Timothy Stultz - President and CEO Jeffrey Andreson - CFO Claire McAdams - IR at Headgate Partners LLC.

Weston Twigg - Pacific Crest Tom Diffely - D.A. Davidson Patrick Ho - Stifel Nicolaus David Duley - Steelhead Securities Mark Miller - Benchmark Company David Wu - Indaba Global Research.

Good afternoon, and welcome to the Nanometrics’ First Quarter Financial Results Conference Call. [Operator Instructions]. A question-and-answer session will be held at the end of the call. Until that time, all participants will be in a listen-only mode. Please note that this conference call is being recorded today, May 2, 2017.

At this time, I would like to turn the call over to your host, Claire McAdams. Please go ahead..

Thank you, and good afternoon, everyone. Welcome to the Nanometrics’ first quarter 2017 financial results conference call. On today’s call are Dr. Timothy Stultz, President and Chief Executive Officer; and Jeffrey Andreson, Chief Financial Officer. Shortly, Tim will provide a recap of the quarter and our perspective looking forward.

Then, Jeff will discuss our financial results in more detail, after which we will open up the call for Q&A. The press release detailing our financial results was distributed over the wire services shortly after 1.00 PM Pacific this afternoon.

The press release and supplemental financial information are also available on our Web site at nanometrics.com. Today’s conference call contains certain forward-looking statements including, but not limited to, financial performance and results including revenue, margins, operating expenses, profitability and earnings per share.

Such statements may be identified by the use of words like believe, expect and similar expressions that look toward future events or performance.

Although Nanometrics believes that the expectations reflected in the forward-looking statements are reasonable, actual results could differ materially from the expectations due to a variety of factors including general economic conditions, changes in timing and levels of industry spending, the adoption and competitiveness of our products, industry adoption of new technology and manufacturing processes, customer demand, shift in timing of orders or product shipments, changes in product mix, our ability to successfully realize operating efficiencies and the additional risk factors and cautionary statements set forth in the company’s Form 10-K on file for fiscal year 2016.

Nanometrics disclaims any obligation to update information contained in any forward-looking statement. During today’s call, we will also refer to financial measures not calculated according to generally accepted accounting principles.

Please refer to today’s press release for an explanation of our reasons for using such non-GAAP measures, as well as tables reconciling these measures to our GAAP results. I will now turn over the call to Tim Stultz.

Tim?.

Thank you, Claire. Good afternoon, everyone. Today in my prepared remarks I will briefly review our first quarter results before sharing our views on the current business environment and our outlook for the year. Jeff will review the financial details of our recent results and guidance before turning over the call for Q&A.

Our first quarter revenues were in line with our outlook, which was for sales to be at a similar level as the previous quarter and year-over-year growth of 25%. During the quarter, we posted record foundry and service revenues complemented by continued strong business from the memory sector.

First quarter shipments were a record high for Nanometrics largely driven by strong follow-on demand, new customer wins and multiple first-in-fab deployment of our latest flagship system, the Atlas III.

The strong market response and rapid adoption of the Atlas III exceeded our prior expectations, as most of our larger customers opted to move applications for their most advanced devices onto our newest platform. Our current outlook indicates shipments of the Atlas III could exceed 40% of our full year Atlas sales.

The significant increase in installation and warranty activities tied to simultaneous multi-tool first-in-fab installations at multiple customer sites in several different geographic regions required us temporarily expand the number of field engineering and application resources dedicated to the initial deployment of this new product.

The addition of resources required to meet the timing and magnitude for the Atlas III ramp drove our decision to increase the warranty accruals for all the first-in-fab toolsets ship to-date.

This incremental accrual along with shifts in product and customer mix had an adverse impact on our gross margin for the quarter, resulting in performance below our model and expectations.

For the actions we have already taken, we expect an immediate rebound in gross margin in the second quarter and a return to our target gross margin ranges in the second half of the year. Turning to our business outlook.

Since our last earnings call, we have seen a significant uptick in our business outlook for the year with increasing strength in the second half. While Q2 revenues are still expected to be at record levels and the first half in line with what we discussed last quarter, the second half is now expected to be up at least 10% from the first half.

This would result in record annual sales and year-on-year revenue growth exceeding last year’s performance. With our growing confidence in our sales pipeline for 2017 and the improving tailwinds of recently announced customer spending plans as a backdrop, I’ll share a bit more color on our expectations for key areas of our business.

