Claire McAdams - Managing Partner, ‎Headgate Partners LLC Pierre Yves Lesaicherre - President and CEO Greg Swyt - VP, Finance and Principal Financial Officer Kevin Heidrich - SVP, Corporate Development Rollin Kocher - SVP, Sales and Marketing.

Patrick Ho - Stifel Tom Diffely - D.A. Davidson Graham Tanaka - Tanaka Capital Management Weston Twigg - KeyBanc.

Good afternoon. And welcome to the Nanometrics Fourth Quarter Financial Results Conference Call. [Operator Instructions] Please note that this conference call is being recorded today, February 06, 2018. At this time, I would like to turn the call over to your host Claire McAdams. Please begin..

Thank you, and good afternoon, everyone. Welcome to the Nanometrics fourth quarter 2017 financial result conference call. Speaking on today's call are Dr. Pierre Yves Lesaicherre, President and Chief Executive Officer; and Greg Swyt, VP, Finance and our Principal Financial Officer.

Also available today for Q&A are Kevin Heidrich, Senior Vice President, Corporate Development; and Rollin Kocher, Senior Vice President, Sales and Marketing. Shortly, Pierre will provide a recap of the quarter and our perspective looking forward.

Then, Greg 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 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 statements 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 towards 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 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 Pierre Yves..

Thank you, Claire. And good afternoon, everyone. It's a pleasure to meet you all on my first earnings call with Nanometrics. Today in my prepared remarks, I will briefly review our fourth quarter and full-year results, share our views on the current business environment, and give our perspective looking forward.

Greg will then review the financial details of our recent results before opening the call up for Q&A. Our first quarter results were favorable to guidance and set multiple records.

Revenues of $78.2 million were at the high-end of the range with all the revenue delayed from Q3 being recognized in Q4 along with some high margin sales upside that also led to gross margin exceeding our forecast.

The two primary factors driving this upside were a higher than expected mix of software sales and a fully depreciated evaluation system that a customer decided to sign off for revenue in the quarter.

Absence these unusual factors, gross margin would have been around 55%, still above guidance and showing that our gross margin improvements are flowing through ahead of schedule and that we are already achieving our target model range of 55% to 56% at these revenue volumes.

For the quarter margin, our gross margin, operating margin and earnings per share all set new five-year records.

Looking at the full year, Nanometrics has distinguished its performance in the semiconductor capital equipment sector by delivering four straight years of double-digit revenue growth and four straight years of increasing gross and operating margins.

Since 2013, our compound annual revenue growth rate of 16% is the highest organic growth rate among all our peers in process control and 36% of all incremental revenue since 2013 are flowed through to non-GAAP adjusted net income.

Our revenue growth performance over this period is indicative of the company's success in gaining market share both by winning new key customer accounts and by expanding our position at existing accounts.

We had five customers who contributed at least 10% of our revenue in 2017 Samsung, SK Hynix, Micron, Intel and Toshiba and our five largest customers are amongst the six largest spenders of wafer fab equipment in 2017.

This more balanced customer profile is also indicative of our end market success in 2017 with 65% of our product sales to the memory segment, 25% to logic and foundry, and 10% to other applications. Now I will turn to our outlook looking forward first for 2018 specifically.

We agree with others in the industry who said that the vast majority of incremental growth and equipment spending is taking place in the memory segment which is beneficial to Nanometrics. First in the NAND segment, sustained to slightly increased investments in NAND overall is the year-over-year headline.

We enjoyed leading market share in optical critical dimension or OCD metrology in the 3D NAND segment and expect our growth in NAND revenues to continue in 2018. This continued growth in our NAND revenues follows four years of an annual growth rate exceeding 40%.

In 2018, our growth in NAND will be fueled in part by of our success in winning share in China. We already have a strong position with the multinational firms adding wafer starts in China this year and just today we announced a major win with the domestic China 3D NAND manufacturer.

We have own the OCD business for both automated and integrated tools, in addition to wafer substrate metrology for this company first high volume production line. In total, our robust customer positions in China are expected to drive record revenue from this region in 2018.

