a strong start and it appears the momentum we built at the end of 2017 is continuing. Beyond that, our growth prospects are coming closer to being realized as we make progress on our expansion into China.

I really like the direction we are heading and the future we are creating. I would like to thank the entire Photronics team for all your hard work during Q1 to both deliver on the quarter as well as build towards a bright future in 2019 and beyond. I will now turn the call over to John for more details on our Q1 performance and our Q2 outlook..

Thank you, Peter. Good morning, everyone. As Peter commented, our demand trends continued to improve during the first quarter.

And we achieved sequential revenue growth of 2%, countering what is typical seasonal headwinds, and 12% year-over-year growth, driven once again by high-end revenue, particularly high-end IC that was up 51% compared with last year. Before discussing our results in more detail, I will point out that we have modified the definition of high-end IC.

Previously, we classified anything 45 nanometers or smaller as high end. Based on the evolution of technology and consistent with the classification used by many of our customers, we now classify anything 28 nanometers or smaller as high end. In the supporting slides, all periods have been modified to reflect this change in definition.

IC revenue overall was essentially flat compared with the previous quarter. Strong high-end growth was offset by seasonal softness in mainstream. The high-end growth of 10% over Q4 fiscal 2017 derived from logic demand from foundries in Asia. In fact, as Peter mentioned, for the second consecutive quarter, our PDMC JV in Taiwan posted record revenue.

Memory was down slightly, but likely due to order timing rather than any change in underlying demand dynamics. On a year-over-year basis, IC grew 11%, driven by that 51% increase in high-end demand. Both high-end logic and memory were up compared with somewhat softer demand last year.

Similar to IC, FPD achieved strong high-end revenue growth compared with last quarter and last year. Mainstream FPD also delivered strong improvement. All combined, FPD revenue improved 11% sequentially and 19% over the same period last year, including high-end increases of 10% sequentially and 9% over prior year.

The biggest driver of this growth, as Peter alluded to, was strong demand for LCD masks, as our customers are actively releasing new panel designs to maintain utilization levels in their operations to compensate for the softer demand for existing LCD panels.

While AMOLED demand was off slightly this quarter, we expect improvement going forward, as customers will also release new designs to optimize utilization. Plus, there is more AMOLED panel demand coming online.

If all goes well, we should be able to leverage this increase in AMOLED demand with the installation of our new mask writing tool, the P-800, which will begin at this quarter and be completed in Q3. Gross margin improved to 22.4% in the quarter from 21.9% in Q4 and 20.9% in Q1 prior year.

But not as much improvement as we would typically expect due to mix. Operating expenses were $15.9 million in Q1 fiscal 2018 compared to $14 million in Q4 fiscal 2017. A large part of the increase over Q4 is attributable to one-time favorable adjustments that reduced OpEx in Q4 and did not repeat in Q1.

The ramping China operations are also beginning to impact operating expense. In Q1, operating expenses represented 12.8% of revenue compared to 13.1% in Q1 prior year. As a result, operating income in the quarter was $11.8 million and operating margin was 9.6% compared to 10.3% in Q4 and 7.9% in Q1 2017.

Below the operating income line, two factors had a significant impact on income. First, we incurred a foreign exchange loss of $4.7 million or after-tax and minority interest $2.7 million, about $0.04 a share, primarily as a result of the weakening of the US dollar during the quarter and the impact that had on our foreign entities holding US dollars.

Secondly, we recognized tax benefits of $4.2 million or $0.06 a share as a result of two factors. The first was a change included in the Tax Reform Act that allows immediate recognition of accumulated alternative minimum tax or AMT credits. Our valuation allowance against these credits was reversed in the quarter, providing a $3.9 million benefit.

This provision in the tax law will enable us to monetize those credits in the future. We also realized a net benefit from the tax rate increase in Taiwan that increased the value of our tax loss carryforward there.

After consideration of the operating results, the tax benefit, and FX impact, we delivered $5.9 million of net income to our shareholders or $0.09 per diluted share compared to $5.4 million and $0.08 in Q4 2017 and $1.9 million and $0.03 in Q1 2017. The Q1 fiscal 2017 result also included a loss attributable to foreign currency of $0.02 per share.

On the balance sheet, our cash balance at the end of the quarter increased more than $40 million to $349 million, primarily due to another quarter of strong operating cash flow, including $22.4 million of depreciation and amortization and a little less than $900,000 of share-based comp.

