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Advanced Energy Industries, Inc. (NASDAQ:AEIS)

Citi Technology Conference Call

September 6, 2012 11:00 am ET

Executives

Yuval Wasserman – President, AE Thin Films

Danny Herron – Executive Vice President and Chief Financial Officer

Unidentified Analyst

Our next company is going to be Advanced Energy Industries. We’ll lead off with Mr. Yuval Wasserman, President of the Thin Film business unit and from there we’ll share remarks from Mr. Danny Herron, Executive Vice President and Chief Financial.

So with that, I will turn it over to Yuval.

Yuval Wasserman

Good morning. Before we start, I’d like to look at the Safe Harbor slide for a second. Starting with background about the company, Advanced Energy is a 30 years old power conversion and control solutions company providing solutions for Thin Film processing and the Solar Energy market. In the Thin Film processing area, we provide the activation energy that is required to make some of the deposition of Thin Films and the etch processes possible.

We provide RF DC power supplies that we sell to equipment manufacturers around the world. For the market of the Solar Energy, we provide DC to AC inverters specifically targeted for the commercial and utility scale obligation. The company is build into two business units, I run the Thin Film business unit and Gordon Tredger runs the Solar Energy business unit. The company combined revenues of $500 million a year. We have a very strong balance sheet, nice position of cash and no debt.

Last year November, we presented our three year strategy and our goal for the future of the company. Our main focus is to increase shareholder value and we do that with an intense drive for revenue growth, cash generation deployment and earnings per share growth. We feel very good about our progress versus the plan.

During the first two quarters of this year, we generated $65 million of cash. Since Q4 2011, we had taken more than $30 million of cost out of the operation and we feel very comfortable meeting our long term growth trajectory as we serve the market that I mentioned before.

The company serves very diverse two market, the Thin Film processing market, a market where we sell our products to equipment makers. We develop the RF DC power supplies and we sell them to the semiconductor industry, the PV solar and glass industry, Solar Power manufacturing industries, industrial coating and a significant service business we have. This business that we serve is very diversified and we are growing not only in the semi business, but we are having nice growth outside of the semi world in those additional market segments that I talked about.

The Solar Energy market, we focus our product through the utility scale and the commercial inverters business. We have established our self really well in North America. We continue to position our growth expanding beyond North America to additional world regions.

During the last three years, a portion of our business that goes to the Solar Energy has grown to a point at right now about 50% of our combined revenue serve the solar business. That is very much in line with other diversification strategy to be much less dependent on a semi business and much less dependent on the general Thin Film business to create a much more balanced business that is more immune against the cyclicality of the markets we have traditionally served before. That growth and balance allows us to be more effective in driving common practices and common tools throughout the business unit, leverage each other and drive synergy within those two areas.

The three pillars of our three year strategy as we presented last year are margin expansion, revenue growth, and cash utilization. In the margin expansion, we have done a tremendous job so far taking cost out of the operation. We have restructured the company to be profitable comfortably during the downturns of the cycle. We have now transitioned into the next phase of cost reduction as we go from reduction in operating expenses into reduction of the cost of goods. That will be in the next phase and we have visibility to do about $15 million to $20 million cost reduction that will come from that effort of cost of goods.

We focus on revenue growth in both the years as we continue to both invest in R&D to develop the products in each of the markets we serve, but also expand geographically and increase the geographical areas we serve and I’ll talk about that in a minute. Our cash utilization, we effectively utilized the cash of the company as was demonstrated already by the share buyback we have completed, Danny will talk about that later, as well as investing in our self, invested in the company, in our growth and expansion globally.

Our factory in Shenzhen, China is one of the key enablers for us to continue to drive efficiencies, to drive cost. This is an award winning factory that has a tremendous quality capabilities, very flexible operation and very effective cycle time. We have implemented recently demand flow technology and mixed line manufacturing in Shenzhen in this factory, which effectively allows to continue to drive efficiency, reducing cost down, reducing of inventories and continuously managing the cycles of our business effectively.