In total at this point early in the year, we believe NAND will again be the largest contributor to our revenues with meaningful sales to all six of the largest 3D NAND manufacturers in 2018 with a relatively balanced first half and second half and continued year-over-year growth.

Turning to DRAM which is expected to receive a higher balance of the memory spend in 2018 versus 2017. Strong year-over-year spending increases in DRAM are a positive for Nanometrics because of the strong attach rate for our flagship Atlas systems in DRAM wafer starts.

Today we also announced a strategic competitive went win for our integrated metrology solutions at a major DRAM manufacturer, which means we expect DRAM to grow significantly and become our second largest contributor to product sales for the full-year.

While we expect memory to be more front half weighted in 2018, foundry and logic will be more back half weighted to help balance out the year, we also expect an increase revenue contribution from our materials characterization business in 2018 which will benefit from plan capacity increases by the world's largest silicon substrate manufacturers.

It's far too early in the year for me to provide a formal revenue outlook for the year but the pipeline is incredibly strong right now.

For the first quarter it is expected to be similar to the adjusted Q4 revenue level of around $73 million, we have positive momentum going into Q2 which together drives the revenue growth expected for the first half compared to the prior six months.

For the full year, I believe we can achieve double-digit revenue growth and again increase our gross margin and operating margins year-over-year. So these are the trends we are seeing for 2018, best summed up by revenue outperformance and expanding margins but there's much more to our story for this year.

As evidenced from multiple new product introductions in 2017, new products are an important part of our growth strategy. Last year witnessed the successful adoption of our new OCD flagship system, the Atlas III as well as introduction of two new software and analytics based product solutions SpectraProbe and NanoDiffract 4.

We have also been investing in new process control technologies and platforms beyond OCD and films metrology. These new platforms are targeting applications where current technologies and tools are hitting technical walls.

Over the past two to three quarters, we’ve been hearing about our progress developing an entirely new product platform for introduction in 2018. This new platform is a major development program for us and is a key driver of the 16% year-on-year increase in R&D spending in 2017.

This new platform will go to a leading-edge launch customer who has been closely collaborating with us during the development phase. As the leading supplier of data rich process control platforms and solutions, we are in a unique position to benefit from the increasing demand for data analytics needed to ramp and drive fabs to profitability.

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.

We believe that these focused investments into new technology solutions both hardware and software base will expand our served markets and help us achieve revenue growth well above the pace of industry investments. Which is why in our call today, I am announcing an incremental increase in our R&D investments in 2018.

Our plans call for an increase in total R&D spending of roughly 20% year-on-year, I'm passionate about these opportunities ahead of us to meaningfully expand our served markets. Our revenues and our profitability by offering new technology solutions that solve our customer's most pressing challenges.

Since coming onboard two months ago, there are couple of aspects about Nanometrics that have greatly impressed me, exceeding my expectations going into this position. First, is the collaborative nature of our customer relationships.

We have very close relationships with all of the leading semiconductor manufacturers worldwide which have entire technology teams that collaborate with our people to solve highly complex problems.

We enjoy the same access to the technology leadership of the key customer accounts as the industry's largest suppliers and these customers come to us to present their challenges and ask how we can help them solve these challenges, which brings me to the second aspect that is impressed me and that’s the technical strength of our team.

As you all are aware, Nanometrics has been around a very long time and was a pioneer in developing optical metrology solutions for the semiconductor industry. But the Nanometrics of today is in a unique position to achieve significant growth and relevance by working with our customers to develop new products.

I am passionate about these development programs but require an increase in our R&D investment in 2018, that will drive significant revenue opportunities in the coming years. And this brings me to our financial model.

As I noted earlier in my remarks, our fourth quarter results and first quarter outlook demonstrate that we're now achieving our target gross margins of 55% to 56% at these revenue volumes. I've just provided guidance for 20% year-over-year increase in R&D investment in 2018. We also expect to see about a 10% increase in SG&A expenses.