In 3D NAND, we expect to continue to benefit from our leading market share and strong tool record positions with every company ramping production of 3D devices.

Our products both CD and films in both automated and integrated formats along with our DIFFRACT modeling and analytics software are being used throughout the industry for high volume manufacturing of 32-pair 3D NAND chips, ramping of 64-pair devices and the development of 96-pair and greater architectures.

In 2016, we achieved record 3D NAND sales nearly doubling from 2015 levels. Our forecast for 3D NAND sales this year have increased since our last call and the NAND segment is again expected to be the largest contributor to our total revenues for 2017.

We continue to see 3D NAND investments somewhat weighted to the back half of the year with strength coming from each of the top five customers.

While our long-term outlook on total spending by Chinese national fabs for 3D NAND devices has actually increased, we believe meaningful contributions and opportunities in this market are now more a part of our 2018 growth story.

For DRAM, we continue to expect another strong year of spending in 2017 with revenues slightly weighted towards the front half of the year. In the foundry segment, we expect to see significant year-on-year growth with foundry becoming the second largest contributor to our revenues for the year.

Increased investment plans by a customer in this segment while we enjoy a strong share position combined with continued strong spending by the market leader has led us to raise our expectations and outlook for foundry in the second half of the year.

Additionally, foundry investments by Chinese national fabs in advanced logic devices where we believe we have a competitive advantage, for example, in FinFET structures are expected to become part of our 2018 growth story.

In the logic segment, we are encouraged by improvements in the spending outlook for the second half of the year and now expect we’ll see significant growth in logic sales, albeit off a small base in 2016.

Finally, while our greatest growth for the year will come from our flagship Atlas platforms and OCD applications, we expect continued strong revenue contributions from our integrated metrology, films, materials characterization and service businesses. Turning to our business model.

We have worked hard to drive operational efficiencies over the past few years keeping operating expenses essentially flat for three years straight, while growing revenues in excess of 50% during the same timeframe. This in turn helped us achieve incremental operating margin performance exceeding 65%, well ahead of our target model.

We previously announced planned increases in R&D investments for the development of entirely new technology platforms and products. Targeted for full release in 2018, these products are expected to expand share markets, provide incremental revenue opportunities and be additive to our long-term growth strategy.

And while our first quarter margins came in below our operating model, we expect significant improvement in the second quarter and to be back within our model ranges in the second half.

To sum up our thoughts on the year, the customer response to the Atlas III product launch has been the strongest we have ever experienced for our newly introduced product and is a key contributor to our 2017 growth story.

3D NAND where we have a sizable market lead across both our automated and integrated product lines continues to be a robust market in 2017 with a strong investment outlook persisting for the next several years.

And finally, with our tool record positions across all device types with every leading customer combined with the overall positive outlook for wafer fab equipment spending, we are increasing our revenue expectations for the full year and forecasting record revenues in 2017.

The year-on-year growth at a rate greater than 2016, our fourth sequential year of double-digit revenue growth and our fourth sequential year of outperformance versus overall industry spending. With that, our Q2 guidance is as follows.

Revenues of $64 million to $68 million, gross margin of 51.5% to 53%, operating expenses of $21.8 million to $23.5 million and earnings per share of $0.28 to $0.34. I’ll now turn the call over to Jeff to discuss our financial results and guidance in more detail.

Jeff?.

Thanks, Tim. Before I begin my comments, I'd like to remind you that a schedule which summarizes GAAP and non-GAAP financial results discussed on this conference call, as well as supplemental revenue segment information by product, end-market and geographic region, is available in the Investor section of our Web site.

The P&L metrics discussed are non-GAAP measures, unless I identify the measure as GAAP based. These measures exclude the impact of amortization of acquired intangible assets, restructuring charges and discrete tax items. First quarter revenues were $59.3 million, similar to Q4 and up 25% from Q1 of 2016.

Product revenues were $48.2 million, down slightly from the prior quarter and up 23% year-over-year. Service revenues were a record $11.1 million, up 7% from Q4 and up 35% from the year-ago period. By end-market, product sales to the NAND segment were the largest contributors at 40% product revenues, down slightly from Q4.

