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Operator
Good day and welcome to the Nova Measuring Instruments Ltd.
Third Quarter 2018 Results Conference Call.
Today's conference is being recorded.
At this time, I would like to turn the conference over to Miri Segal of MS-IR.
Please go ahead.
Miri Segal-Scharia
Thank you, operator, and good day, everybody.
I would like to welcome all of you to Nova's Third Quarter 2018 Financial Results Conference Call.
With us on the line today are Mr. Eitan Oppenhaim, President and CEO; and Mr. Dror David, CFO.
Before we begin, may I remind our listeners that certain information provided on this call may contain forward-looking statements.
And the safe harbor statement outlined in today's earnings release also pertains to this call.
If you have not received a copy of the release, please view it in the Investor Relations section of the company's website.
Eitan will begin the call with a business update, followed by Dror with an overview of the financials.
We will then open the call for the question-and-answer session.
I'll now hand over the call to Mr. Eitan Oppenhaim, Nova's President and CEO.
Eitan, please go ahead.
Eitan Oppenhaim - CEO & President
Thank you, Miri, and thank you all for joining our third quarter 2018 financial results conference call.
I will start the call today by speaking about our third quarter results and performance highlights.
I will conclude by providing guidance for the fourth quarter of 2018.
Following my commentary, Dror will review the quarter's financial results in detail.
Nova continued to perform well, setting quarterly record revenue at the high end of the guidance and exceeding the profitability guidance for the quarter.
These achievements are further evidence of our steady progress, demonstrating consistent execution of our long-term plan to diversify our product offering, differentiate our solution and expand our available markets.
We are very encouraged by this progress as the company continues to achieve solid results despite the increased market volatility.
Following our quarterly earnings and the guided revenue for December quarter, we expect 2018 to be our sixth consecutive growth year with revenues at record high.
With this milestone clearly in our reach, we are progressing steadily towards our long-term target of $300 million in revenues annually.
We plan to achieve this aggressive plan through continuous growth of our organic product lines, which are well supported by significant investments in developing new disruptive solutions.
In fact, the expected revenue mix this year reflects a growing portion of new differentiated applications which can be sold today exclusively by Nova.
As a result, we are generating opportunities that set us apart from the traditional competition and diversify our growth.
Our solid results are highlighted by growing revenue from the Memory segment, which reached a quarterly record with substantial contribution from all leading customers.
In addition, following our press release this quarter, we initiated the deliveries of our dimensional OCD and materials solutions to the most advanced 5-nanometer technology nodes.
Our strong performance is also reflected in our diversified customer mix, which yielded 5 large customers this quarter, 3 of which are leading memory providers.
As a result, Memory contributed approximately 65% to our overall product revenue, setting new Memory record.
The significant progress we made in growing our market share in memory, which resulted in increased annual revenues, deserves emphasis considering the recent softness in Foundry, which was the main revenue driver a few years back with approximately 85% of our product revenue mix.
Our expected yearly contribution from memory customers in 2018 is driven by more than 60% growth year-over-year, well above the expected market performance.
This could be achieved continuously following the significant inroads we have made to strengthen our competitive position with all memory providers.
As for the territory mix, we continue to see strong demand for a broad range of products from our Chinese customers both in Memory and Foundry.
As a result, China accounted for roughly 30% of the overall products revenue this quarter.
In our view, although we may see a transition period while local establishments move from R&D stages to high-volume production, we still envision China as a significant sustained driver for our long-term growth.
As we continue to diversify our product offerings to meet new process control challenges, we are encouraged by the strong traction our new-generation products are creating in the market.
As part of our strategy, we anticipate that in order to improve device performance, materials complexity will evolve to be one of the toughest challenges to overcome.
To continue improving semiconductors, scaling and architectural changes are not sufficient enough and introduction of new materials are required.
Currently, in order to scale the logic device or increase the vertical memory cell or [transit to] 1Z DRAM structure, new materials are introduced to improve performance and reduce leakage.
The number of periodic elements that are used today has tripled over the last few years and supports all the latest technical conditions.
This shift requires more control and more materials measurement in the production environment.
Composition, stress, strain and others evolves to be major parameters to measure and are required in all device types.
Because of these trends, we believe that materials metrology overall available market will grow significantly in the coming years.
Analyzing our performance in these areas reveals continuous growth in materials metrology revenues which come both from the OCD and X-ray solution.
This part is one of our major differentiators going forward and will accounts for substantial future growth.
In order to support this direction and other unique growth engines and as previously discussed in both our first quarter and second quarter earnings call, we intend to maintain high level of R&D spending in 2018.
