Claire McAdams - Managing Partner, ‎Headgate Partners LLC Timothy Stultz - President and Chief Executive Officer Jeffrey Andreson - Chief Financial Officer.

Patrick Ho - Stifel, Nicolaus & Co. Thomas Diffely - D.A. Davidson & Co. Weston Twigg - KeyBanc Capital Markets Mark Miller - The Benchmark Company LLC.

Good afternoon. And welcome to the Nanometrics third quarter financial results 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 follow at that time. [Operator Instructions]. 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 third quarter 2017 financial result conference call. On today's call are 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 shortly after 1 PM Pacific this afternoon. The press release and supplemental financial information are also available on our website at www.nanometrics.com.

Today's conference call contains certain forward-looking including, but not limited to, financial performance and results, including revenue, margin, 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 product, 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 in 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 expectation of our reasons for using such non-GAAP measures, as well as tables reconciling those 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 third quarter results, share our views on the current business environment, and give our perspective looking forward. Jeff will then review the financial details of our recent results before opening the calls up for Q&A.

Our third quarter results were consistent with our pre-release earlier this month, with revenues of $56.7 million and earnings of $0.22 per share. The shortfall in revenue compared to our initial guidance in August was the result of a delay in revenue recognition of Atlas tools into Japan.

These tools were follow-on installations of our older Atlas platform into an existing, but new area of a fab, which resulted in some unexpected delays in installation and acceptance. We fully expect to complete customer acceptance and recognize revenues for those systems in our fourth-quarter results.

Businesswise, our focus continues to be on above-average growth and improved profitability through customer footprint expansion, further share gains, new product-driven SAM expansion and margin expansion through execution and business model leverage. Since our last earnings call, we've made progress on a number of these fronts.

As we have mentioned before, the strong market response and rapid adoption of the Atlas III significantly exceeded our initial expectations. Notably, for the second quarter in a row, Atlas III comprised more than 50% of our automated tool sales.

Significant performance improvements in sensitivity, precision and productivity have led the majority of our key customers to aggressively adopt this platform for their most demanding process control applications across all device types.

This is by far the most successful new product launch in company history, both in adoption rate and revenue ramp contributions, and continues to be a key factor in our progress on winning additional key account tool-of-record positions.

In July, we launched two new software tools for process control data analytics and are making steady deploying them into multiple sites and applications. First was NanoDiffract 4, the latest generation of our industry-leading, OCD modeling software, delivering significant improvements in productivity, time to data and modeling capabilities.

Retrofittable to our Atlas III, NanoDiffract 4 has already been deployed at multiple sites. The second software tool was the newest member of our data analytics family, SpectraProbe. SpectraProbe is a proprietary OCD analytics tool, which provides rapid identification of process excursions and device feature shifts.

Developed in close cooperation with several key customers, SpectraProbe has been validated and deployed for multiple applications and contributed to our revenues for the first time in Q3.

As a leading supplier of data-rich, process control hardware solutions, Nanometrics is in a unique position to contribute to the increasing demand for data analytics needed to ramp and drive fabs to profitability.

In response to this opportunity, we have a pipeline of new software tools in development and expect data analytics to be an important and growing part of our business in the future. On the hardware side, we've been investing in new process control technologies and platforms beyond OCD and thin films metrology.

These new platforms are targeting the applications where current technologies and tools are hitting technical walls. Our first new platform is scheduled for introduction next year, following an initial delivery to a leading-edge launch partner who has been closely collaborating with us during the development phase.

Successful development and introduction of new products and technologies are the lifeblood of companies in our industry. In addition to remaining competitive and relevant, new product solutions become additive to revenue profiles, an ability to benefit from industry inflection points.

We believe our long-term focused investments into new hardware and software solutions addressing these inflection points will expand our served markets and be instrumental in helping us achieve revenue growth above the pace of industry investments.