This is above our incremental margin model as a result of a couple of factors. One, is the build-out of infrastructure to support the record level of the business from China, and the other is some added selling costs related to our sales structure and distribution partners serving the domestic China fans.

When you combine these two increases, total operating expenses will be above our target model range of 30% to 32% of revenue at these volumes in 2018. However, I'm firmly committed to achieving our operating profitability target in 2019 as we reap the benefits of our 2018 investments.

Our net profitability targets will also benefit from some tax savings we expect to realize this year. Our non-GAAP effective tax rate in 2017 was 29.5%. For 2018 we previously guided to a 30% rate and we now expect that rate to be in the 25% range.

Finally, our model shows our free cash flow target of 20% of revenue at this annualized level, while free cash flow in 2017 was below the model due to the strong revenue ramp to new record levels and associated investments in inventory to support this new level of revenue we will start to show strong cash flow results as we move into 2018.

This expected strong cash flows help support the Board's approval of the $50 million stock repurchase program in November. We completed 27 million of these repurchases before year end and an additional $17 million through yesterday.

Turning to our guidance for the first quarter, as I said earlier in my remarks we expect both revenues and gross margin to be similar to our normalized fourth quarter performance after adjusting for the $5 million revenue delay from Q3 and the unique factors that drove margin upside in the fourth quarter.

We continue to be shipping at these record levels early in the year and also see positive momentum going into Q2, largely driven by continued strong environment for memory spending.

And with that, our Q1 guidance is for revenues of $69 million to $75 million, gross margin of approximately 55% plus or minus 1%, operating expenses of $25 million plus or minus $500,000 and earnings per share of $0.38 to $0.50. I will now turn the call over to Greg to discuss our financial results and guidance in more detail.

Greg?.

Thanks, Pierre Yves. 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, severance related costs, executive search costs and discrete tax items.

Starting with a summary of our full-year results for 2017, total sales were $258.6 million up 17% from 2016. Product revenues increased 16%, while service revenue increased 21% from 2016. By end market, 65% of product sales were to the memory market in 2017 compared to 70% in 2016.

The NAND segment grew in line with overall revenues and again comprised 51% of product revenues for the year, while DRAM sales were down from 2016 comprising 14% of product revenues in 2017. The foundry segment comprise 90% of product sales similar to the prior year.

The remaining 60% of product sales were to IDM logic and other devices and substrates. As Pierre Yves commented, we had five customers which contributed to at least 10% to our revenues for the year and together they totaled 72% of our total revenues for the full-year.

Below the topline, gross margin increased over 80 basis points from 2016 to 53.1% for the year. Operating expenses were $92.7 million up 9% from the prior year, and our operating margin for the year was 17.3% up over 340 basis points from 2016.

Our earnings of $1.23 per share reflected a non-GAAP effective tax rate of 29.5% and was our fourth sequential year of improvement in earnings per share. Turning to the fourth quarter, fourth quarter revenues were $78.2 million up 38% from Q3 and an increase of 32% from the fourth quarter of 2016.

Product revenues were $67.6 million, an increase of 48% from the third quarter and 39% year-over-year. Service revenues of $10.7 million declined 4% from the third quarter and was up 3% from the year ago period.

As discussed earlier, our fourth quarter results included approximately $5 million of revenues delayed from the third quarter due to revenue recognition. Adjusting for this delay, our fourth quarter revenues were up approximately 19% from Q3 and 24% higher than the same period last year.

By end market, products sales to the NAND segment continue to be the largest contributor at 67% of product revenues. DRAM sales were 9% and foundry logic sales were 11% of product revenues. All other devices and substrates comprised 13% of product revenues. Our 10% customers in the fourth quarter included Toshiba, Samsung and Micron.

Our Q4 gross margin of 56.4% increased 200 basis points from the third quarter and exceeded the high end of our gross margin range due to the fact as previously discussed by Pierre Yves.

