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Photronics, Inc. (NASDAQ:PLAB)

F1Q2014 Earnings Conference Call

February 19, 2014, 8:30 am EST

Executives

Peter C. Broadbent – Vice President of Investor Relations & Marketing

Constantine S. Macricostas – Chairman and Chief Executive Officer

Peter S. Kirlin – President

Sean T. Smith – Senior Vice President, Chief Financial Officer

Christopher J. Progler – Chief Technology Officer & Strategic Planning

Analysts

Thomas Robert Diffely – D.A. Davidson & Co.

Patrick J. Ho – Stifel, Nicolaus & Co., Inc.

Operator

Good day ladies and gentlemen, thank you for standing by. Welcome to the Photronics First Quarter Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded Wednesday, February 19, 2014.

I would now like to turn the conference over to Pete Broadbent, Vice President, Investor Relations and Marketing. Please go ahead, Mr. Broadbent.

Peter C. Broadbent

Thank you, and good morning, everyone. I would like to thank you for joining our first quarter 2013 conference call.

Before we begin, I would like to remind all participants about the Safe Harbor provision under the Private Securities Litigation Reform Act of 1995. And thus, any statement we make during this call, except for historical events, may be considered forward-looking and may be subject to certain risks and uncertainties that could cause actual events to differ materially from those projected, including uncertainties that may affect the company's operations, market, pricing, competition, procurement, manufacturing efficiencies and other risks detailed from time to time in the company's SEC reports. These statements will contain words such as believe, anticipate, expect or similar expressions. This call will be archived on our website until we report our second quarter 2014 results.

Joining us on the call today are Constantine Deno Macricostas, Chairman and Chief Executive Officer; Dr. Peter Kirlin, President; Sean T. Smith, Senior Vice President and Chief Financial Officer; Dr. Christopher Progler, Vice President, Chief Technology Officer and Strategic Planning.

During our remarks this morning, we will be referring to slides posted on our website under the Investor Relations link.

And now, I would like to turn the call over to Deno Macricostas. Deno.

Constantine S. Macricostas

Thank you, Pete, and good morning, everyone. I would like to begin with a few high level comments on our business outlook and then turn the call over to Peter to discuss our results in the first quarter and the trends we see in the market.

Over the past several years our leadership team has worked hard to position us to take advantage of the opportunities we see interesting right now. We established a strategic plan to maximize our growth in both mainstream and high-end, with lower cost strengthen our financial base, aligned our strategically and build stronger partnership with our customers. As a result, we now have the opportunity to capitalize on the strong trends to gain markets share, outgrow the industry and build shareholder value.

The semiconductor photomask business our high-end equipment footprint is well positioned globally to support our customers. We are presenting a largest installed base of our best advanced equipment of all the merchants combined. As Peter will note, we are strategically located close to our customers. Our costumers continue to be aggressive in moving to advanced nodes, and we expected to be a strong major supplier at the high-end for several years.

In FPD in Korea and Taiwan our team is well established with leading technology and capability. We will benefit from strong customer relationship as a transition to new technologies, we expect this industry to continue to innovate and increase the demand for our leading-edge photomask. So as we look forward I’m very optimistic of our ability to deliver to our customers and our shareholders.

Our pending joint venture with DNP in Taiwan is progressing well through the regulatory approval process. This combination of resources and capability will create the largest domestic supplier of leading-edge photomask in Taiwan. With the scale project 28-nanometer and beyond technology, when we close this, we expect to drive significantly high-end foundry logic business of Photronics.

Our partner Micron continues to successfully integrate its Elpida capacity and offer us opportunity a high-end memory. Our FPD customers continue to advance new designs that will bring opportunities for accelerated high-end growth. Importantly, we have several banking arrangements and a strong management team. As a result, I’m very excited about the opportunities ahead for the company. As the marketplace continues to move in our favor, we are at the best positioned merchants in the industry, we expect this to translate to a meaningful growth and profitability for the company and our shareholders.