Other significant cash flow items included a $12 million capital contribution payment from our JV partner in China as their initial contribution to our newly established PDMCX JV, which is consolidated into the Photronics, Inc. balance sheet. CapEx was $11 million during the quarter.

We still anticipate spending a total of $250 million this year as we complete construction and begin to install tools for our two new facilities in China. Recall that about half of the 2018 CapEx is planned to occur in the fourth quarter.

Before providing second-quarter guidance, I will repeat our reminder that our visibility is always limited, as our backlog is typically only one to two weeks. And demand for some of our products is inherently uneven and difficult to predict. Additionally, the ASPs for high-end mask sets are high.

And as this segment of the business grows, a relatively low number of high-end orders can have a significant impact on our revenue for a quarter.

Given those caveats and factoring in the potential impact of Chinese New Year and the continued ramp of our new China operations, we expect second-quarter revenue to be in the range of $120 million to $128 million.

Based on this revenue expectation and our current operating model, we estimate earnings for the fiscal 2018 second quarter to be in the range of $0.04 to $0.09 per diluted share. We have begun the year on a good foot, achieving revenue growth on good demand trends for our high-end products.

Cash generation during the quarter helped to further strengthen our balance sheet, placing us on solid ground ahead of large investments later this year.

As a management team, we are highly confident that our investments in China will enable healthy market share gains, especially with our PDMCX JV now established to position Photronics to compete effectively where the merchant IC market is growing.

And continue improving our profitability and cash flow to invest in organic and M&A growth opportunities. I will now turn the call over to the operator for your questions..

[Operator Instructions]. Our first question comes from the line of Edwin Mok with Needham & Company. Your line is open..

Morning, guys. Good job for the quarter. So first question I have on FPD; I guess a two-part question. First is I remember previously some of your customers converting lines from LCD to OLED. And that caused some headwind for your business.

Do you see any risk around that as we go through this year? And then for AMOLED, is it still predominantly that one large customer that you are seeing demand? Or you start to see demand coming from the second or even like beyond the other Chinese customers?.

Yes, as far as the conversion is concerned, the AMOLED capacity that resulted from that conversion should be coming online in the second calendar quarter of the year. So we don't see that presenting a risk. We see that presenting a business opportunity for us towards the end of our second quarter and building beyond that.

So that's not in our business at the present time, but we expect to see the demand resulting from it. And yes, as far as your question on the second-tier AMOLED customers, we've now shipped AMOLED reticle sets to more than a half a dozen customers. A lot of those sets are the first pipe cleaners, but they are certainly indicative of business to come..

Okay, great. That's helpful. And then on the high-end IC, on your guidance you expect logic to be weaker this quarter. When do we expect that to start recovering? Maybe you can talk a little bit about the dynamics around that..

Yes, our logic business really -- the significant uptick in revenues we had in Q4 in the high end was largely driven by logic. Likewise, we saw incremental growth in the high end in our logic business in Q1. Memory was actually down for the first time in five quarters in Q1. So logic has actually performed quite well.

And I would point you to UMC's quarterly release, where for the year, even though their 28-nanometer revenues are down, the way they are building their 28-nanometer business back is with small not large customers. So Jason predicted double the 28-nanometer tapeouts this year versus last year and we are seeing the benefit of that.

Beyond that, in the last quarter, the largest of segment of our high-end business was falling in the 14 to 22 nanometer slot. And again, I said memory was down. So we have other customers helping us along in the logic market.

So given that we've seen good growth for the last two quarters, and our business tends to be a bit saw-toothed, we are assuming given Chinese New Year's and how much strength we've had that logic is going to be down. But also in our prepared remarks, we mentioned we expect memory to be up again.

And we have a good reasons based on the amount of memory WIP we have at the present time to believe that's going to be the case. So a bit lumpy, but generally up and to the right..

Okay, great. That's helpful. Last question I have, just on the cost side. I think John, you mentioned that some of the costs of the Chinese ramp is starting to come in your OpEx in the fiscal first quarter.

So how do you think about OpEx trend in the second quarter and maybe for the rest of the year? Also, just in terms of ramp of the new facility, since you guys are going to start taking tools later on this fiscal year, do you expect depreciation to start coming in the second half of this year? Or is it more like 2019 when we start to see the depreciation expense start to come in?.