Turning to our business outlook by end markets, globally, investments in 3D-NAND continue to be robust and growing. We expect our revenues from 3D-NAND where we have particularly strong market share to increase double-digits from the 2016 record levels after doubling last year and to once again be the largest contributor to our 2017 sales.

We've already established high-volume manufacturing tool-of-record positions with the top five producers of 3D-NAND devices and announced last quarter that we recognize first revenues from a domestic Chinese 3D-NAND customer.

Overall, our confidence on the long-term outlook on spending by domestic Chinese fabs, in particular our memory devices, has increased this year from our earlier expectations. And these customers are expected to become an important part of our growth story starting next year.

While 3D-NAND is clearly a major driver of our expected second half and year-over-year revenue growth, we also expect every other business segment outside of DRAM to grow double-digits this year.

Turning to our outlook for next year, current business trends, combined with additive contributions from our R&D pipeline, and the prospect of further growth in spending on wafer fab equipment gives us confidence for growth at new revenue records in 2018, supported by six key drivers.

First, increased 3D-NAND and DRAM memory investments where we have established strong market share positions. Second, the emergence of significant spending from domestic Chinese fab projects. Third, secular growth in OCD for advanced three-dimensional device structures. Fourth, share gains in thin film integrated metrology and DRAM.

Fifth, initial revenues from our new product platform. And six, increasing contribution from our software and analytics products. Summing up our 2018 outlook, we believe we are positioned for a fifth year of double-digit revenue growth and another record revenue year.

This combined with the leverage of our business model will lead to another year of expansion of both our gross and operating margins.

Turning to our forward-looking guidance, Q4 is expected to be an exceptionally strong quarter, meaningfully exceeding our previous quarterly revenue records even before adding the contribution of revenues delayed from the third quarter.

Our guidance for the fourth quarter is revenues of $72 million to $80 million; gross margin of 53.5% to 54.5%; operating expenses of $23.5 million to $24.3 million; and earnings per show $0.40 to $.50. 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 Investors section of our website.

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, executive search costs and discrete tax items.

Third quarter revenues were $56.7 million, down 3.5% from the third quarter of 2016 and 12% from the prior quarter. Product revenues of $45.6 million, a decrease of 15% from the second quarter and 8% year-over-year. Service revenues of $11.1 million were up 2% from the second quarter and up 22% from the year-ago period.

By end market, product sales to the NAND segment continue to be the largest contributor at 36% of product revenues. Foundry sales comprised 20% of product revenues. DRAM sales were 14% and IDM logic sales increased to 13% of product sales. All other devices and substrates grew significantly, to comprise 16% of product revenues.

By product type, total third quarter revenues were comprised of 55% automated systems, 14% integrated metrology systems, 12% materials characterization systems, and service of 20%. Our 10% customers in the third quarter included Samsung at 32%, Micron at 19% and Intel at 14% of total revenues for the quarter.

Our Q3 gross margin of 54.4% increased 200 basis points from the second quarter and exceeded the high end of our gross margin range due to better-than-expected service margins of 59%, well above our target model for the service business, largely attributed to a higher level of utilization of our field service engineers to support the higher level of installations.

Product gross margins increased 60 basis points from the second quarter to 53.3%. Our fourth quarter gross margin guidance of 53.5% to 54.5% results in our gross margin for the second half being in line with our financial model at the second half revenue level.

Also, in Q4, we expect to see our service margin normalize and product margins improving on the increased sales volume. Operating expenses of $23 million were up 2% from the second quarter and came in at the low end of our initial guidance range, primarily due to the timing of certain R&D program expenditures.

Below the operating line, other income was $36,000, consisting primarily of investment and interest income, largely offset by unfavorable foreign exchange losses. Our tax expense for the quarter was $2.2 million or 28% of pretax income.

Our tax expense on a GAAP basis which includes the benefits associated with the difference between the actual settlement of employee equity earnings versus the initial grant value.