And now I would like to turn the turn call over to Peter.

Peter S. Kirlin

Thank you, Deno and good morning everyone. Please turn to Slide 3 in our slide presentation. In Q1 we achieved a sales of $101.5 million meeting our revised guidance. Sean will provide a detailed breakdown of our financials. First, a few highlights on the quarter and some comments on the trends in our business.

ICs were $76.2 million, down $3.6 million sequentially, this was attributable to decline in our mainstream sales of $4.6 million, high-end IC sales were up 7% sequentially, FPD sales came in at $25.3 million and though this is was down 3% sequentially, sales were essentially flat in Q1 a year ago and represent solid demand for us in display of photomasks.

If you look at the performance of these three segments of our business, FPD was basically stable, high-end IC was up $1 million in a seasonally soft quarter and mainstream IC was down on more than usual seasonal softness. Q1 is typically our weakest quarter due to the holidays. This year the way the holidays fell in the U.S. and Europe, we respectively saw a two week versus one week shutdown.

In Asia, we expected some pull-in of business prior to Lunar New Year that did not materialize. From the mainstream market we experienced pronounced seasonal weakness. Today the mainstream business has returned to pre-holiday levels. Finally, we had hoped to see the beginning of the ramp in the next technology node, our large memory customer would have generated an uplifts in our revenues they have delayed ramp. We are confident this new transition will occur this year, and when it does, it we’ll have a significant impact on our top line.

Looking forward we are hearing from our customers that they expect 2014 to be strong. Generally speaking when our customers business is strong, our business grows. As we’ve stated before, we expect 2014 to be a growth year. We have several drivers that will enable us to help grow the photomask industry as a whole, in memory with Micron’s acquisition of Elpida; we have recently completed a qualification of the Boise campus. Silgan another memory customers spilt in its technology.

So we’re sitting in a very good position with memory. In the next memory node ramps, we expect to do well. As far as logic is concerned, we are installing a strong high-end footprint globally, which will drive our 28-nanometer revenues as our foundry customers begin to ramp strongly at 28.

Regarding high-end logic qualifications, just like memory, we are clearly seeing that the process technology is used behind leading-edge e-beam and equipment is becoming more important, because it creates its own unique signature on the vertical. In order to make these very difficult qualification seamless, you really need to work for the customer as a partner and that means being local.

And as our competitor have become more conservative in phase of this challenge, we have become more aggressive in supporting our leading-edge customers and secured customer service, this is a cultural upon which our company is built, plays right into this new reality. So on one hand we are relying on what’s called which is Photronics focus on service. We are also relying on what’s new, which is our leading-edge technology. To bring the solution not just the high-end in memory in the U.S., but the high-end customers everywhere.

Throughout the world we are installing a local capability and then partnering with our customers to give them a mass solutions networks. As far as the FPD business goes, overall the market has the very positive turn right. Our largest customers are in Korea, we have a strong footprint there.

As you seen, we have done well on the AMOLED space and that is a clear growth driver for us. Another positive trend we are seeing is that standard display technology is moving from Amorphous to low-temperature Polycrystalline Silicon due to higher electron mobility. This provides pure brightness, we saw an uptick in that work during the past quarter to the extent this new material gains traction in the current year has created additional demand in the flat panel photomask volume.

When you look at the landscape, not only do we see upward trend in IC market, we see the same thing with FPD space. So we’re quite optimistic for our prospect. We will benefit from both ICs customers ramp in technology nodes and FPD customers ramp in new materials. With this AMOLED and Polycrystalline Silicon, we’ll benefit from both.

On the bottom line we continue to be tenacious in controlling costs, in Q1 we achieved gross margin in 22.5% and non-GAAP operating margin of 6%. Non-GAAP diluted EPS of $0.04 per share at a revised guidance range of $0.03 to $0.04, non-GAAP EBITDA was $25.7 million for the quarter.

And now for a more detailed breakdown on the financials, I will turn the call over to Sean.