Edwin, good question. Our plan, obviously, to be able to go into production in the beginning of next year is to staff up and be ready for that. So the OpEx will continue to increase during the year as we fill that staffing requirement. We won't start depreciating the tools, though, until they are actually in production, which will be next year..

Any way you can kind of quantify both the OpEx or the depreciation piece?.

So you can assume that the effect on EPS for the Chinese ramp is in the range of $0.01 to $0.02. And that will increase somewhat in third quarter and in fourth quarter..

Edwin, I will just remind you that we will give much more color on the China ramp during our Investor Day. But we have this kind of long-term objective to get to $1 a share. And the investments we are making in China are absolutely essential to hit that target. And yes, there is a small bleed right now. As John said, it's $0.01 to $0.02.

We will do our best next quarter to keep it under $0.02, but we can't get to where we want to get to without some short-term pain. But we will do our absolute best to mitigate it..

Great. I think that's it for now. Looking forward to the event. Thank you..

Our next question comes from the line of Patrick Ho with Stifel. Your line is open. .

Hi, good morning. This is Brian Chin on for Patrick. Thanks for letting us ask a few questions. I guess first question, maybe following up on Edwin.

In terms of foundry logic, is it fair to characterize perhaps, given your current visibility, that that business, especially from your lead customer, reaches a bottom in fiscal Q2 and maybe stays there for a quarter or two? Or do you think the drawdown in sales could last over a couple quarters?.

Looking at the business levels from that customer, they actually troughed three quarters ago and have been building back since. And I just will reiterate first, tapeouts usually precede revenues by a quarter or two for our customers.

And beyond that, UMC, again, has publicly stated the way they expect to build their 28 nanometer back with small not large customers. That means lower wafer volumes per every design win. So that means more reticles per foundry dollar. So I'll say our business troughed with that customer three quarters ago and is growing..

Okay, interesting. Also, wanted to ask about the P-800 and the expectation again to install that tool in the second quarter. When again can we expect the Company to begin to generate meaningful sales from installation of the new tool? Granted that it's for, like you said, higher resolution screens..

Our expectation for that tool is it's going to hit the sweet spot of the uptick in the next wave of growth in AMOLED. So when it's installed, it should ramp quite quickly. We are already doing the work with some large customers to ensure that that is going to be the case. And maybe Chris can make some comments about where the industry is with AMOLED.

Chris?.

Sure. Thanks, Peter. Yes, Brian, just broadly, we are tracking a variety of AMOLED projects, fabs, also litho tool installations that are targeted for AMOLED. The P-800 we think puts us in a unique position to be, at least for the time being, one of the only suppliers to be able to service those sorts of masks.

And while in 2017, Samsung shipped maybe 100 times more AMOLED panels than others that are getting into it, as Peter said, about a half a dozen new customers are starting to do pipe cleaners. When we look at the specs for those, they are kind of P-800 class specs.

So we are excited about that ramping capability and how it is going to fit in with some of these new AMOLED ramps that are really going to start 2018. We are going to see I think a strong pickup in that..

And just to add one other bit of color, the first Chinese AMOLED manufacturer to produce screens in volume is being -- those screens are being delivered to a Chinese phone manufacturer. The reticles behind that were provided by Photronics. So yes, we are gaining traction in that market..

Okay, great. Maybe one more question and then I will hop back in the queue. But just doubling back on the gross margin headwinds you've alluded to for a few quarters here, it sounds like maybe the brunt of the gross margin headwind you will feel will occur more probably fiscal 1Q 2019.

I would imagine that's a period where you are sort of in a preproduction qualification, installing the tools, and not yet getting maybe the absorption from a revenue standpoint.

I know maybe it's a little preliminary, but just ballpark, are we talking about potentially a 300 basis points upwards of that kind of impact? Or is my math kind of way off there?.

Well, it is true that during the first half of 2019 is when the investments in ramping the two foundries in China will be at their -- kind of at their peak. And the revenues will not have yet materialized to offset them. So that's the right timing for the maximum drag.

Again, we will do our best to make sure that the timing of that is as short-lived as it possibly can be. But it's unavoidable. And as I said earlier, a three-to five-year kind of target is $1 a share, so we -- it's a necessary aspect of the journey..

[Operator Instructions]. Our next question comes from the line of Thomas Diffely with D.A. Davidson. Your line is open..

Yes, good morning. Quick question on the AMOLED side again. So over the last couple quarters, a lot of new tools have shipped in the industry.