As in previous investment years, to deliver such R&D spendings supports our long-term vision to expand our core differentiators which set us apart from the conventional competition.
Our product rollout is on track and expected to be delivered to the market in the first half of 2019.
Following this strong quarter, in which we continued to leverage our efficient operational model and grow our cash reserve, we have decided to launch a share repurchase program to reflect our confidence in the company's long-term growth.
Nova will continue to leverage its strong cash flow and solid balance sheet to invest in disruptive new technologies, pursue relevant merger and acquisition activities and enhance shareholder's value.
In conclusion, though the industry is currently experiencing some extreme challenges mainly in adjusting memory capital intensity and improving yields, we expect to continue executing successfully our long-term growth trajectory.
We believe that the long-term industry momentum will continue as the semiconductor market benefits from multiple solid catalysts which are driven by the increasing demand for sensor, powerful devices and dense memory cells.
Technical inflections such as scaling and materials engineering will continue in order to enable new device architecture in both memory, logic and foundry.
Our widened exposure to multiple segments, customers and geographies, combined with the traction our differentiated portfolio is creating in the market, position us to benefit from the long-term growth potential in multiple differentiated applications.
As for the fourth quarter guidance, we expect revenue in the range of $56 million to $64 million, diluted EPS on a GAAP basis in the range of $0.28 to $0.40 per share and diluted EPS on a non-GAAP basis in the range of $0.35 to $0.46 per share.
Now let me hand the call over to Dror to review our financial results in detail.
Dror?
Dror David - CFO
Thanks, Eitan.
Good day, everyone.
In my following prepared remarks, I will refer to both GAAP and non-GAAP results.
You can find a detailed reconciliation per item at the end of the earnings press release.
Total revenues in the third quarter of 2018 were $63.6 million, a record quarterly level.
Product revenues for the quarter were $49 million, comprised of approximately 65% from the Memory segment and 35% from Foundry.
hynix, Huali, TSMC, Micron and Samsung each accounted for 10% or more of product revenues.
Service revenue came in at a normalized level of $14.6 million, a reduction relative to the previous quarter, which included major upgrade projects to the existing installed base.
Blended gross margin in the third quarter increased to 59%.
Product gross margin increased to 64%, largely resulting from a favorable product revenue mix in the quarter.
Services gross margin decreased to a normalized level of approximately 42% after reaching a record high of 49% in the previous quarter, which included higher revenues related to the installed base upgrade.
Operating expenses for the quarter totaled $21.7 million on a GAAP basis and $20.1 million on a non-GAAP basis, slightly lower than the previous quarter.
The decrease in operating expenses resulted from a decline in sales and marketing expenses, while R&D and G&A expenses remained stable.
As previously communicated, the company currently invests in several product development projects, which are expected to move into the product rollout phase during the first half of 2019.
Most of the R&D funding that the company currently receives for these investments is generated by several European funding program.
In parallel, the company is working to complete the transition of its local Israeli research funding from a royalty-bearing program which was concluded under a royalty buyout agreement in 2016 to a non-royalty-bearing program which is called generic R&D program.
Although we do not have control on the timing of such transition and its final approval by government authorities, we hope that this transition will conclude in the coming months and will generate additional funding opportunities for current and future R&D investments.
Operating margin in the quarter was 25% on a GAAP basis and 28% on a non-GAAP basis.
The effective tax rate of the company was approximately 19%, slightly higher than the average in 2018 due to the mix of profits between the different tax jurisdictions.
GAAP EPS in the quarter was $0.46 per diluted share and non-GAAP EPS was $0.52 per diluted share, both higher than the company guidance for the third quarter.
The company cash reserves increased to approximately $172 million at the end of the third quarter of 2018.
This cash level will enable the company to continue to pursue new business opportunities in parallel to executing the announced $25 million share repurchase plan.
Regarding the company guidance for the fourth quarter of 2018, at the midpoint of this guidance, we expect the following.
Blended gross margin is expected to be approximately 57%.
Operating expenses are expected to be approximately $22.5 million on a GAAP basis and approximately $20.5 million on a non-GAAP basis.
Effective tax rate is expected to be approximately 17%.
Based on the midpoint of Q4 guidance, annual gross margins for 2018 are expected to be approximately 58% and annual operating margins for 2018 are expected to be approximately 26%, both within the targeted financial model of the company.
With that, I will turn the call back to Eitan.
Eitan Oppenhaim - CEO & President
Thank you, Dror.
With that, we are pleased to take your questions.