Sean T. Smith

Thanks, Peter and good morning everyone. I’ll provide a brief analysis of our financial results for the first quarter of fiscal year 2014, review our balance sheet and cash flows, our forecast going forward and also provide a brief update on the Taiwan JV. Please refer to Slide 4 for our GAAP to non-GAAP net income and EPS reconciliation as we review the first quarter.

For purposes of our discussion, I will be comparing our non-GAAP operating results to the revised first quarter guidance we published in our February 10, 2014 press release. Slides 5, 6 and 7 show a sequential quarterly and year-over-year IC and FPD revenue performance.

First quarter revenues decreased by 4.2% sequentially to a $101.5 million for the reasons Peter discussed, revenues for IC photomask was $76.2 million down $3.6 million sequentially. While FPD photomask revenues decreased $900,000 to $25.3 million, breaking out sales geographically, 65% of total sales were from Asia, 25% from North America and 10% from Europe.

High-end global IC sales were $16.6 million or 22% of total IC sales for the quarter. This represents the sequential increase of $1 million. Advanced FPD sales were $15.6 million or 62% of total FPD sales. As a reminder, high-end IC revenue consists of revenue derived from semi-designed at and below 45-nanometer, and high-end FPD revenues consist of revenue at and above G8 as well as AMOLED-based products.

Now let's continue through the income statement. Gross margin for the first quarter was 22.5%, down 270 basis points sequentially as a result of the decreased sales volumes. Selling, general and administrative expenses for the fourth quarter were $12.3 million, and includes $400,000 of expenses related to pending JV. Sequentially, SG&A was down a $100,000 when excluding the transaction cost for the pending JV for both quarters.

R&D expenses which consist principally of continued development for our global advanced process technology and qualifications of advanced nodes was $5 million down $1.4 million sequentially, primarily as a result of the progress made on an Asian foundry qualification.

During the quarter, we generated operating income of $5.6 million or 5.5% of sales. Excluding the costs related to the pending JV, operating income was $6.1 million or 6% of sales. Sequentially, operating margin was down 47% of the lower sales which is exclusive of JV cost.

EBITDA, as defined in our credit agreement, for the quarter was $25.7 million and for the trailing 12 months was $109 million. Other income and expense for the fourth quarter was expense of $900,000, down $500,000, sequentially due primarily to favorable FX. During the first quarter, we recorded a tax provision of $2.7 million, which was higher than our guided range of $1 million to $2.5 million as income from taxable jurisdictions was higher than forecasted.

GAAP net income was $2 million or 3% per – $0.03 per diluted share, non-GAAP net income, excluding the pending JV transaction expenses, was $2.4 million or $0.04 per diluted share. At the end of the first quarter, we have 1310 full time employees. This equates to revenue per employee of $310,000 on an annualized basis and non-cash stock comp experience was $1.1 million for the quarter.

Now turning to the balance sheet. Although we reported lower sequential operating results, our balance sheet was stable. Cash and cash equivalents at the end quarter amounted to $189 million and our net cash, which is cash less debt, was $19 million down $3 million sequentially.

Our working capital at the end of the quarter was $177 million down $37 million sequentially compared to Q4. this was due principally to a $19 million repayment of a term loan in the quarter which was classified as long-term, as well as a $20 million increase in our accrued CapEx. Accounts payable and accrued current liabilities at the end of the quarter amounted to $106 million and at the end of the quarter we had $39 million of CapEx accrued for and as I mentioned which was up $20 million from the fourth quarter.

Please turn to Slide 9 as we review our capitalization. During the quarter, we announced we entered into a 5-year $50 million revolving credit facility and the repayment of a total of $21 million term loan, previously due in 2017. The new credit facility provides for increased financial flexibility, reduced interest rates and relaxed financial covenants.

