Good afternoon and welcome to the Nanometrics Second Quarter Financial Results Conference Call. [Operator Instructions] A Q&A 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, July 31, 2018.

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 Second Quarter 2018 Financial Results Conference Call. Speaking on today's call are Dr. Pierre-Yves Lesaicherre, President and Chief Executive Officer, and Greg Swyt, VP of Finance and our Principal Financial Officer.

Shortly, Pierre-Yves 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 1.00 PM Pacific this afternoon.

The press release and supplemental financial information are also available on our Web-site at www.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, shifts 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 2017.

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. Today in my prepared remarks, I will briefly review our second quarter 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 up the call for Q&A.

Our second quarter results set new records for both revenue and earnings. Revenues of $88.6 million were at the upper end of our guidance range and increased 8% from our record first quarter and 38% from the same period last year.

Our strong results were again driven by the robust spending environment for memory devices in the first half and our leading market share in those segments. For the first half of 2018 in total, $171 million in revenue is an increase of 38% over the first half of last year and 27% higher than the second half of last year.

Clearly, we have scaled to an unprecedented revenue level for Nanometrics and have been making increased investments in R&D and our global sales organization to support this increased level of business. Gross margin performance again came in favorable to our long-term target at 57.5% for the second quarter.

The continued strong gross margin performance for the last few quarters is evidence of our improved operations and certainly some favorable product mix as we scale to these revenue volumes. The strong gross margin in the second quarter drove our record earnings per share, which also benefited from a lower tax rate, as Greg will detail shortly.

We continued to deliver strong free cash flow generation in the quarter, adding $25 million in cash to the balance sheet, to a record $149 million at quarter end. Year-to-date we have generated over $57 million in free cash flow, equal to 33% of first-half revenues.

In total, the first half set new records in both product and service revenues, as well as gross margins, earnings per share, and cash flows.

While our first half results demonstrate that the ramp in investment in both NAND and DRAM technology and capacity has grown to historic levels, our relative outperformance in terms of revenue growth this year is also indicative of our market share gains in both NAND and DRAM.

While most industry expectations are for flat to down spending here for NAND, our continued share gains and market leadership position are driving another strong year of growth in our revenues from the NAND segment in 2018.

During the second quarter, we won qualification by a fifth major 3D-NAND manufacturer for our Atlas III flagship system and began shipping tools. We also reported a new 10% customer for Nanometrics, with the largest domestic China 3D-NAND manufacturer installing our full suite of process control metrology solution into their new fab.

This sixth major 3D-NAND manufacturer helped drive significant quarter over quarter growth in our NAND revenues, which also benefited from some acceleration of 3D-NAND project spending by multiple key customers.

This acceleration of multiple 3D-NAND project in the second quarter was partially offset by a modest decline in our DRAM revenues, off a record first quarter. The good news is, the deferrals in some DRAM project spending into the second half have resulted in DRAM revenues this year being more balanced than we previously forecast.

So, while there have certainly been shifts in spending between NAND and DRAM, and among our largest customers, our forecast for revenues from the memory segment this year are consistent with our last earnings call.

The fact that our memory forecast is consistent with our last call, in spite of reported push-outs in spending, warrant some further discussion. First of all, we've been consistent in our expectations that revenues from the total memory segment would be front-half weighted for this year. This has not changed.

The change is that NAND became front-half weighted and DRAM is more balanced than we previously forecast. Secondly, we reported two major market share wins earlier this year, one with a major DRAM manufacturer and one with a sixth major 3D-NAND manufacturer.

While we believe our 2018 memory revenues will increase year-over-year even without these two wins, these market share gains are suddenly helping drive our significant year on year revenue growth in both memory segments.

And lastly, it's important to remember that we have strong positions with all six of the largest 3D-NAND manufacturers, and if one of the largest customer decides to defer some wafer capacity additions into next year, we still have five others customers who drive their own plans.

So even with the recent shift, pushes and pulls in customer spending plans for NAND and DRAM, we continue to forecast total memory revenues for Nanometrics will be up significantly thus year. We also continue to expect our foundry and IDM revenues to be second-half weighted, off of a small base of revenues in the first half.

This will result in an overall decline in foundry and IDM revenues compared to 2017 levels, given the major shift in Korea-based foundry spending towards memory this year and that the timing of other foundry and IDM investments in process control continues to push into 2019.

Our revenue outlook for the year continues to be balanced in the low 50s in the first half and high 40s in the second half. With our current visibility, we continue to forecast 2018 revenue growth of at least 20% year-over-year. This would clearly result in revenue growth outperformance versus the overall industry.

It's also worthwhile to note that as we look towards 2019, the push-outs in some of this year's project spending across DRAM, NAND, foundry, and logic, are all expected to resume in 2019, giving us increasing confidence that the industry could see a sixth year of CapEx growth next year.

