Troy Dewar - Director of Investor Relations Peter Kirlin - Chief Executive Officer John Jordan - Senior Vice President and Chief Financial Officer Christopher Progler - Vice President and Chief Technology Officer and Strategic Planning.

Tom Diffely - D.A. Davidson Patrick Ho - Stifel Nicolaus.

Good day, ladies and gentlemen. And welcome to the Photronics’ Third Quarter Fiscal Year 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will be given at that time [Operator Instructions]. As a reminder, this conference is being recorded.

I would now like to turn the call over to your host, Troy Dewar, Director of Investor Relations. Please begin..

Thank you, Laura. Good morning, everyone. Welcome to our review of Photronics' 2018 third 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 and 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 our discussion, we will refer to certain non-GAAP financial metrics. These numbers are useful for analysts, investors and management, to evaluate our ongoing performance. A reconciliation of these metrics to GAAP financial results is provided in our presentation materials. At this time, I will turn the call over to Peter..

Thank you, Troy and good morning everyone. We achieved another quarter of solid growth with 22% improvement over last year's Q3 revenue and 4% sequentially increase over our strong Q2 results.

End market demand is robust across nearly all of our markets and we are realizing the benefits from successfully repositioning the business to take advantage of growing markets in China and demand from captives.

We have now achieved sequential revenue growth for five consecutive quarters and double-digit year-over-year growth for the last four quarters. It’s rewarding to see the Company achieve near record performance while stepping up consistently. Year-to-date revenues up 18% and we are on track to have the best year in the history of the Company.

Previous two years’ were challenging and it has taken a lot of work by the entire organization to reach this level again.

I’m extremely pleased with what we have achieved so far in 2018 and the team is focused on continuing to build momentum as we look forward to the completion of our China factories by the end of Q4, and the expected revenue ramp in the second half of 2019.

IC and FPD both achieved sequential and year-over-year growth, with high-end IC being the biggest contributor to the improvement. Gross and operating profit improved as we achieved margin expansion through operating leverage and cost containment. Net income was $13 million or $0.18 per share at the very top of our expectations.

In addition, our cash balance improved on strong operating cash flow.

We are at a great point at this time in our China investment trajectory and feel increasingly confident in our ability to finish these projects on time and on budget; further, as we highlighted during our recent investment day, our cash generation should significantly improve once the Chinese facilities are up and running.

This confidence, together with our view that our own equity is a compelling investment led to the decision to initiate a share repurchase program adding another lever to our shareholder value creation strategy. During our recent Investor Day, we described how and why we have repositioned our business. This repositioning provides two benefits.

First, we've been able to grow our top line despite facing significant challenges if the three of our largest customers reduced their demand for our products, creating $110 million gap to fill. The second benefit is a more diverse and stable revenue stream with less customer concentration.

The way we implement the repositioning with the focus on two strategic priorities; one was growing our business in China; the second, to increase our business with customers that also make their own masks for those who we refer to as captives. This quarter demonstrates the success we've achieved in executing against both priorities.

Revenue from products delivered to China increased 44% sequentially and is up 132% from Q3 of last year. Year-to-date, China revenue was up 125% and represent 17% of our total revenue, which is a significant diversification of our customer base. This remarkable accomplishment was achieved ahead of the completion of our new facilities Hefei and Xiamen.

Once these facilities are completed, equipped and qualified, we expect our China revenue to accelerate, especially for FPD as we will be the first producer of G10.5+ photomask in the country and the only one with the experience making high-end masks for leading panel producers in China, Korea and Taiwan.

The construction of our two facilities in China is progressing and we are on track to complete both facilities by the end of Q4. After that, we will begin to moving tools in other systems to support our operations.

Once the tools are operational, we will begin the process of qualification, which will take two to three months for FPD and several months for IC. Based on these timelines, we expect to begin to realize revenue from our China facilities in the second half 2019.

On the subject of China, I would like to offer a few thoughts on the recent and ongoing trade discussions between the U.S. and China. By the very nature, geopolitical events like these are very unpredictable. That said I believe the impact to Photronics’ will be minimal and manageable.

On the tariff front, we do not export any products in China into the U.S. and do not plan to when our China facilities ramp. Therefore, U.S. tariffs should not directly impact our business. Regarding potential restrictions on transfers from the U.S. into China, this could impact our IC business.