Total debt at the end of the year was $170 million the principal components of outstanding debt include $22 million of 5.5% senior unsecured convertible note due in October, $115 million 3.25% senior unsecured note due April of 2016 and approximately $9 million for capital lease obligation and $24 million related to a capital lease for an e-beam tool. As of today and throughout the quarter we do not have any borrowings outstanding in our new 5-year $50 million credit agreement.

Taking a look at our cash flows. Cash provided by operations for the first quarter was approximately $14 million. And D&A was $17.9 million for the quarter. Cash flow used in investing activity for CapEx during Q1 amounted to approximately $12 million. Net cash used by financing activities during the quarter, amounted to $23 million of which all was primarily related to related to repayments of debt.

No, if you please refer to Slide 10. A quick update on our planned JV in Taiwan, as we’ve stated before in November we announced the formation of a noncash JV with DNP in Taiwan. In essence, PSMC our wholly owned subsidiary will be merged with DNP’s Taiwan subsidiary, DPTT. The joint venture is subject to regulatory approvals and closing conditions and is projected to be finalized in the next few months.

Let me briefly highlight some of the key provisions of the JV. Photronics will own 50.01% and consolidate the JV in our financial statements. Photronics will manage and control the JV. This is absolutely critical to our ability to be successful with our high-end strategy. We estimate that our top line will grow by at least $80 million annually, with the vast majority of revenue being comprised of high-end IC products. The JV will be well-capitalized and should be self-sufficient. We expect to incur $1.5 million to $2.5 million in additional expenses related to the JV prior to the closure. We also expect to extract annual cash synergies of at least $5 million to $7 million beginning within two quarters of the formation of the JV, and we do expect the JV to have an accretive impact to the bottom line and EBITDA in fiscal year 2015.

Please turn to Slide 11 as we take a look ahead. We expect our cash CapEx needs for 2014 to be in the range of $70 million to $90 million. We do, however, have the flexibility to accelerate or decelerate our spend depending upon market conditions. We expect to continue to generate free cash flow once again in 2014. And our 2014 investments are principally geared towards high-end leading-edge products for IC and FPD applications.

During Q2, we do expect depreciation and amortization to increase $1 million to $2 million sequentially as certain tools will be placed into production. Our visibility has always continues to be limited as our backlog is typically one to weeks. As we are in the third week of Q2, we can report our mainstream IC business in the U.S. and Europe as we turn to a more normalized run rate.

We also expect a delay in the memory ramp to Q3 for our key customers and while we are optimistic we will complete the 28-nanometer qual, for our key logic foundry customer, we are not banking on a substantial uplift to Q2. So taking this all into consideration, we are projecting revenue for the second quarter of 2014 to be in the range of $100 million to a $105 million. That said should the high-end IC memory and/or logic ramp accelerate during the later part of the quarter, we do have some upside as we have installed equipment to enter the business.

During 2014, our tax rate will be affected by the flow of income from jurisdictions for which we may have tax credits and upon our limited ability to recognize tax benefits in the areas for which we are taxable. For the second quarter of 2014, this will equate to a range of $2 million to $3 million. For fiscal 2014, we estimate total taxes will range from $11 million to $13 million. As a result, based upon our current operating model, we estimate EPS exclusive of any JV transaction costs the second quarter of 2014, to be in the range of $0.01 to $0.05 per diluted share.

In summary, I’ll leave you with a few key thoughts. First, we expect top and bottom line improvement in 2014 and continue to expect to generate free cash flow. Second, we are confident about our business model and our ability to grow market share at the high-end. We see continued opportunities in our customers' businesses and node migration plans, and we have a strong financial position and excellent technology to capitalize on those plans. And finally, we expect to continue to build on the momentum that we have established over the past few years as a leader in advanced photomask technology

Now I would like to turn the call over to the operator for Q&A.

Question-and-Answer Session

Operator

Thank you ladies and gentlemen (operator Instructions) Our first question comes from Edwin Mok with Needham

Thomas Robert Diffely – D.A. Davidson & Co

Asking for Edwin Mok today. So the first question I guess about the expense and margins, directionally speaking where do you guys see the OpEx and gross margin go into next quarter?