On an ongoing basis, in 2017, we expect our non-GAAP tax rate to remain at approximately 30% and our cash tax rate to be about 19% due to our ability to utilize our deferred tax assets during the year. Net income for the third quarter was $5.7 million or $0.22 per share. Turning to the balance sheet.

Cash and investments grew to $140.4 million or $5.49 per share. Days sales outstanding remain flat to the second quarter at 66 days.

Inventory increased $7.8 million to $58.3 million at the end of the third quarter to support the record level of shipments in the fourth quarter, as well as reflecting several systems already shipped and awaiting customer acceptance. Cash flow from operations was $5.1 million and free cash flow for the quarter was $4.3 million.

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

Operator?.

[Operator Instructions] Our first question or comment comes from the line of Patrick Ho from Stifel, Nicolaus. Your line is open..

Thank you very much. Maybe at the big picture question in terms of gross margins, Tim, you talked about some of the new products. And some of the ones you did talk about generally have higher margins like software and some of the data analytics.

But as you introduce new products, what is the potential impact of, say, new tool introductions or new features or things of that nature that potentially could impact margins for a quarter or so as they begin to ramp up?.

Thanks for calling in, Patrick. It's a good question. There is always of kind of pressure on new tools when you bring them in because of the installation and the learning process.

But as I look at the new tools we are working on, they will be strongly priced on a value basis and I think they are going to be accretive to our gross margins, pretty close to coming right out of the shoe..

Great, that's helpful. The follow-up question I have is, the mix of your customers has been pretty steady. You again mentioned that 3D-NAND is going to be your largest contributor in 2017 to revenues. I know it's hard to look out forward into 2018.

Do you believe that continues into 2018 as well where 3D-NAND is the largest contributor or are there other segments that you think can either increase or become a bigger contributor for 2018 as a whole?.

Yeah. Right now, we think 3D-NAND is going to be the strong player again for us next year, for the domestic as well as the Chinese national fabs. There are some very large investments that we're participating in. So, I fully expect that that's going to be the largest contributor to our revenues looking forward..

Great. And maybe a final question just for Jeff in terms of cash flow. Obviously, revenues were pushed out this quarter in terms of the timing.

Did that also push out some of the cash flow and the cash delivery on some of those systems and we could expect an increase in the cash flow from operations in Q4 or is that a Q1 story?.

So, they pushed a little bit, but I wouldn't say it was a giant contributor. In Q4, I'd say we were going through a pretty healthy ramp. So, we're investing in working capital. So, I think you'll start to see this cash flow improve going into the first quarter..

Great. Thank you very much. .

Thank you. Our next question or comment comes from the line of Tom Diffely from D.A. Davidson. Your line is open..

Yes. Good afternoon. So, I guess, following up on the memory questions, you talked about how that's still going to be one of your drivers in the out year.

Are you expecting both DRAM and NAND individually to be up year-over-year as a driver?.

Yes. So, we do think that NAND is going to be a big driver, but we do see growth in the DRAM investment profile and we think it will be an increasing contributor next year. .

Okay. I think, somewhere else, starting to speculate that we're going to have some greenfield DRAM facilities opening up here pretty soon.

Is that your view as well? And do you think DRAM becomes a pretty large percentage of the business over the next couple of years?.

There are some greenfield DRAM facilities and there are some – specifically some in China, as we're also seeing some new development in Korea that will be dedicated to DRAM that recently we've been made aware of. So, yes, we see increased capacity and investments in DRAM.

Most of it that we understand is less on total wafer starts, as much – it's really to offset the reduction in the number of die as they are going into the next generation devices..

Okay. So, the total industry wafer starts is actually staying the same, but may begin to split out into some new facilities to cover the lower –.

I know that there will be some facilities – I'm sorry, I misspoke on the starts.

That will be more capacity put in place, but the total bits, if you look at what they're trying to drive and the number of die, they're trying to deal with the reduction in number of die with the new scaling structures, and they are putting the capacity to offset that as opposed to bit demand, which will be in the low single digits..