FPD is largely immune as essentially none of the technology or tools used to manufacture display photomasks originate in the U.S. Within IC there is some possible, but I want to emphasize not currently implemented restrictions that has potential impact or ramp.

To this end, we have continued to see plans developed, such as moving technology or assets from another global location or from our partner. It gives us confidence that we will be able to manage this risk should it arise.

Furthermore, once our facilities ramp, our presence in China as a strong local merchant supplier should provide us with a competitive advantage over mask makers outside the country, enabling us to meet all our customers’ mask needs. So they can focus on making semiconductors and displays to advance their respective businesses.

On the second strategic front, we have also done a tremendous job of increasing our IC revenue with captives. Some of these operations can be large and comprehensive. For example, one of our customers operates the largest IC mask making facility in the world, while others are more limited in scope.

Regardless, we have worked very hard to turn this challenge into an opportunity. There are several reasons why customer with their [indiscernible] masks, including business continuity concerns, capacity constraints or product outsourcing, so they can focus internal resources on the most advanced nodes.

We have positioned Photronics as the supplier of choice for captives when they choose to outsource mask production. Our revenues quarter with IC captives increased more than 2.5 times compared to the same quarter last year. We’re now at annual run rate in excess of $120 million to these customers.

This is a clear demonstration that we can work together to meet their requirements, while also improving our financial performance. As I stated early in the call, we are on track to have the best year in the history of our Company. Our business is growing both top line and bottom line.

We are generating cash to further strengthen our balance sheet, providing more options in how we increase shareholder value. We are meeting our strategic objectives to increase our China revenue and our business with captives, and our China investments are on budget and on schedule.

I’m very excited about the direction of the Company, and look forward to updating you as we move forward. I will now turn the call over to John for more details on our Q3 performance and Q4 outlook..

Thank you, Peter, and good morning everyone. Third quarter 2018 continued the resurgence of the business after repositioning the Company during 2016 and 2017. Operating results improved over our strong second quarter and positions us to hit record revenue levels for this fiscal year.

Revenue of $136.4 million is the second highest quarterly revenue in the Company's history with growth in both IC and FPD.

Sequential revenue growth over what is typically a seasonally strong quarter was boosted by strong industry demand and our successful repositioning of the Company to take advantage of unique and strategic opportunities in the market.

Revenue recorded by our existing Photronics operations from product delivered to customers in China, as Peter mentioned, has increased significantly during the past year.

The cost recorded by our new China start up operations nearly entirely independent of those revenues are increasing as we hire resources and begin paying operating expenses when the new facilities are completed. The effect of those costs on Q3 results was inconsequential. I’ll discuss the anticipated effect on Q4 results when I discuss guidance later.

IC revenues improved 26% year-over-year and 5% sequentially, driven by strength in high-end up 94% year-over-year, primarily due to our customers’ new designs for logic chips particularly 28 and 14-nanometer. We're also seeing the positive results from targeting China and captive producers.

IC revenue from deliveries into China has increased three-fold since last year and now represent 16% of IC revenue. Revenue with customers with captive mask shops has increased 2.6 times and represents 29% of total IC revenue.

We believe these trends are sustainable and as we assess Q4, we anticipate that demand will keep revenues at these at current levels. FPD growth was driven by displays used in mobile applications, specifically LTPS and AMOLED. We classify LTPS as mainstream due to the masked size, even though the circuit geometries are similar to AMOLED.

Our LTPS revenues are on the rise because of LTPS recent widespread adoption by smartphone manufacturers. This technology currently offers most of the performance at one-third of the price of AMOLED, and as a result has gained significant market share.

We believe that as the price gap between LTPS LCD and AMOLED narrows, LTPS equipped phones will eventually transition to AMOLED. Meanwhile, our deliveries of AMOLED for mobile also increased as that market showed signs of growth and we began to ship products from our new P800 mask writer, fortifying our technology leadership in this sector.

Despite improved AMOLED revenue, high end was down sequentially as we pivot away from G8.5 panels used for large format TVs. Gross margin improved to 26.1% and operating margin expanded to 15% as operating leverage and cost control enabled us to grow earnings more quickly than revenue.

Below the operating line, other income was lower due to less foreign exchange gain, tax expense decreased primarily due to one-time tax benefit of $2 million or approximately $0.01 per diluted share. And minority interest increased due to strong earnings at our JV in Taiwan.