The higher margins for these items drove product gross margin to 57.6%, an increase of 430 basis points from the third quarter, while service gross margins was within our targets at 49%. Absent the items unique to the fourth quarter, gross margins would have been about 55%.

For the first quarter of 2018, we are guiding gross margin to be similar to the normalized level of Q4 or 55% plus or minus 1%.

For the full year 2018, we will continue to see the benefits of our 2017 cost improvement initiatives, as well as a higher mix of our flagship OCD systems and an increased acceptance of our software and analytics based solutions.

The combination of these items and overall growth projections gives us confidence that we remain on track to meet our target model performance of 55% to 56% gross margin at these revenue volumes.

Q4 operating expenses of $24.3 million were up 6% from the third quarter and came in at the high-end of our initial guidance range primarily due to higher variable compensation on the higher profitability achieved for the year.

For 2018 we are guiding Q1 operating expenses of $25 million plus or minus $500,000, and this amount will step up incrementally through the year to the $27 million range by the second half of the year. As always, we will closely monitor our business outlook as we progress through the year and we'll adjust our investments accordingly.

Our non-GAAP tax expense for the fourth quarter was $6.5 million or 32% of pretax income. Our tax expense on a non-GAAP basis includes the benefits associated with the difference between the actual settlement of employee equity earnings versus the initial grant value, as well as the impact of the transition taxes associated with the Tax Reform Act.

On an ongoing basis in 2018, we expect our non-GAAP tax rates to decrease approximately 25%. Net income for the fourth quarter was $13.6 million or $0.53 per share.

Turning to the balance sheet, cash and investments decreased to $170 million or $4.53 per share which reflects $27 million used to repurchase 1,066,000 shares in the last six weeks of the quarter at an average price of $25.33 per share.

Through Monday, February 5 we have repurchased an additional 659,000 shares at an average price of $25.69 per share bringing us to a total of 88% completion of our $50 million stock repurchase program. Because of the record level and timing of product deliveries, our days sales outstanding increased to 72 days up from the third quarter 66 days.

Inventory decreased $3.9 million to $54.4 million at the end of the fourth quarter. Cash flow from operations was $4.5 million and free cash flow for the quarter was $2.4 million. And with that, I'll turn the call over for questions.

Operator?.

[Operator Instructions] The first question is from Patrick Ho, Stifel. Your line is open..

Congrats and welcome to board Pierre Yves and good luck going forward. First in terms of the market environment, you talked about your win with a indigenous Chinese community manufacturer. I guess two-part question there, is one how do you see that part of the spending environment growing in 2018.

Do you see more of these local vendor starting to buy for production. And secondly, how much more infrastructure do you need to place to I guess meet that customers demand because you obviously been in China will a lot of the multinationals.

But how do you support the local vendors that are starting to emerge?.

Yes. So your question is related to the Chinese local manufacturers China Inc. We see definitely a variety of customers emerging and building factories, but to provide maybe a little bit more color I’ll ask Kevin who has been really working with them for a variety of years to provide a little bit more color on exactly what we’re seeing there..

There's two sides to it, on the domestic China there's the new shells that are going in and we’re seeing the first phase of new shells going in for memory customers as well as incremental expansion for foundry case. The infrastructure that we have to put in is really related to the fact that these customers are geographically spread out across China.

And so with the emergence of the new campuses and new shells we do need to put in local sales and service and that's the focus of the infrastructure spending into that region. Timing wise, obviously they have to do - build-up a shell, do pilot line, factory qualification to ramp.

And so we think these projects are going to be multiyear projects and the first phase for domestic NAND is just starting. So I think we love to see that play out over the next couple of years..

And my follow-up question regarding the increase in R&D, I understand lot of it does need to be put in for next-generation product development.

Could you give a little bit of color of how you are using that R&D, is it going to be for “next-generation hardware solutions” or are some of the products that are going come out of this are they going to be software, are they going to be other kind of data analytic items that support your current hardware portfolio?.

So we’re investing in all directions of what you just discussed. We are investing in software, we’re investing in data analytics and we're investing in hardware.