This factory is also a place where we have started moving sub-components of our solar inverter business from their final assembly in test manufacturing site into these factory which will allow us to utilize the assets we have, the tools and methodologies we have developed, to reduce cost and better manage our capital.

Our manufacturing strategy, in general, is focused on the hub in China and capitalized around the world. This hub in Shenzhen in addition to the capabilities we have there will allow us to also locally drive local supply chain, outsource locally to low cost areas within the China area, and with the hub we have and the satellites we have around the world, we are able to place final assembly and test facilities close to our customers where there is a specific need for local manufacturing.

In some of the inverter business, we have local final assembly and test facilities around the world. In the Thin Film area, we have a manufacturing final assembly and test plant in Korea, very close to our flat-panel display customers and semi customers.

Revenue growth is the next phase of our focus and effort. We have invested in R&D capabilities close to our customers. In the Thin Film area, we continue to invest in developing products specifically for the next generation technology nodes and next generation wafer side. We have product right now that’s been evaluated for sub 22 nanometer technology and we have products that are being tested on 450 millimeter R&D tool. We are continuing to invest in these programs as a growth vehicle for the future.

At the same time, we move in general capabilities closer to our customers. We just finished building an R&D center in San Jose, close to a key customer. We are hailing engineers right now in Korea to be placed close to a Korean customer and we will continue to pursue that strategy placing our engineering resources closer to the user where we can get engagement from a very early stage of the development and develop products that the customers really need.

In addition to that, we continue to broaden our product portfolio. That will allow us to migrate outside of the current markets we serve into new markets, adjacent markets and totally new markets we are going to grow and expand into both in Thin Film and outside of Thin Films wherever Deposition Power Conversion is required.

The environment around us is changing and about to use our growing by optimizing and investing in distribution network in a global footprint. In the Thin Film area, we’ve invested to optimize our locations. In some countries, we show our customers moving to low cost regions as well and we align ourselves to be close to our customers. In the Inverter business, we invest in local, sales, marketing and support centers close for the regions where we want to grow.

Lastly, we intend to increase our growth by acquisition. We made it very clear during our strategy presentation, we are going after a tuck-in or bolt-on acquisition that will allow us to use our current infrastructure our current skills, proofing capabilities to observe new products, manufacture them in our manufacturing site in Shenzhen, and increase their growth rate. And that will be in both core and adjacent market.

In the Thin Film business, it became clear to us that to address the two very different type of customer that we have, we need to increase our focus. And in the copy exactly world, where development is very long, very precise, very close to the customer, in a very long period evaluation and testing is required as to which design win is being accomplished and beyond that point, we operate in the copy exactly environment where the product lifecycle management is much more challenging. It requires a specific focus and specific marketing and engineering capabilities.

In the general industrial Thin Film market, we have a much higher flexibility to quickly develop products to specific applications that are required in a market and these products are not under copy exactly, so it is much more effective, easy and flexible to manage the product lifecycle which allows us to really drive cost down by design changes that are very flexible in comparison to the copy exactly environment.

To be able to serve all these customer type, we have created focus area in the BU focused team. One team focuses on the copy exactly product, that the semi product and the other team is focusing on the general industrial Thin Film product, where we quickly generate products that are specifically designed for specific application and specific region.

In the solar inverter area, we are really well established in North America. In U.S., we have a very strong position. We have a very healthy pipeline and very healthy backlog right now, and we continue to share this market by addressing to commercial and utility scale. We are pretty comfortable right now with our position in Canada. We have established a local manufacturing site in Canada which allows us to serve the local market and meeting our target cost and profitability for the business.

In the rest of the world, we continue to grow by expanding in world regions that we would like to pursue first and two examples are China and India. In China, we have established a strategic relationship with the local entity called SGEG. We jointly work on a product that we take the market together. They have a local technology, AE is bringing the local they control and the software system. And together, we take a product to the market, AE takes the product to the world, SGEG sells the product in China. In India, we’ve established a relationship with the local entity and this relationship will allow us to go and build the team, the channel, the product that will be localized and serve the market effectively.