Sean T. Smith

To the extent we have additional incremental revenue; we would expect a 50% drop through on the gross and operating margin.

Thomas Robert Diffely – D.A. Davidson & Co

50%. Okay, then how about the OpEx?

Sean T. Smith

We do not anticipate any substantial changes in our OpEx going forward.

Thomas Robert Diffely – D.A. Davidson & Co

Okay, I see. That’s great. Then I guess the second quarter I have is with regards to the Ultra HDTV, do you guys see the 4K UHDTV to be a driver for your flat panel display business this year?

Christopher J. Progler

Hi this is Chris, I think from the development side we are seeing activity on 4K mostly shrinking the pixel size and resolution on the mask, in terms of volume adoption that technology into mass production, it’s too soon for us to see that. Price point is still high et cetera, but in terms of R&D masks and design activity we are seeing we are connected with 4K, but I don’t think that’s a driver or at least my view of the flat panel business. I think there are other things such as new materials that will be stronger drivers for the industry this year.

Thomas Robert Diffely – D.A. Davidson & Co

I see, I see. So perhaps later next year then. Okay that’s all I have. Thank you very much. Thanks.

Sean T. Smith

Thank you.

Operator

Our next question comes from Patrick Ho with Stifel, Nicolaus.

Patrick J. Ho – Stifel, Nicolaus & Co., Inc.

Thank you very much. Maybe as a follow-up to the gross margin question, going forward not only in this quarter but over the next few quarter what are going to be the key variables that will I guess drive gross margins whether up or down?

Sean T. Smith

Patrick the key variable is the volume that’s going to come through and our ability to maintain a cost structure and reduce some cost, that’s why we still project to have a 50% drop through on incremental revenue, the model is intact and you noticed these past quarter we had a 47% reduction in operating income on the decreased sales volume so it does tie closely together. I did mention that our D&A would go up $1 million to $2 million during the quarter. So we have to do some more work on our operating cost to minimize that impact.

Patrick J. Ho – Stifel, Nicolaus & Co., Inc.

Great that’s helpful and a bigger picture question, in terms of qualifications. Now that you are kind of in the process or done on the 28-nanometer side, now how does it look going forward in terms of qualifications for next generation nodes whether it’s 20-nanometers or the next generation after that but didn’t say 14-nanometers, how are those qualifications going, because just want to get a bigger outlook in terms of the roadmap?

Peter S. Kirlin

Yes, the qual is generally are proceeding well globally whether they would be 1X memory or 14 nanometer is a logic, if you look at the business generally where customers are headed on the logic nodes anyways, it looks like as everyone knows that the 2X the 22-nanometer or 20-nanometer node with the exception of in other words West Coast. Semiconductor manufacturer is going to be a non-node.

So we are doing well sub-20 on the quals, but I also would point out that on the 28-nanometer node, with the exception of PMSC the rest of the foundry space is still really early, it’s really early in the game. So we expect to see as the year evolves and the other foundry suppliers including PSMC as they really gain traction we expect to see significant revenue this year on 28.

Patrick J. Ho – Stifel, Nicolaus & Co., Inc.

Great, thank you

Operator

(Operator Instructions) Our next question comes from Tom Diffely with D.A. Davidson.

Thomas Robert Diffely – D.A. Davidson & Co

Sean, first a question on the guidance, $100 million to $105 million. It seems like if your mainstream business is returning to normal levels that should be enough in and of itself to get you above $105 million. So, are you actually expecting a decrease on the high-end side due to the memory ramp delay?

Sean T. Smith

Not necessarily, but we just wanted to make sure that we are prudent in our guidance, and just on another topic that we are not providing specific guidance. Typically over the last couple of years Q2 and FPD is down a little bit. So based on the visibility we have today and the impact of some of the high-end memory ramps comes in we could – like I said we have the opportunity to be better than that’s our best estimate on where we stand today.