So software where the software principally supports our current entry to platforms, hardware platforms, the data analytics we’re working on both data analytics that will support our hardware but also other hardware in the factory.

And as far as the new products, we are making a little bit of a shift of really looking at multiyear investment for us to have the ability to introduce new product platforms on a yearly basis. So this is an acceleration of the product introduction as we go forward with new product introduced in 2018, 2019, 2020 and we want to pipeline that.

So some projects are more advanced in terms of getting to international products and some others will take a longer time to deliver a product. So, we’re really pipelining the R&D to have the ability - to have these new product introductions that will fuel our growth from 2018 all the way to 2021..

The next question is from Tom Diffely of D.A. Davidson. Your line is open..

Maybe going back and looking at the suite of products that you announced on to the Chinese customer.

I'm just curious what is the relative revenue opportunity when you sell that suite versus just the kind of marquee OCD tool?.

I think - right we’ll point to the intensity table that we have at the back of the investor presentation that you’re familiar with. So clearly there is an opportunity for standalone automated for OCD and films in the Atlas, as well as the integrated systems for CMP and other layers.

And I think we see customers still choosing that relative split amongst themselves, so - we’re in both positions we obviously benefit regardless of how they choose that that standalone versus integrated split. And additionally we see incremental layers added as we develop new applications between the platforms.

So I think I’ll point you to the intensity table for the 3D NAND opportunity which really compromises the whole opportunity..

Is it the same - do you use the same table so to speak if it's a new customer that's trying to build up these ramps for the first time versus more mature customer?.

I think the timing on that is a little bit - we’re obviously front half loaded - sorry front of the ramp loaded in terms of ordering window. So that’s a per 10K wafer start opportunity, they may buy more in the early phase of the pilot versus the last phase of the shell build out.

So over a mature 100K wafer start fab that I think those numbers hold up. We may see some early orders in that first pilot to support the faster ramp and factory qualification..

And Kevin when you look at the DRAM announcement that you made, does that mean you now have tools in all the major DRAM manufacturers?.

No, it’s an incremental win for integrated force. We still have opportunities for organic growth and share gains in DRAM..

And then finally look when you look at the software business obviously its great high margin business.

What has been the biggest driver of that over the last couple of quarters and then when you look out to some new software development, where are the areas that you think are the fastest-growing going forward?.

Maybe we’ll ask Rollin to answer that..

Could you repeat the question one more time..

Just curious you know with a lot more made of the software business over the last few quarters, what has been the biggest driver of software say in 2017 and then what do you think is the biggest drivers are going to be on a go forward basis?.

So one of the things that we were focusing on in 2017 was taken our product lines and being able to offer new enhancements, new features and you saw that to the announcement of the SpectraProbe right.

So we’re looking at leveraging that through 2018 been able to take that and develop and the adoption and use cases moving forward in 2018, and continuing on with the progress with that particular product line..

[Operator Instructions] The next question is from Graham Tanaka of Tanaka Capital Management. Your line is open..

I just thought if you could maybe give us a little bit big picture or view of what the China potential is. What kind of share of sort of global capacity do you think the Chinese fab will be adding - by the end of this year, by the end of next year perhaps just to give us a view of how proportionally how big that opportunity is? Thank you..

I think we see - I don’t know if we have as much color as out of some the process driven companies do on where all that capacity goes in mostly it’s a pilot line focus right now. So domestic China there is some new 3D NAND fabs going in, there is new DRAM fabs going in and there is new CMOS image sensor fabs going in.

And all three of those new domestic Chinese companies need to qualify their factory and qualify their production. Additionally you’ll see the multinationals adding capacity with foundry expansion and 3D NAND expansions. So I think that - we see opportunities maybe..

So it is very hard to estimate how much these pilot and new capacity from the Chinese manufacturer is adding and what relative share they will have. But what I can tell you that for us with the wins we have in China that we've announced and a few others that represents doubling our business in China in 2018 versus 2017.

So this is major growth for us..