Okay.

As they move down to the different [indiscernible] nodes, do they get more capital-intensive for OCD?.

They do, yes. They definitely displace a little bit some of the high aspect ratio components and the tighter process tolerances..

Okay.

So, even if an existing fab updated their facility and didn't increase their wafer starts, you'd still see some incremental business?.

Yeah, we absolutely do. We do see a growth in our business in DRAM and it's both driven by the technology nodes as well as the additional capacity and some of the new players coming on in China..

Okay, great. And I also reference, the new product has been a driver next year.

So, you expect revenues in the second half of next year, even if it's released kind of mid-year?.

Yeah. We think we have a solid shot at that. The plan is that. And we're looking at at least getting our launch partner transition from initial evaluation feedback and adoption. And we're looking at the second of revenue contribution. .

Okay, great. And then, you had a few times referenced double-digit growth.

I just want to confirm that you referenced that for both 2017 and 2018?.

Yes, absolutely. .

Great, okay. And then, on the service side, service margin was pretty strong.

What drove that?.

Hey, Tom. It's Jeff. It was mainly just the high-level of utilization. As we go through these ramps, we have our field service engineers working on all these installations. That basically is attributed to the product revenue. So, the service utilization was up. And it drove the majority of that upside.

And now, we're starting to hire some new people to support the higher levels of revenue and installations that we see going forward. So, that will normalize down as we bring some more people on..

Okay, makes sense. And then, on tax rate, you talk about 30% as being your current rate.

When you look forward, especially with the cash tax rate at 19%, how long can you sustain a cash tax rate at that level before you would expect it to go back up towards the normal rate?.

I think as we look to next year, I think it will be certainly in the first half of the year. We'll be able to continue to utilize it, but you get some limitations. And so, they vary by type of tax assets. So, I still think it will be well below the 30% range.

And as we look to next year, we're probably seeing a moderate increase in the tax rates with the growth we see now because it's US-based profits..

Okay. And then, finally, the other part of your business seems to be percolating here.

What is the driver behind that, the non-semi side?.

So, there's a couple areas. There's the adoption of our tools and CMOS sensors. Also, bare silicon wafer applications for our infrared systems..

Great. Okay, thanks for your time today. .

Okay, Tom..

Thanks, Tom..

Thank you. Our next question or comment comes from the line of Weston Twigg from KeyBanc. Your line is open..

Hey, thanks for taking my question. I have a couple of them. I want to ask the growth question next year in a different way.

Can you outline which customer segments, whether DRAM, NAND, foundry logic will drive the most growth for Nanometrics in 2018?.

We're still seeing a lot of strength primarily coming out of NAND. It has been one of our biggest opportunities because of a lot of the new capacity we've put in place. We think foundry is going to be coming up for us in the second half. Again, China is going to help in some of those areas. DRAM investments in China are new – new opportunities.

They are greenfield fabs. I would say the one we're looking to, but don't have as clear a handle on would be the advanced logic. Right now, we see some improvement in it, but I don't know if it's a strong driver going into 2018. .

Okay. So, when you say NAND offers the most – what did you say before? The strongest segment.

You also expect the most growth to come from NAND?.

Out of 3D-NAND, yes. .

3D-NAND, okay. The other question I had is, this year, just looking at the numbers, I have semi CapEx now up over 30%. And part of the estimate is Samsung guidance. But it looks like Nano growth should be a little over 16% this year. So, it seems like there's a little bit of a disconnect between the CapEx level in the industry and where Nano is growing.

I just wonder if you could help us understand [indiscernible] revenue recognition or something else..

That's a good observation. We, over the last three, four years, have clearly grown at a pace quicker than the investment profile. And this year, we're actually behind the investment profile of the industry for the first time, as I said, in almost four years. There's a couple of things to look at.