Along with expectations for positive year-over-year revenue growth, our gross margin profile is strengthening, which has enabled us to step up our investments in R&D and our global sales organization to support higher levels of business.

This means that along with revenue outperformance, we have expanding gross margin and expanding operating margin this year along with significant free cash flow generation. I'll make a few more points before turning the call over to Greg. One is to highlight the expanding adoption of our Atlas III system.

I mentioned earlier that our newest flagship system was qualified by a fifth major 3D-NAND manufacturer during the quarter and we began shipping tools. This means that our Atlas III has now been adopted by each of the five 3D-NAND manufacturers and both of the two largest DRAM manufacturers.

As testament to the rapid and successful introduction of the Atlas III, we shipped our 100th system earlier this month.

I also wanted to reiterate the multiple revenue drivers for our growth this year, which is expected to be a record year for both our automated and integrated metrology platforms, a year of increased contribution from software and analytics, a growth year for our optical critical dimension solutions, as well as a growth year for our thin film and material characterization product, and a year with new records set for our service business.

Finally, I will summarize the call with some of the early indications of drivers for continued growth in 2019. First, the push-outs referenced earlier are expected to become 2019 revenue events. Second, we expect a continued robust spending environment for memory, both in 3D-NAND as well as DRAM.

Third, we expect our foundry and IDM revenues will grow year-over-year in 2019 due to the timing of project spend on 10-nanometer and below devices. Fourth, we have a growing pipeline of new products and new customers that are incremental to our current level of business.

And finally, we see opportunities for additional market share gains and further growth in our software and services businesses.

Each of these aspects of revenue growth we expect to complement with continued strong operational execution, with expanding margins, and strong cash flows, and we're firmly committed to creating shareholder value as we drive towards our revenue growth and profitability targets.

Turning to our guidance for the third quarter, we continue to expect the second half will moderate from the first half record rates.

Our Q3 guidance is for revenues of $70 million to $78 million; gross margin of approximately 57%, plus or minus 1%; operating expenses of approximately $29 million, plus or minus $0.5 million; and earnings per share of $0.36 to $0.52. I'll now turn the call over to Greg to discuss our financial results and guidance in more detail.

Greg?.

Thank you, Pierre-Yves. Before I begin my prepared remarks, 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 end market and geographic region is available in the Investors section of our Web-site.

The P&L metrics discussed are non-GAAP measures unless I identify them as GAAP based. These measures exclude the impact of amortization of acquired intangible assets, severance costs, costs related to executive transition and search costs, as well as discrete tax items.

As Pierre mentioned earlier, our second quarter revenues were $88.6 million, an increase of 8% from the prior quarter and 38% from Q2 of 2017. Product revenues were $76.7 million, an increase of 8% from the prior quarter and 43% year-over-year.

Service revenues of $11.9 million increased 5% from the prior quarter and were up 10% year-over-year and comprised 13% of total sales for the quarter. By end market, product sales to the NAND segment contributed 57% of product revenues. DRAM was 33% of product revenues.

And all foundry, IDM, and other device sales comprised the remaining 10% of product revenues. Our 10% customers in the second quarter were Samsung, YMTC, Intel, and Toshiba. Our Q2 gross margin of 57.5% exceeded our forecast, primarily due to favorable product mix, including an increased contribution of high-margin upgrades.

Gross margin was 30 basis points lower than Q1's record, which had benefited from one-time factors unique to the first quarter. For the third quarter of 2018, we are guiding gross margin to 57%, plus or minus 1 percentage point.

For the full-year 2018, as we previously stated, we are seeing the benefits attributed from our 2017 cost improvement initiatives in our product costs as well as a higher mix of our flagship OCD systems and an increased acceptance of our software and analytics based solutions.

Given these items and the overall revenue growth projections, we expect to deliver gross margins near the high end of our financial model targets for the year.

Operating expenses of $29.5 million were up 11% from the prior quarter and exceeded our forecast primarily due to accelerated timing of R&D project spending, increased investments in the global sales organization, and increased accruals for variable compensation due to increased profitability.

We expect our overall operating expenses to average $29 million per quarter in the second half of 2018. Our non-GAAP tax expenses for the second quarter was $3.8 million or 18% of pre-tax income.

Our tax expense on a GAAP basis include the benefit associated with the non-GAAP expenses previously mentioned as well as the benefit associated with the difference between the actual settlement of employee equity earnings versus the initial grant value.

On an ongoing basis in 2018, we are now forecasting our non-GAAP tax rate to be 19% to 20% as compared to the 22% to 23% range previously guided. We continue to account for the changes from the 2017 Tax Cuts and Jobs Act based on our interpretation of the most current guidance available.