And the size of China's to last year was roughly what - that compares to what last year in China?.

With 16% of our revenue..

Okay, 16%, great, thank you. Just also curious it sounds like you're making great strides in gaining share, you continue to even doing it for few years now.

I'm just wondering what - if you’re able to give us a kind of rough estimate of what your market shares are in the major end markets and what potential upside you might have in new products coming ahead in the next two, three years? Thank you..

So I think Graham we don't try to point out share specifically by segments and type and product but overall we believe we’re the market share leader in OCD with over 50% share of the OCD segment. Additionally, we participate in other segments for thin films metrology, materials characterization and other.

The focus of the share gains is obviously been recently on OCD wins but along with those is the incremental orders for other systems..

We have also and I think we’ve reported that a very strong position in 3D NAND and that would be our strongest position. Our second strongest position would be in DRAM. So this year the increase in the first half in particular of the DRAM investments is going to be very beneficial to us because we have a higher attach rate in DRAM.

So these are some of the maybe some other elements to consider in our response..

The next question is from Weston Twigg of KeyBanc. Your line is open..

I was just wondering the service line grew quite a bit last year's.

I was wondering if you give us an idea of what it might look like in 2018, what are your growth expectations for services?.

So for the service business we’re expecting it to grow comparable to the 2017 levels which is about 15% to 17% year-over-year..

And then on OpEx, just I was trying to run through the numbers here and I wanted to make sure I got everything right, you can correct me if I'm wrong. But I think you said R&D up around 20% this year, SG&A up around 10%, and the numbers leveling off to around 27 million a quarter.

And the reason I ask is if I do that I'm getting to a number that seems a bit too low, sort of I missed something?.

So we had - in my comments we had identified that our first half overall OpEx is going to be around the $25 million plus or minus range for the first half. Second half growing incrementally to about $27 million a quarter. So if you do the math on the R&D you'll be able to get to the SG&A section, as well as the total overall..

Did you say R&D would be up around 20% or I did miss hear that..

For the full year 20%..

And then just finally, you did mention that new product line going out is in R&D or developing tools to a customer.

I think last quarter you suggested that that would be a revenue generator for 2018 so I’m just wondering if that still the case or there might be more between 2019 story, the new product platform?.

It's currently in the evaluation of the customer and depending on how the evaluation goes with the customer, if I think goes well it could be at the end of the year, but most likely it will be in 2019?.

The next question is from Tom Diffely of D.A. Davidson. Your line is open..

Just a quick follow-up on the logic side of the business, a lot of your peers are talking about logic and a pretty good driver in 2018.

And I know you said it was going to be second half a little bit but just want to give your thoughts on whether now you think it's going to be nice incremental driver to 2018 over 2017 because I know in years past there has been a lot of reuse with your logic tools? Thanks..

So what we're forecasting at this time and I’ll start from a high level is a much stronger half of 2018 relative to the prior six months driven by our leading positions in memory. And as I referenced in my prepared remarks, we expect the increase in foundry and logic spending in the second half to result in a relatively balance year for us.

So between the first half and the second half in 2018 relatively balanced. And we can see that others who are more weighted to foundry and logic expect maybe less growth in the first half and a more backend weighted year but we are more balanced between the first half and the second half..

But did logic grew year-over-year for you, do you think?.

No, I don’t think it’s going to be a major element of growth for us..

[Operator Instructions] There are no further questions at this time. I like to turn the call back over to Dr. Lesaicherre for closing remarks..

So before ending this earnings call, I want to state my appreciation for what Tim Stultz has built over his 10 years at the company. He built a very strong foundation for the growth. We expect to achieve over the next several years and I'm very excited to be leading Nanometrics through this next phase of growth and expansion.

I, with the support of all of our employees at Nanometrics remain focused on responding to the day-to-day challenges and opportunities in front of us, executing in a robust spending environment, and profitably growing our business to create incremental shareholder value. Thank you for joining our call today..

Thank you. Ladies and gentlemen, this concludes today's conference. You may now disconnect. Good day everyone..