Net income attributable to Photronics shareholders increased to $13 million or $0.18 per diluted share, continued improvement over previous comparable periods. We ended the quarter with $333 million in cash and $58 million in debt, consisting of the convertible debt issue that matures next April.

Operating cash flow improved from the Q2 level to $49 million. We spent $20 million on CapEx, $6.8 million on share repurchases and received $6 million capital contribution from our China JV partner. Year-to-date, CapEx is $64 million and we’re adjusting our full year CapEx guidance, down to $135 million to $150 million.

This does not reflect any change in the schedule of the China products projects or the amount of investment, but mainly reflects the timing of cash flow payments for the buildings and tools. A significant amount of cash outflow that we expected to occur in Q4 '18 has been deferred to Q1 2019.

Total estimated costs for the China project remains unchanged. As a result, our CapEx for Q1 '19 is expected to be $135 million to $150 million, which will be in the preponderance of our CapEx spend next year.

Before I provide fourth quarter guidance, I’ll remind you that our visibility is always limited as our backlog is typically only once or 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 lower number of high end orders can have a significant impact on our revenue and earnings for quarter. Given those caveats, we expect fourth quarter revenue to be in the range of $133 million to $141 million.

End market demand especially for high end products should remain positive during the quarter, and we will continue to focus on growing our business in China and with captives.

Based on this revenue expectation and our current operating model, we estimate earnings for the fiscal 2018 fourth quarter to be in the range of $0.14 to $0.19 per diluted share.

As we ramp the China operations, hiring qualified resources and paying operating expenses, the negative effect of those start up operations included in the Q4 guidance is approximately $0.03 per share.

In our current model, we anticipate the lowest point in China operations to have a negative effect on quarterly earnings of approximately $0.06 per diluted share and anticipate China to be accretive to earnings by the end of fiscal 2019.

We are on pace to have one of the best years in our history and are very pleased with the performance and the Company's positioning. We are growing our China business ahead of the completion of our operating facilities there, and our construction projects on time and on budget.

We are growing our business with captives, effectively expanding our servable market. Our cash generation and balance sheet are strong, enabling initiation of a program to return cash to shareholders as we complete the China investments. This is a very exciting time for Photronics, and we are glad you have chosen to join us.

I will now turn the call over to the operator for your questions..

Thank you [Operator Instructions]. Our first question comes from Tom Diffely of D.A. Davidson. Your line is open..

So first question on the cost, John, you just alluded to the impact on the cost side to the margins for China expansion.

Is that evenly shared between flat panel and IC?.

No, it isn’t common. As you know, the IC facility is a joint venture so it’s a mix and a share of the loss with the joint venture partners. So it's a little more complicated than it even share..

I guess my question then was if it is on the joint venture side, does some of that get offset by the non-controlling interest what we see that dip down due to that increasing cost?.

Yes, and we have some of that actually in this quarter, a small amount. But in Q4, it gets a little bigger. So the minority interest that we shared for the Taiwan facility gets reduced somewhat by the minority interest and the loss in the China facility..

And the $0.06 impact the maximum impact is going to be the quarter before revenue starts rising?.

Well, we haven’t actually disclosed which quarter it is, but it could be..

And then maybe question for Chris on the high end flat panel tool that you just started to get some revenues from.

Is this tool more aimed at the leading players in Korea? Or is in situation where the tool is very well for new Chinese customers that increase their window, so to speak, on the production to help them increase yields?.

Yes, really it’s both -- it's still only one of a kind in the fields, so it’s giving us a real competitive advantage and we’re getting broad interest among both of those groups, you mentioned for capability of this tool. And we have shipped masks to both of those groups for the highest end application.

So I think it’s pretty broad-based and we’re leveraging it for PORs and new products as we speak..

And then it seems like perhaps the biggest news or the most exciting part of the business is with the captives right now you had 29% of the business.

How stable do you see that business or how volatile do you think it will be on a quarterly basis?.

I think if you look at how that business has evolved over the last year, it’s been a consistent ramp quarter-by-quarter. I think now where we sit with the captives we've reached a period of stability for the next quarter or two.

But having said that, I think we see more room to run in that marketplace as we move into the early part of next year or next fiscal year..

And then finally, John, it looks like the R&D spending has come down a little bit in recent quarters. I would have expected that to go up with some of these new programs over time.