Operator
(Operator Instructions) We'll now take our first question from Patrick Ho of Stifel.
Brian Edward Chin - Associate
This is Brian Chin on for Patrick.
First question, that's for Eitan, in terms of the new product day till shipment, it sounds like they shipped on -- or shipped or are shipping on schedule here in the second half.
And you expect those revenue contributions, timing wise, for the first half of next year.
Is it fair to assume that these are more focused on advanced foundry and logic applications rather than memory?
Eitan Oppenhaim - CEO & President
So thanks for the questions.
So regarding the new products, what we said is the initial delivery will take place in the first half, where we expect to see revenue in 2019.
Now regarding the applications, the applications are not unique for foundry or memory.
It's for both.
And actually, we started -- we're starting those betas in the memory side.
Brian Edward Chin - Associate
Okay.
Got it.
And one question kind of around sort of the contributions that the new products could make next year and just establishing a baseline in the service revenue as well.
Firstly, in service, is there any reason to think service wouldn't grow another, say, 10%-plus in 2019?
It's been operating at or above that in the past couple of years.
And then secondly, just in terms of understanding the materiality of the new product contributions, is -- something [in the level of] 500 basis points of incremental growth in 2019, is that sort of a reasonable expectation?
Dror David - CFO
So in terms of the service revenues, obviously, this year, we saw a slightly higher growth relative to the average.
Service revenues are driven mainly by the increase in the installed base, and yes, we do expect the installed base to grow on average 10% a year, and service revenue growth should be parallel to that.
In terms of new products, given the fact that we are in early phases of better interest and introduction into customers, I will say it's early to say exactly how much contribution will be in 2019.
However, we do expect initial revenues in the second half of 2019.
Brian Edward Chin - Associate
Got it.
And so just consistent with that, should we expect OpEx to kind of run above the 30% of sales long-term model maybe through the first half of the year then somewhat into the second half when you start to maybe deliver against those new products?
Dror David - CFO
Correct.
Brian Edward Chin - Associate
Perfect.
Maybe one last thing real quick.
I think previously you've talked about how the spending pendulum in the industry could shift towards foundry and logic in the first half of next year from the memory strength this year.
Just curious.
From a baseline perspective, other companies have talked about kind of a flattish product shipment environment first half of next year versus second half of this year.
Do you think that's sort of the assumption you're operating against for your business?
Eitan Oppenhaim - CEO & President
So I think, Brian, it's a more broad question, and I really or particularly talk about the market as we see that entering into 2019.
So obviously, we don't guide beyond the coming quarter and the recent challenges in a volatile market reduce anyway the visibility.
And therefore, it's hard to predict exactly the timing and capacity of each investment in '19.
Nevertheless, I can discuss the overall environment and investment pattern in the different segments.
So I think that, in terms of Memory, we expect a balanced investment mix, where we still see continuous investments in DRAM and moderated investments in NAND.
We have to pay attention also that there are also -- some other elements influence Memory beside the supply-demand situation, which are the technical condition in both VNAND future phases like the 96 layers and more; and in DRAM, the scaling below 20 nanometer, which require more investment beside just capacity.
Additionally we expect in Memory some investments of the global players in China, and it's not only for one players.
We're talking about both the Korean players as well as the U.S. player.
In logic, foundry, we expect, as you said, one major event, ramping 5 nanometer.
We do see it happen in the first quarter.
We don't yet see the full visibility on the capacity and exact timing, but we see that happening.
But we also see capacity add-ons in 10 and 7 nanometer by other customers as a result of GLOBALFOUNDRIES muting investments in this 7-nanometer node.
And we also see some investment in trailing nodes both in Taiwan, Korea and China.
Basically, in -- Taiwan, where we started to ship equipment, already should increase the revenue from these customers -- sorry, from this customer, a leading foundry, to be the highest -- in the highest level for the last 6 quarter.
So we definitely expect to this event.
Combining these elements together, at this point in time, our best assumption will be stability in overall business level, at least when we enter 2019.
Additionally to that, on the rest of the year or what will be evolved the second half, I can't predict currently, and I think that the industry cannot predict.
Operator
(Operator Instructions) It appears we have no further questions at this time.
Mr. Oppenhaim, I'd like to turn the call back to you for any additional or closing remarks.
Eitan Oppenhaim - CEO & President
Thank you, operator, and thank you all for joining our call today.
With that, we conclude our Q3 2018 earning conference call.
Thank you very much for joining.
Operator
This concludes today's call.
Thank you for your participation.
You may now disconnect.