We focus, as I said before, on cash utilization. In addition to returning cash to our shareholders through stock buybacks that we have completed, we continue to utilize our cash for investing in our self, expanding our capabilities and also looking for potential acquisition where we can bolt-on or tuck-in acquisition to our company. One area that is more of an area of focus is the Thin Film area, and we are pursuing a pipeline of potential acquisitions right now and the idea is to accelerate our growth in the core market as well as adjacent in new market that we are looking into. We are pursuing markets outside of Thin Film such as the medical, food packaging, gas abatement et cetera.

So in summary, we are well ahead of our plan in pursuing our restructuring and cost reduction. We feel very comfortable with accomplishing the targets we have put up in front of us. We continue to generate cash, the focus on utilizing the cash effectively and right now the company is on a major focus on generating growth by developing products, region and accelerate the growth by division.

I will hand it to Danny.

Danny Herron

Thanks, Yuval. I want to wrap up with some of the financial stats and show you where we are in our goals and our cost reduction plan. So I just want to take you back to last November, we laid out these goals for each business unit.

So in our Thin Film business unit, we think realistically at cycle peak, this business earns 23% to 25%. And if you go back to last year, certainly did that in the first quarter. And as Yuval said, we’ve really restructured this business to where it’s very profitable in the trial. Our revenue last quarter was $65 million and we still earned $8 million towards operating income, and that’s a low point of the cycle.

A year ago, revenue in this unit was probably $105 million. So it’s very cyclical, we got it structured right. The key thing in this business returns, we will not be adding cost back to this business. So as revenue comes back, you take our gross margin that’s coming to the bottom as operating income.

If we look at our solar business, a little bit different business and different model for sure. It’s a pretty high growth business. We expect about 20% to 22% CAGR over the next several years. The industry is probably growing at 30%. We are growing less than the industry because we are focused on profitable growth. We have market share – we are not out there trying to buy market share. We want to return value to our shareholders and we think the best way to do that is to have profitable growth (inaudible).

So we focus on good account. We give a good product. We have good service and that allows us to have profitable growth. As Yuval mentioned, we’ve restructured this business also. We are doing our sub-assemblies in China and we bring them most to the U.S. for final assembly and test. And that leads requirements some countries have local content requirements. In Canada, we do – we have a final assembly and test in local there. It allows us to play in the Canadian market and that will be our strategy as we develop into new market.

And then to talk about our restructure, Yuval mentioned we’ve taken over $30 million of cost out of our business. We started last year in the third quarter, we had a restructuring charge as we set up our – primarily our Thin Film business unit and then we did our Solar business unit in the December timeframe. We got out of some extra locations that we had. We had some warehouses around that we found a way to be more efficient and not have an offsite warehouse, so we moved that product into our factories instead of paying the handle at twice our site. We got out of some excess buildings in the past. In total, we generated savings of about $30 million and we’ve had about $10 million to restructuring charges. So very good return to our shareholders for the charges we have taken.

Where the cost is? Primarily three buckets. There is the restructuring cost of getting the organization leaner and more efficient. So that’s about $12 million of reduction. We revised our compensation plan, that’s about another $12 million and that was in two phases, one on the short term incentives and one on the long term incentives. The key thing for you, shareholders, on the long term incentives, we were diluting our company about 4% a year with our equity program. It’s now about 1.5% a year target. So once again, the focus is on creating shareholder value.

So if you look in 2012, we are about $30 million right now and the other savings were really the space eliminations, getting out of a couple of buildings into warehouses. If you look at going forward where the big opportunity is, its $15 million to $20 million in material cost reduction, primarily in our solar business unit as we move our sub-assemblies to China and take advantage of our low cost manufacturing operation there.