Just curious if you've seen an increase in business yet from the new capacity coming online? Or is that still waiting to be installed and you will see that down the road one or two quarters?.

I think it's both, Tom. We started to -- we have seen, I think, the first wave of tapeouts from nearly all of the customers and there's a decent number of them. Having said that, there's likely a quarter, maybe two, pause until they ramp their -- until they ramp their lines to yields where they will start to order more. So we are optimistic.

And of course, the largest customer, I mentioned it earlier, is bringing a new factory online post Chinese New Year. And even presently, they are I think now starting to actively look for business, given the pullback in Apple's demand.

So the AMOLED market is shaping up really nicely for us, I think, starting in the next quarter and it should build from there..

Okay, great.

And then moving over to the IC side, when you look at the memory recovery from current levels, do you think it's more going to be NAND-driven or DRAM-driven? And longer term, which of those two end markets you think is the bigger driver inside of memory for you?.

Boy, I think it's driven by both markets for us. I think that in the near term, perhaps we have a little more upside in the NAND market, given what's happening with some of our largest customers ending a long-standing JV that they have had. That generates nice business opportunity for us with one of them. But beyond that, I think it's pretty balanced..

Okay. Then moving over--.

Chris, would you like to make any comments regarding the memory market?.

No, I think some of the comment Peter -- starting in 2018, we are going to enter into, I would say, mass production level for two new products we qualified in 2017. One is a DRAM and one is NAND. They are both advanced nodes. So for us, I think it will be pretty balanced between the two. Overall, DRAM had a tremendous run in 2016 and 2017.

I think we expect the DRAM market overall to temper some in 2018 and 2019, but that will mainly be due to capacity adds. So we do think, particularly the Tier 2 players in DRAM are starting to introduce some very competitive new products into the market. And we are well positioned with those DRAM makers. So I think it's pretty balanced.

I would agree with Peter, and we have a good position in both applications..

Okay, thanks, Chris. And then moving over two the model itself. John, I think you talked about record business again in the joint venture in Taiwan. But I noticed that the controlling interest was actually down quarter over quarter. Just curious if you could reconcile that..

Yes, so the margins varied this quarter versus last quarter. Some of the adjustments we made in Q4 were in the joint venture that improved their results that we didn't get this quarter..

Plus the joint venture is right now carrying part of the -- or not the joint -- well, the two joint ventures, right. One of them is now carrying the operating investments we are making in -- or the ramp investments we are making in China. So it had an offsetting effect. You can't see the breakout.

And then of course, John also mentioned FX and the movement of the New Taiwan Dollar versus the US dollar being very unfavorable last quarter..

And more than half of it was in the joint venture..

Okay, great. All right, thanks for your time today..

We have a follow-up question from the line of Patrick Ho with Stifel. Your line is open..

Hi there again. Maybe one or two more quick follow-up questions. Peter, you have previously talked about having some good long-term commitments on the flat-panel side with customers in China as you ramp that capacity.

I'm just curious, do you expect to receive customer deposits, perhaps from some of those customers? And could you help us -- if so, could you help us size that and maybe the timing?.

So yes, when we were in conversations with our customers regarding starting up an FPD factory in China, many of them were wanting to throw money at us for equity investments. And we told them we didn't want money; we had our own. What we wanted was business commitments.

And we have plenty of those, enough really to ensure that the FPD factory once ramped will operate profitably for a three-year period. So the commitments are large and they are substantial, but they are for business. They are not for capital..

Got it. And then maybe a question for John. I did notice that the tax expense seems maybe high relative to what the provision has been in prior quarters. Maybe if you could flesh that out a little bit. Thanks..

Yes, of course, there are no taxes in the US, but it depends where our income comes from. So just the weighted average put the -- absent the reversal of the valuation allowance, our rate was at 28%, which is higher than it has been. But it's based on where the income lands..

Okay. I was talking about the guide -- this April quarter guidance? The $3 million to $4 million absolute dollars..

Yes. It's just based on the weighted average of where the income is..

Okay, great. That's it for me. Thanks..

I am showing no further questions at this time. I would now like to turn the call back to Dr. Peter Kirlin for closing remarks..

Thank you once again for joining us this morning. This year is shaping up to be a very important year for us. We believe our markets will grow and we will see improvement in financial results compared to last year.

In addition, we are investing in our future by expanding our capacity and capability as we establish two new manufacturing facilities in China. We really appreciate your support and we will continue to update you as we move forward..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day..