Our effective tax rate for 2018 continues to be subject to revisions and changes as we complete our analysis of the Act. Net income for the second quarter was a record $17.4 million and $0.71 per share.

Weighted average diluted shares outstanding declined to 24.4 million in Q2, reflecting the nearly 2 million shares purchased during the fourth quarter of 2017 and first quarter of 2018. Going forward, we expect the weighted average diluted share count to increase by approximately 150,000 to 200,000 shares per quarter.

Now turning to the balance sheet, cash investments increased to $148.7 million or $6.18 per share based on 24.1 million basic shares outstanding at quarter end. Days sales outstanding decreased to 55 days from 65 days in the prior quarter due to the timing of our shipments and collections within the quarter.

Inventory increased $1.5 million to $56.1 million at the end of the second quarter. Cash flow from operations was $26.3 million and free cash flow for the quarter was $25.8 million and 29% of revenue. As included in our earnings release, first-half capital expenditures were $1.8 million.

We expect CapEx to increase in the second half to support the increased scale of our operations and growth in our strategic R&D programs. This concludes our prepared remarks. Operator, we will now be happy to take any questions..

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

Quick question on just the ebbs and flows with some of these projects being pushed out and pulled in, so obviously you had a nice win that kind of masked the fact that some of the core business was down.

I'm curious if you're seeing the same trends as have been reported over the last week or two and truly just have a customer overlap that basically was not [indiscernible] in the numbers, or perhaps with your products there you're seeing slightly different trends?.

So, we indeed have a few wins this year that make us a bit different from the other players in the industry. The two that we reported, one with the Chinese 3D-NAND customer and the other one with a large DRAM customer, and that's a [indiscernible]. We do see some similar trends to what is being reported in the industry as far as NAND is concerned.

So we see some push-outs in NAND from the second half into 2019. And this is why now we see the NAND being more front-half weighted than we expected. But we also at the same time see some other customers strengthening in DRAM for example in the second half, and I don't know how much this has been reported, but that's important also to us..

Okay.

And just [indiscernible] one step further, do you also see a little bit of delay in some of the logic and foundry ramps?.

So yes, what we reported is we see the push-out of some of that logic and foundry revenue into 2019. Still, the second half will be stronger than the first half, but we're operating from a small base, and really some of these push-outs into 2019 are actually strengthening 2019..

Okay, great.

And then when you look at your long-term model, what do you think the projected mix on a go forward basis is going to be between memory and foundry logic for you? Is memory now going to be the dominant piece going forward?.

We have a very strong position in NAND. So we reported that we are a supplier to the five largest, and now sixth one if I include the Chinese customer, and that position is believed to be very stable based on the direction that these customers are taking.

With 3D-NAND structures becoming more and more vertical, we believe the need for OCD will continue increasing. So, I don't see that declining. We have a very high attach rate in DRAM. We are participating with two of the largest customers.

We are working very hard on the third one, and if we're successful to penetrate the third one, DRAM will also be very important to us. So, I expect memory to continue to be a strong segment for us. We are also working very closely on the logic and foundry business. Sub-10-nanometer, the business is expected to ramp up next year.

So, I would expect next year to be a little bit more balanced than it is this year in terms of memory versus logic and foundry..

Okay.

And then just finally, when you look at kind of the push-outs and in some cases pull-in of the business right now, does any of that impact the launch or the release date of your new tool?.

No, it's not related, so it has no impact..

Okay, great. Thank you..

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

This is Brian on for Patrick.

I guess first question just to start to double-back for a second on some of the mechanics of the broader market, but Pierre, based on the updates you provided, is it right to infer – your revenue is still up at least 20% for the year and you provided the Q3 guide, so can we infer that Q4 is sort of flat to down, is that the right way to think about Q4?.

So we just confirmed that we expect to be up by more than 20% this year compared to 2017. And the way we see it today is Q4 will be at least as strong as Q3..

Okay, got it..

So, equal or above..

Equal or above. And then just staying with this kind of rhythm, other equipment companies have talked about first half of next year being above second half of this year.

And if you take some of your commentary about foundry and logic, some of that second half business perhaps pushing into next year, also some NAND activity pushing into next year, are you also in the mindset of first-half 2019 being above second half 2018 as well as maybe even first half of 2018?.

Yes, we expect the first half of 2019 to be above the second half of 2018..

Okay, great..

I confirm that..

Okay.

And then also, given all those project activity pushing into perhaps early part of next year, first half 2019 above first half 2018 as well?.

That is difficult to tell. It's more than nine months out, so difficult to tell..

Okay, fair enough. One question about cash, you're growing good cash, close to 60 million I think free cash flow year-to-date, $150 million almost on the balance sheet. I know you didn't buy back any stock in the quarter.