If you think about the $15 million to $20 million, if you look at cost of goods sold of running probably 70% to 75% on the solar business unit and you do some simple math, the $15 million to $20 million is only another 8% or so reduction in material cost, very achievable. We are deploying some software that allows us to do reverse options and take vendors and the gentlemen who came on board to help us deploy that, he is done it at several companies prior. So he has got a good track record and our first blush the 8% that we are taking about is very achievable. So we feel good about getting to those goals. And at the end of the day, our tax rate is very good return for our shareholders.

So I’m going to close with once again the company goal, 11% CAGR for the next three years on revenue. We are well on our way to meeting that target. If you look at cash generation, we laid out a goal of $180 million to $200 million of cash, obviously that was before any buyback, while in the first half of this year we are at $65 million. So we are well on track to achieve that goal.

And then our EPS, we laid a goal out there of about $1.90 to $2.10 a share. And if you just take where we are today and you role forward, if you take our Thin Film business and get it back to 90% of the peak and we laid our solar business growth, we feel very comfortable. And we fill out about $1.90 to $2.10, Garry would say it was an aspiration goal. Now we are feeling much more confident that there is actually a pathway to get there given our current level of performance.

In summary, I think Yuval repeated this already but we are well ahead of the game on our restructuring plan. Originally we felt we are somewhere of $18 million to $20 million of cost, but we are now in excess of $30 million and we have a pathway to get to over $50 million of cost reduction and that cost won’t come back when the cycle return. That’s the real key difference to may be AE in the past. Our cost is out of the business and its out to play.

We are now turning the focus to the cost of goods sold. We think that will allow us to preserve margin. Obviously there is price pressure in any business, but as we continue to get better cost of goods sold reduction, we will be able to maintain margins and overall that helps us grow. And then our revenue is the real key. And as Yuval mentioned, we are constantly focusing on finding the right tuck-in acquisition so that we can continue to grow the top line and we did complete our buyback in about six and a half months. So it was a one year program and like most of things we want to try to overachieve and we did on that one. So we got it done in six and a half months and it’s behind us. And we still have much cash now as we did in, so that allows us to be a very accusative and we find the right target.

I think we can open up for questions now.

Question-and-Answer Session

Unidentified Analyst

We have a little bit of time, so if there are any other questions, I’ll allow this time now to post questions.

Unidentified Analyst

You invest in the software, can you say if that was just build internally or whether used some external platform and build on top of that, I’m just curious?

Yuval Wasserman

Software (inaudible).

Danny Herron

It’s our design. We said basically we combine the best of workplaces right. It’s the brain of the inverter that you develop and the technology of the inverter that SGEG developed. If you combine that together, the product we believe is going to be very competitive and we can take it worldwide.

Unidentified Analyst

Go ahead.

Unidentified Analyst

Just talk a little bit more broadly about the growth opportunity in solar. I mean there is a lot of sort of controversy and struggle in different parts of the world. That seems like you are more focused on the North American market and sort of just from a secular point of view, what the drivers are in fact kind of 20% to 30% growth opportunity in the market.

Danny Herron

Yeah, if you look at North America, the third party forecasters out there are calling in the sectors we play in which is utility and commercial. They are calling for 40% growth. I think next three years in utilities must be 41% and I think its 37% in commercial. And there is a pipeline of projects out there. There is a website that’s got all the projects under development. There is probably 12 gigawatts under development in North America.

So we affect to get our fair share of that, but we also want to get the ones that allow us to be a good partner to them and that means, we have to make little money, they’ve got to make money. We bring a certain efficient fee in our unit. We bring the design technology on the utility scale with our bipolar design. It allows for lower balance of system cost and we have very good efficiency. So North America is going to grow with those rates. So we are very comfortable with the 20% to 22%.