Foundry sales saw the largest growth, up 15% quarter-on-quarter and 86% year-on-year to comprise 29% of product sales for the quarter. DRAM sales declined to comprise 13% of product revenues. IDM/Logic sales were 10% and all other devices and substrates comprised 8% of product revenues.

By product type, total first quarter revenues were comprised of 58% automated systems, 16% integrated metrology systems, 7% materials characterization systems and service of 19%. Our 10% customers in the first quarter included Samsung at 22%, TSMC at 17%, Intel at 16% and SK Hynix at 14% of total revenues for the quarter.

Our Q1 gross margin was 48.3%, below our guidance and our target model range at these revenue volumes. Within this margin, service margin improved to 52.6%. However, product gross margin declined to 47.3%.

Given the significant number of new product and first-in-fab deliveries we have in the field and expect for the year, we are investing in additional resources in both service and application organizations to support the higher level of installation and warranty activity as Tim talked about earlier.

The increased costs associated with bringing new staff on and training them increases our cost of warrant and installation which necessitated the additional accrual we booked in Q1. This accrual combined with the adverse impact of mix of products and customers in the quarter resulted in gross margin being below guidance and below our target model.

We expect margins to recover in the second quarter and be back within the target model ranges for the second half of 2017. For the second quarter of 2017, we are guiding gross margin in the range of 51.5% to 53%, which is slightly below our target margin.

But for the second half of 2017, we expect to meet our target model performance of at least 53% at these revenue levels. Operating expenses of $22.8 million were above our guidance range primarily due to higher year-end audit and legal expenses along with higher stock compensation expense as a result of the appreciation of the stock price.

For 2017, we are planning an overall increase in R&D spending, as Tim noted earlier. We expect to increase R&D expenses by about 15% year-over-year.

With the improvement in our outlook for the year, we expect our variable compensation expense to increase at higher level of compensation expense and expect total operating expenses for the year to reflect our first quarter run rate.

Below the operating line, other expenses reported $200,000 consisting primarily of foreign exchange losses offsetting interest income in the quarter. Our non-GAAP tax expense for the quarter was $1 million or 17.5% of pre-tax income.

This was lower than expected due to a change in the tax treatment for one of our European entities, which resulted in a favorable adjustment.

Our tax expense on a GAAP basis also included a benefit associated with the adoption of a new tax accounting standard that now requires that the differences associated with the settlement of employee equity earnings that defer from the grant value go through the GAAP tax rate.

On an ongoing basis in 2017, we expect the tax rate to be approximately 30% and our cash tax rate to be about 17% due to our ability to utilize our deferred tax assets during the year. Net income for the first quarter was $4.8 million or $0.19 per share at the low end of our guidance range as a result of the lower gross margin.

Turning to the balance sheet. Cash and investments grew $132 million or $5.24 per share. Days sales outstanding increased to 73 days from 60 days in the prior quarter due to the timing of our shipments in the quarter.

Inventory increased $3.5 million to $44.8 million at the end of the first quarter while deferred revenue also increased by $3 million as a result of new first-in-fab shipments that require acceptance to recognize revenue. Cash flow from operations was $3.1 million and free cash flow for the quarter was $3 million.

And with that, I’ll turn the call over to questions.

Operator?.

Thank you. [Operator Instructions]. Your first question comes from Weston Twigg from Pacific Crest Securities. Your line is now open..

Hi. Thanks for taking my question.

First, just wondering in that second half uptick in terms of revenue, is there any delayed revenue from recognition related to the new Atlas III platforms?.

Yes, there will be some. We don’t really want to quantify it but we’ll still have some new applications that may crossover into the second half..

So, Tim, the uptick is rev rec [ph], not just demand related?.

A little bit..

Okay. Also was wondering if you could comment on the DRAM outlook. You mentioned second half strengthened 3D NAND and foundry.

Are you seeing any new DRAM projects or anything that would maybe bring up your outlook in the second half, upside opportunity or maybe in early 2018?.

I think at best probably – Wes, this is Tim. For the DRAM, it maybe 2018. DRAM continues to be pretty flat to strong – it’s a strong market. It was pretty flat for the year. What’s really driving second half is foundry and logic for us..

Okay, all right. And then just finally, KLA highlighted OCD as a growth area for them on their earnings call.