Maybe you can kind of talk about sort of the minimum cash you want to hold on the balance sheet as well as sort of how we should think about the remainder on the buyback moving forward?.

So, we completed the buyback at the end of or within Q1. You're right, we generated 57 million actually in the first half and the current balance is 149 at the end of the quarter. At this point in time, we have not announced any decision on a further buyback. We're considering options. We are definitely investing in the business in R&D.

And then after that, as you know, the options are either returning cash to the shareholders or using it for M&A, and we're considering our options today..

Okay, great, very helpful. Maybe one last question, just take it in, just curious if you've seen any – completely switching gears here for a second, but curious if you've seen any pull for UniFire, driven maybe by high-bandwidth memory [indiscernible] or perhaps other wafer level packaging applications.

Also just, how to unify our backend metrology to fit into Nanometrics' longer-term strategy?.

UniFire is a tool that we developed more than 10 years ago. It's a very, very small portion of ourselves today. We do not have a continuing product after that. So, it's really not an important product in our strategy going forward..

Okay, great, very helpful. Thank you so much..

Our next question comes from the line of Weston Twigg from KeyBanc Capital Markets. Your line is now open..

First, just wanted to clarify, it sounded like you said or mentioned that you saw some push-outs of NAND.

Did you mean multiple customers, because most of them are pointing to one major customer, and so I'm just wondering if you've seen that spread, and if you did, how recent those changes were?.

No, it's mostly one customer..

Okay, that's helpful.

And then on the big Chinese customer that you mentioned that you have some incremental NAND business with this year, you think that flattens out or maybe drops off next year or do you see that spend continuing through 2019? I'm just wondering because I would expect them to focus on product activity for a while and I'm wondering if they've spent what they need to spend for a while..

So there, the plan was for that customer to install the first 5,000 in capacity and then prove that they can get to yield by the end of the year, and they are on target to do that. So we expect that there's going to be a ramp next year, progressive ramp of additional capacity in that fab. Given the position [indiscernible], we'll benefit from that..

Okay, that's very helpful. And then just finally if I could, Atlas III you mentioned some NAND and DRAM traction. You didn't mention logic and foundry. I can't recall if you've had some wins with Atlas III or not or if those might occur next year. If you could help us understand that, that would be helpful..

We're in the process of getting wins and orders in both the largest logic and the largest foundry customer. So this is in process. We're very confident about that and it might happen either in Q4 and Q1 next year..

All right, very helpful. Thank you..

Our next question comes from the line of Mark Miller from Benchmark Company. Your line is now open..

Congratulations on the very strong quarter, record quarter. You mentioned one Chinese domestic manufacturer expected to ramp significantly next year.

Do you see any other opportunities among the Chinese domestic manufacturers for ramp next year?.

Yes, we're engaged with quite a few of the customers there. There are two DRAM companies, Innotron and Fujian Jinhua IC, FJHIC. So we are engaged with both DRAM customer, with the NAND customer. We're engaged with [indiscernible] and others in foundry and we're also engaged with a CMOS sensor company HIDM. So, we have a strong team in China.

We are penetrating these customers. The business volume with the China domestic customers is ramping up slowly I would say, except for the NAND customer this year. But we expect that this will improve in the coming years..

Can you give us any color or opportunities, whether it's upgrading in terms of software, your software opportunities, are you seeing significant upgrades or new sales of software?.

It is actually new sales. It's a new software. It's the SpectraProbe, which is a data analytics software based on machine learning.

So, it's the very advanced AI type software that runs on our tool, additional to the tool software and that allows to extract advanced information and has very specific use cases where we can predict the profile for example of a tranche, whether there's [indiscernible], tilt, shift, twist. So, that's the type of software we are selling today..

And would that be available to existing customers, prior customers?.

Yes, it's available to existing customers. What we see is, we work with a few of them to develop a use case, a specific yield issue that they have linked to overlay, to misalignment, or to some shape changing in their structure, and once we develop that, typically we will sell them the software after we can prove the use case.

So, this is what's happening. Every one of our customers today can buy that software and have that additional level of data analytics performed on the tools that they have..

Margins for the software I assume are at or above Company average?.

Yes, they are significantly above. We are in line with what software typically sells in the industry, so it's significantly additive to our margin..

Thank you..

And I show no further questions at this time. I would like to turn the call back over to Dr. Lesaicherre for closing remarks..

First, thank you for joining our call today. Together with the leadership team and our employees, we 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 stakeholder value.

I look forward to updating you on our next earnings call in October. In the meantime, we have plans to attend D.A. Davidson, KeyBanc, and Jefferies conferences in August and look forward to seeing you at one of these events. And that concludes our call for today. So long..