One is, what was our growth rates over the two to three years before this year? Because it was materially above it. And it was the process control investments, the timing with these customers and where our customers are putting the tools. So, there's some timing issues.

When you look at our growth over multiple years, you'll find out we're outpacing the industry. We've also – if you look at one of the biggest contributors for us, has been – for many of the folks in the industry has been Samsung. And we've seen growth at Toshiba, we've seen growth at Samsung.

But some of the other elements haven't been as strong for us and it's really the timing of those investments. So, one of the things that I'd like to point out is that, over the last four years, our NAND market share has grown 80% with the advent 3D-NAND. So, last year, we had – we doubled. This year, we've got double-digit growth on top of that.

And at some point, when you're tracking so far ahead of the industry, you roll over a little bit.

We're seeing a resurgence of that and we fully expect to outpace investments in WFE next year as a lot of these new sites come onboard, the growth in the 3D-NAND where we have strong market position, the opportunities in foundry, I think all those are going to contribute..

Okay. That's helpful color. And if I can sneak one more. This one should be for you, Jeff. I think, OpEx, looks like it is running a little higher than you thought it would be a quarter ago, just a touch in Q4. Just wondering if you could help us understand the difference and then maybe the trends on OpEx heading into 2018..

Hey, Wes. It's Jeff. Yeah, it's a little higher in Q4 than maybe we thought a quarter ago. And some of that is just related to the timing of spend and engineering on our program. It can just shift a week or two and it shift quarter. So, I think our view of the second half is about the same.

I think as we exit the fourth quarter and look into next year, that's probably our run rate and we'll probably need a little incremental investment to support some of the platform roadmap that Tim talked about and then a little bit of infrastructure to support China is how we're looking at it now..

Okay, very helpful. Thank you..

Thank you. Our next question or comment comes from the line of Mark Miller from The Benchmark Company. Your line is open..

You mentioned you saw strong growth at Toshiba and Samsung.

Did you lose share at any of the customers?.

In total, no. There's always some shifts in share in any market and it was a move around. But it you look at our revenue growth – take Samsung, for instance, which is the big spender. In the first nine months year-over-year, our revenues were up over 5x versus last year's first nine months. Now, we've got very strong numbers coming out of that.

Great growth at Toshiba. Great growth, as I said, with Samsung and so on. So, there are always puts and takes, but we still believe we have over 70% of the 3D-NAND market. We've got the strong position at all the major customers.

There's a couple where we're kind of holding our own on a couple of defense strategies, trying to get into more the foundry business where we've been successful in getting critical layers. We're trying to get additional layers.

But I think when you roll it over and you look at our revenue growth and you look at where it comes from, we've done a really good job not only of defending our markets, but I'd say taking some share in a couple of key areas..

For your new platform planned for next year, what are the incremental improvements?.

It's not an incremental improvement. It's a brand-new platform. It's a brand-new tool. So, it's not an extension of the OCD or films markets. It's a product that, as we mentioned, we've developed in collaboration with one key customer – actually, multiple customers have been involved in helping direct us.

And it's targeted at an application that is not served at this time, but has become a critical process control parameter for our customers. .

Thank you..

Thank you. I'm showing no additional questions in the queue at this time. I would like to turn the conference back over to Dr. Stultz for any closing remarks..

Thank you. Before ending this call, I want to offer a brief update on our CEO succession plan and progress. Our board is well along in the search process for our next CEO. We consider this process and decision to be the most important our Board of Directors makes.

And to that extent, the board is working hard to ensure that the next CEO will be exceptionally well-qualified to lead Nano through its next phase of growth and expansion.

Meanwhile, with the support of my leadership team and all our employees, who I thank for their hard work and dedication, we remain focused on responding to the day-to-day challenges and opportunities in front of us, executing in a very robust spending environment and profitably growing our business to create incremental stakeholder revalue.

And with that, I want to thank you all for joining our call. And we'll end the call at this time..

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone, have a wonderful day..