It doesn’t sound like it, but are you seeing any increased competitive pressure from them, or is there any share risk to worry about as we look into second half 2017 and into 2018?.

Yes, I think as a company we always consider it a highly competitive market. We know it is. I think we’re doing really good and sustaining and/or gaining share. But I don’t take it for granted. They’re a tough company.

All our competitors are tough and we have to do our best to not only hold our positions but expand in some of the areas that we’ve targeted. So I don’t see – it’s always that risk but I don’t see there’s a real risk. I think it’s our execution that will keep us there..

All right, very helpful. Thanks, guys..

Thank you. Our next question comes from Tom Diffely from D.A. Davidson. Your line is now open..

Good afternoon.

I guess following up from the last question here, when you look at the growth of the foundry business, is that purely just capacity or do you think that was share gains?.

It represents the resumption of spending by an additional foundry customer which is an uptick in their plan spending. They’ve been relatively absent over the other time. The market leader has been where most the business come.

We’ve gotten a little better share gain but it’s really the resumption of spending from a customer where we have a strong share position..

Okay, great.

And then if you look at just the broader market, I assume that OCD is still taking share from CD-SEM in the marketplace and I’m curious if you’re starting to see the other side of that with E-beam starting to take some leads away from OCD?.

We don’t fear those competing direction in the E-beam. That’s more of an inspection area anyway versus the metrology. OCD still is chipping away at CD-SEM, although CD-SEM continues to be strong. We don’t have one-offs in either applications or footprint or layers against the E-beam business..

Okay. Your tools, it sounds like they’re qualified or good to go down to these lower nodes, ultimately 7 and 5 nanometers..

Absolutely. We’re engaged in 5 and 7 nanometer. We have technology roadmaps – we’re doing actually some chip development activities with most of the accounts. We also have a technology roadmap on a current platform that will allow us to take us into those future nodes..

Great.

And then finally when you look at the Atlas III and the higher warranty costs, has it been tougher than you expected to install and qualify these systems or is it just the fact you have so many going out at the same time you needed a bigger workforce?.

It’s more the latter. I don’t know if I’d call it tougher. It certainly doesn’t reflect like on experience that we have with other tools. We were caught a bit by surprise on the number of conversions over to the platform.

If you look at our planning, one could argue that we could have done a better job of planning the resources and the training so we could deploy them in a timely fashion.

And it’s at multiple customer sites with multiple tools and multiple geographic regions, and we’ve just had to step up both our training and the dedicated resources aligned specifically to that platform at a faster rate than we planned..

Okay.

So the training cost will be one-time but then the people cost will be ongoing?.

Right. What it gets down to is it’s then efficiency. When you’re in training, the folks that we are training have to be shadowed by experienced folks and so we didn’t have as large a complement of Atlas III qualified folks to match the installation rates.

And so we’ve had to be a little bit more inefficient, bring us some people and accelerate their training..

Okay.

And then just to confirm, you said that the second half would be more than 10% greater than the first half from a revenue point of view?.

That’s correct. We expect to be at least 10% up second half over first half..

Okay. You said then all of '17 would be up a greater percentage than the 18% you posted last year..

That’s exactly right. That’s what we’re saying..

Okay. That’s a lot of information. Thank you very much. I appreciate your time..

You bet..

Thank you. Our next question comes from Patrick Ho from Stifel. Your line is now open..

Thank you very much and nice work on the outlook. Tim, we’re going to start off with the gross margins to try and get a little more color there. We’ve seen a rapid increase in spending over the last quarter or so and you’ve given an outlook that reflects that.

What gives you confidence that the steps you’ve taken in Q1 and some of the accruals taking won’t pop up once again in the second half of the year if spending continues to be robust as we go into 2018? Could it be one of those cyclical things where it just kind of keeps rolling where you’re always playing catch-up to the rising demand that’s out there?.

So it’s a great question and the biggest response of that is first-in-fab installments where you have customer acceptance, activities are much more complex and require a different set of skills initially to get these tools in and signed off meeting all the new applications.

Once we get through that hurdle, then these become follow-on tools, they become expansion of capacity installations. They’re much more straightforward once the workforce is trained, they’re much more straightforward.

And so when you look at it, it’s really that first-in-fab new customer, new acceptance, new application area that drives up the incremental activities. I have very high level confidence that we’ve got the right people in place with the right training who are going through this initial ramp.