What do you think the steady state is for R&D overtime?.

Tom, I’m not sure there is a steady state, it depends on the qualifications that we do. So in those periods when we’re doing more qualifications, you’re going to see higher R&D expense and then the following periods benefit from those qualifications on the revenue line so it will vary.

And even at its highest point, it's still a pretty low percentage of revenue comfortably..

[Operator Instructions] Our next question comes from Patrick Ho of Stifel. Your line is open..

Maybe as a follow-up to Tom's question regarding the captives. Given that you obviously helping to support some of their IC ramps, Peter, maybe you can just give a little color. What happens when I guess from a capacity standpoint internally for them when they see demand go down, bringing stuff back in house to keep their fabs full.

How do you adjust for those forecasts potentially down the road?.

Yes, so the first point I would make is before the Micron JV ended, our revenue to captives was really dominated by Micron and the affiliates. Today, effectively that similar revenue stream is split across a number of captives. So as any one adjusts their plans the impact to our business is significantly muted.

So we have the benefit of diversification with that customer base. The other thing that we can't discuss in great detail but in some circumstances we have actually contractual commitments from them that extend over multiyear periods to act is the second set of shock absorbers against a downturn in the business.

And then I think the final thing I would say is the other -- your source of revenue diversification. If you look at our business and you do the math around the commentary, you will see that our revenue to captives was about $30 million and our revenue to China was about $30 million.

So that’s just $60 million of significant chunk of our overall top line. And as far as China goes as everyone knows, they’re operating with a different set of criteria regarding any industry downturn. Our customers there have objectives that go beyond the normal profit and loss statement in the business.

So we see the combination of diversification of the captive customer base, the contracts where we’ve been able to get them in place. And then finally the fact that the ramp in China should more or less be downturn proof as three significant shock absorbers on the business should do industry rollover..

And maybe as my follow-up question for either Chris or John. With EUV in the high-volume manufacturing on the horizon over the next year or so. How do we look at both your investments and qualifications related specifically to EUV? I understand a lot of the CapEx right now is obviously due to the China initiative.

But how do we look at EUV in potentially bringing on new tools for that as some of those customers begin to go into high volume manufacturing?.

We have made a few incremental investments for EUV at our Boise nanoFab. They’ve been relatively small and they’re dual use platforms 193 and EUV. And as we had announced, we do have a joint development program with IBM and we are working on some advanced logic tape outs.

As far as when we would need to or want to do a turnkey -- fully turnkey EUV line, we’re still quite a few years out from needing that. Most of our initial EUV work is going to be hybrid flows where we will do some steps maybe a captive will do other steps. And then we will do early production early prototyping.

But I think the full turnkey line, the investment you're talking about is still quite a few years away. So we’re stepping up. We have a lot of development going on. We’re making smaller incremental investments. But we wouldn’t really project any large CapEx expenditures to support our EUV strategy right now.

But we’re definitely in the game and we have a great product and we’re shipping samples to at least three or four different customers..

And just going back to our Investor Day, this call there was a lot of commentary about the repositioning of the business. A significant component of the repositioning was to build and continue to build our book of business in China as we ramp our facilities there.

So the next I think maybe three years, China should provide a nice growth trajectory for the company coupled with basically the mobile display shift into AMOLED. So we’re trying to take advantage of what we described as technology dislocations.

China, the mobile display shift into AMOLED and the large panel shift from G8.5 to G10.5, so three technology dislocations, we’re actively trying to manage to grow our business over the next two to three years. I think EUV lines up pretty nicely beyond that time window for the leading merchant to ride another technology dislocation.

And as Chris said, we are prudently investing and again, the investors don’t see this but we have to develop the customer relationships and due to business development we need to support the investment when it comes time to do it.

So EUV for us is now fitting as the next leg of potential growth in our business, but it’s in our view right now, sitting beyond the China ramp..

Ladies and gentlemen, there are no further questions at this time. I’ll now turn the call over to Mr. Peter Kirlin for closing comments..

Thank you once again for joining us this morning. We are very pleased with how the Company is performing and optimistic that 2018 will be one of the best years in our history, and that 2019 will be even better as we launch production in China. Thank you for your interest and your support..

Ladies and gentlemen, that concludes today's conference. We thank you for your participation. and ask that you now disconnect. Everyone have a wonderful day..