Now, the rest of the world, Japan is going to be a pretty strong growth market. If you don’t realize it, they did have 43 nuclear reactors and they have taken them all offline. I think they brought 2 back online this summer just because they were having (inaudible) but there is going to be a large solar market as is India. And as Yuval mentioned, we have an arrangement with the firm in India to be our distributor there and they help us to create that market. So I think the 22% is a very achievable goal because I think we got a lot of upside outside of the U.S.

Unidentified Analyst

Into the year, you are implying and I thought you expect increased competition in terms of being selecting the right partnership. What’s the competitive landscape look like going forward?

Danny Herron

Well, obviously as you have, Europe is the largest solar market. I think Europe is projected to be flat to down over the next several years. So you will have people coming from Europe trying to penetrate U.S. market. It’s not as easy as coming into put your products in a big box retailer. I mean you got to have a service network. So its not you instantly come over here and you penetrate this market. You got to have a service network to repair the product, to keep them up and running. They have a 99% uptime on our products. You also have to have an established network out there to be able to penetrate the EPCs that are out there.

So it’s not instant that somebody is going to come into the U.S. and penetrate that market. I think you’ve seen that with some of the people that have come over and try to penetrate it. It’s not as easy as they think. And part of it is the product design. The products in Europe generally went into bunkers to where they were climate controlled. In the U.S. the large scale inverters are water cooled and they are in their own container and they are out in the middle of the desert where you have extreme from 30 degrees at night to 120 degrees in the day, so it’s a different market but they have to redesign some products for this market also.

Unidentified Analyst

Maybe I’ll step in with a bit of a general question here. I was hoping to (inaudible) if you see any difference here in the second half of 2012 relative to kind of the first half. I mean you’ve obviously got a fairly solid pipeline, good visibility in kind of the North American markets, but would you anticipate that your second half of 2012 is fairly similar to what you see in the first half.

Danny Herron

Well, we think it will continue to go over the guidance we gave for our third quarter in our solar business had continued growth. If you look on a year-over-year basis, our first quarter and second quarter were both up over 20% versus the same quarter a year ago. And we expect the third quarter to be relatively the same.

Unidentified Analyst

Congrats. Maybe I’ll ask one last question here. I want to – if you noted a number of uses of cash including share buybacks, potential acquisition, continued internal growth. Would you – can’t you perhaps maybe prioritize some of the uses for what you’ll emphasize over the next couple of quarters.

Danny Herron

Well, I think our focus right now is acquisitions and growing the top line. We have established infrastructure. We have a company that is proven that can execute. For the last nine months, we’ve laid out a plan and we hit our numbers. As we’ve laid it out – our short term focus over the next several quarters is on getting some accelerated growth through acquisition. And we think there is ample opportunities out there. As with any acquisition, you got to have well seller at the right price and a buyer at the right price and we will get there on some of these.

Unidentified Analyst

If there are any further questions?

Unidentified Analyst

Do you think the guestimate as to when you think the 450 millimeter becomes a something on the horizon that we need to be (inaudible) testing now, but where do you think more mainstream?

Danny Herron

Yeah. I think that the investments (inaudible). And the follow on participation of the S&P basically solidify the time table. And now everybody knows it’s real, its happening and I cannot give you the specific example, but we know that next year early the first R&D tools are going to be shipped for 450 engineering center for projecting. And from our side, as a critical component manufacturer for those tool, we are already engaged in testing of some of our power supplies for those 450 millimeter plasma system that are going to be shipped to customers next year.

Customers I’m saying to follow in these methods. Right now, we believe our customers when they sell us, 2017 will be the year where production tools are going to be shipped. And in conjunction to the new wafer size, there is an investment in the next generation technology node that will take place at the same time. So we have an interesting convectors falling at the same time investment in power supplies and tools for 450 and investments in power solutions, power conversion solutions for the next generation technology nodes that are much more challenging in terms of the features and the asset ratios and the chemistry apply it.

Yuval Wasserman

Okay. I think with that I think drives you for sometime. Thank you very much.

Unidentified Analyst

Thanks.

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