These will be the same people then that we will require fewer people in the field for follow-on tools. We’ll be more efficient on the number of people applied per tool during the installation. That includes both in the service applications.

Your application requirements go down once the tool has been accepted for a specific application and the recipes have been written. So I have a pretty high confidence that we’ve got this basically and largely under control and it’s not going to be a Groundhog Day, it’s not going to be a reoccurring problem. Maybe Jeff would like to add to that..

Patrick, I would add, as you know we continue to drive cost down here. We’ve always been focused on that. We’ve had some adverse customer product mix that won’t necessarily repeat in the second half but we’re still driving material cost reductions that will help us in the second half as well.

And just the leverage in the factory will help us by the time we get to the second half as well. So there’s other cost reductions on top of anything else..

Patrick, I’d add one other thing too that we’ve tried to not – we’ve tried to only reflect on what we have control over ourselves and what we’re responsible for. But with the growth that this entire industry is experiencing, the supply chains are being strained. And we’re not an exception to that.

So if you look at our supply chain that we tap into, they serve a lot of the other companies that are growing. We’ve had to actually put incremental activity and dedicated resources to help guide our supply chain through a ramp that is greater than we originally communicated to them when we started this product launch..

Fair enough. I appreciate the color. As a follow-up question, you talked about basically the return of another leading foundry in terms of spending particularly in the second half of the year.

Maybe as it goes back to the Atlas III, was the return of that spender and maybe their migration to the Atlas III part of the reason why you had to increase the workforce, the warranty cost? Is it because they transitioned more to the Atlas III than you expected?.

They were a significant contributor to that, that’s right, as they go in and resume spending in this area. As we said, essentially every one of our leading customers has made the decision to move their advanced devices, their advanced technology devices onto the Atlas III a little quicker switchover than we anticipated.

And because there are new devices and there are new fabs, then we have to go through accelerated installation, application development and acceptance processes..

Great. A final question from me more for Jeff. This quarter, you mentioned you generated 3 million in cash flow from operations.

As your revenues ramp and I assume the account receivables start coming down, do you expect this year to be a very strong cash flow generation year for the company?.

Yes. In short terms, I think our inventory will normalize out and we’ll get these ARs turning.

The one thing that you always have to be cautious about is, is that if next year ends up being – we’ve talked about, it’s another growth year, so we’ll still have the need for additional working capital and that could be one thing that would mute it a little bit, because we’re – as you look at '18, there’s some really strong indicators that that’s going to be another good year..

Great. Thank you very much..

You bet..

Thank you. Our next question comes from David Duley from Steelhead Securities. Your line is now open..

Yes. Thanks for taking my question. A couple from me. The incremental warranty reserves this quarter and the impact on gross margins, and I think you mentioned a couple other things that hit the margins this quarter.

Could you just take a guess at what the total impact to margins were in the March quarter either in dollars or as a percentage? And maybe break out what the pieces were, the warranty and the product mix and whatnot?.

Yes, so I’ll break it into two pieces. So if you just start from our range of gross margin that we gave at 48.3 versus the low I think was 51.5, about half of it was warranty related and the other half was customer product mix.

Some of the product mix was customer and product combined and others were related to our software business where we had fairly large program that was delayed and we couldn’t get revenue in the quarter for it and it will come back in out quarters now. So those are the two big pieces. We can’t get any more specific on customer and product..

Okay. And as far as – you mentioned going forward you’re going to step up the R&D dollars to accelerate new product development and that will increase the company’s TAM. Help me understand, I think you mentioned a 15% increase in your prepared remarks as far as the cost go on R&D.

What sort of increase in the TAM do you think that that will yield to you?.

Yes, that’s a great question and we’ve unfortunately and intentionally been rather obtuse about where this product area is going for competitive reasons. But our served market we believe could increase up to 2x based on where we’re going with these new products..

And just to remind me now, what is the size of your served market now?.

So the total OCD market, if you will, is gone the order of $250 million and there are other elements of it. That’s kind of what we flush out. The thin film market is roughly the same size, about 250. So if you take our primary products going into OCD and films, we’re talking about $500 million served market with our core products.

And then there’s some other elements in there..

And that’s the piece that you would think would double with the introduction of the new product sets?.

Yes, I do..