Thomas Diffely – D.A. Davidson & Co.

Okay, when you look at the potential memory ramp is that more of a NAND or DRAM driven events?

Peter S. Kirlin

It’s really – Tom it’s really both, so we expect to see those NAND and DRAM more or less ramp simultaneously. So as Sean said in his prepared marks and I also said in mine, we are expecting now to see that in the third quarter, it will be greater if its pulls out a little bit sooner, but that’s the best information we have now.

Thomas Robert Diffely – D.A. Davidson & Co.

Okay and as you said during your prepared remarks that you are fully qualified, I mean all of the consortium social partners or all the pieces of your big customer in the memory side?

Peter S. Kirlin

Yes, what I said was we worked really hard with the new addition to the family to be qualified on their memory technology which is unique and distinct and yes Boise campus is all set and ready to go. So we’re hopeful that node will ramp sooner rather than later, but also as Sean said, we’ve seen this push out now on this a quarter or two and we are going to wait until it materializes before we guide on it rather than either way around.

Thomas Robert Diffely – D.A. Davidson & Co.

Okay that makes sense. And then on the high-end logic side, does it matter to you whether or not you have big product lines going through your customers, if it’s a number of smaller products, if there is a transition does that matter you, is it just as long as that fab is fully utilized, how do you benefit?

Christopher J. Progler

Hi Thomas this is Chris, can you just clarify the question. Do you mean design starts versus volume usage of a fab on a single part, the difference between those two?

Thomas Robert Diffely – D.A. Davidson & Co.

Yes if you are – yes if you are just looking at some of your high-end customers and them doing a large run for one of their customers, if that transitions and you have a huge run of a single product versus several runs smaller products in a fab, does it matter to you from a profitability point of view? What scenario are you in?

Christopher J. Progler

I think its healthy to have a combination of both, if there are lot of kind of short runner and many designs the mask unit numbers go up, so that’s certainly beneficial, but often times those can be smaller field masks that are little bit lower ASP even with a given – within a given node. The high runners tends to be the largest most complex masks often times, so ASPs tend to be a little higher. The best scenario is both, base of high runners at a given node and then a healthy design mix as well is really the best option for us.

Thomas Robert Diffely – D.A. Davidson & Co.

Okay and then Chris, I know over the last couple years the flat panel business is driven a lot by the new design especially the AMOLED. We’re starting to hear from the other equipment vendors though that capacity buys are coming back and they expect some nice capacity over the next year. Do you see that as a good drivers well?

Christopher J. Progler

For sure we see on the LCD side, particularly kind of a resurgent a little bit in design activity trying to push that platform a little faster and new materials coming in as well, finer pixels and things like that and so it seems to AMOLED is looking strong, but also we’ve seen some R&D resulting in new products on the standard LCD side that should drive demand also.

Thomas Robert Diffely – D.A. Davidson & Co.

Okay and then finally Sean when you look at the joint venture you talked about being accretive in fiscal 2015, is it truly to figure out what the impact on fiscal 2014 is going to be from dollars and cents point of view?

Sean T. Smith

Good point Tom, it’s too early to tell, because we are not sure when it’s going to close. When we announced the JV in November we said it should be accretive in 2015 or sooner and I believe at that point in time we had earmarked at the end of January, but it takes a little while with some regulatory processes and we are dealing with three different – U.S., Japan and Taiwan, so if it happens during this quarter before we end this quarter we will certainly do everything we can to get those synergies in place to make it as accretive as soon as possible.

Thomas Robert Diffely – D.A. Davidson & Co.

Okay, thank you.

Operator

Well ladies and gentlemen; there are no further questions at this time. I would like to turn the call back over to our host.

Constantine S. Macricostas

Thank you for participating in this morning’s call, I would like to thank all the Photronics employees for their dedication and hard work. Thank you guys, have a good day.

Operator

Well ladies and gentlemen, that concluded the conference call for today. We thank you for your participation, and we ask that you disconnect your lines.

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