Okay. And final thing from me just on NAND business, you talked about how you’ve seen a strengthening in your outlook for the second half of the year and it sounded like that’s mostly foundry related.

But perhaps you could give us a little bit more color on the NAND business? What is the linearity of the NAND business in the first half versus the second half?.

So actually we’ve said that the second half is – if I look at what’s going on for the year, it’s really foundry and logic. Those are drivers. NAND has continued to be for the year roughly flat but the second half weighted in terms of total NAND opportunity..

So stronger second half in NAND..

Stronger second half in NAND but relatively flat for the year, still very solid number and it will be our largest revenue contributor for the year..

And then it’s the foundry/logic business that’s driving the uptick in your expectations in the second half of the year?.

That’s correct..

Okay. Thank you very much. Congratulations on nice results..

Thanks..

Thank you. Our next question comes from Mark Miller from Benchmark Company. Your line is now open..

Just wondering if you can give me a little more color on the new customer wins where these foundries, where these NAND, DRAM, et cetera, and for what type tools?.

Hi, Mark. It’s Tim. It’s more about what the spending patterns are. We are making gains here and there but this is not so much a new customer win, it’s really the resumption spending of a major customer that we have in the foundry area where we already had share and they’re spending. The foundry has been rather muted over the last couple of years.

We’re seeing a little resumption of logic spending and that’s helpful. So it’s really more about customer spending time – timing of customer spending than it is about penetrating a new account. We’re pretty solid in all the major spenders and across all the major devices..

Are you seeing any replacement in your legacy tools?.

Tell me what you mean by that, Mark?.

Well, basically we’re going to 64 layer – some people are on the 64 layer NAND Flash and does that require upgrades for software, does it require upgrades for detectors, does it for light source, et cetera, or can what you have in the field handle this?.

I see. With the large installed base, there are upgrade activities and upgrade opportunities. But when you get to the most advanced devices and especially with the number of greenfield fabs are being build and/or new capacity put in place, it’s really – most of our activity is with new tool sales and deployment..

Just speaking of greenfield, I’m just wondering about the Samsung facility. Are they actively taking equipment for the facility now that’s coming up? I thought it was second half or next year..

You’re talking about Xi'an's tech [ph]?.

Yes..

Xi'an's tech is taking tools definitely. That’s the majority of their spending right now..

Okay.

What do you estimate for the breakout roughly between DRAM and NAND production of that facility?.

I don’t have an answer for that, Mark. Right now I know that 3D NAND is a big driver for this. But we expect it to be a little bit of all their devices, but 3D NAND is the primary investment element at this time. Long term, when they fully populate that campus, I can’t tell you. I think they’ll be more market driven..

Okay. Thank you..

Thank you. [Operator Instructions]. Our next question comes from David Wu from Indaba Global Research. Your line is now open..

Good afternoon. I was thinking about the issue in product gross margin. By the second half, all these special training expenses regarding Atlas III will be behind you. So if I look at the product gross margin, it should depend on customer mix, right? The more concentrated your customer mix, the lower the gross margin.

And are there any – I was also wondering whether there are any major differences between your different product areas except for obviously software?.

David, it’s Jeff. So I think when you look at the second half, of course I think in Q1 we had obviously a less favorable customer product mix. We don’t see that as being occurring in the second half. We talked earlier about other cost reductions that were driving that we’ll start to see in the second half.

And we’ve always talked about mix being kind of a half a margin point one way or the other. Of course, it was stronger in Q1 than we had seen it in prior quarters. But there’s always some element of mix..

I see. You also said about the operating expenses at – being maintained at a first quarter level.

Are you talking about GAAP or non-GAAP operating expenses?.

They’re essentially the same but non-GAAP..

Okay, fine.

No change in tax rate I assume going forward?.

Yes, but the timing changed a little with this one-time effect, about 30% for the year..

Okay, fine. Thank you..

You’re welcome..

Thank you. I’m not showing any further questions at this moment. I’d like to turn the call back to Timothy Stultz for any further remarks..

Okay. Thank you for joining our call today. We’re on track to deliver a great growth year for NANO in 2017. And I say with deep gratitude that our accomplishments are directly tied to the performance of our terrific team of employees and our business partners who make it all happen. With that, we’ll end our call..

Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program. You may all disconnect. Everyone, have a great day..