Good day and thank you for standing by. Welcome to the Cohu Inc. Third Quarter 2022 Financial Results Conference Call. At this time, all participants are in listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jeff Jones, Chief Financial Officer. Please go ahead.

Good afternoon, and welcome to our conference call to discuss Cohu's third quarter 2022 results and fourth quarter 2022 outlook. I'm joined today by our President and CEO, Luis Muller. If you need a copy of our earnings release, you may access it from our website at cohu.com or by contacting Cohu Investor Relations. There's also a slide presentation in conjunction with today's call that may be accessed on Cohu's website in the Investor Relations section. Replays of this call will be available via the same page after the call concludes. Now to the Safe Harbor. During today's call, we will make forward-looking statements reflecting management's current expectations concerning Cohu's future business. These statements are based on current information that we have assessed but which, by its nature, is subject to rapid and even abrupt changes. We encourage you to review the forward-looking statements section of the slide presentation and the earnings release as well as Cohu's filings with the SEC including the most recently filed Form 10-K and Form 10-Q. Our comments speak only as of today, October 27, 2022, and Cohu assumes no obligation to update these statements for developments occurring after this call. Finally, during this call, we will discuss certain non-GAAP financial measures. Please refer to our earnings release and slide presentation for reconciliations to the most comparable GAAP measures. Now I'd like to turn the call over to Luis Muller, Cohu's President and CEO. Luis?

Hi, everyone. Good afternoon, and thanks for joining us. Cohu reported another great quarter with revenue of $206.7 million and non-GAAP EPS at $0.74, exceeding the midpoint of guidance. Non-GAAP gross margin of 47.5% continues to progress towards our three-year target financial model and benefited from strong recurring business and sale of differentiated products in the quarter. Free cash flow was approximately 16.7% of revenue in the third quarter delivering strong cash generation in line with the model. Estimated test cell utilization came down 2 points quarter-over-quarter to about 82%, reflecting known ongoing softness in mobility and consumer end markets, but also moderating conditions in the automotive and the industrial markets. Cohu's significant recurring business has produced a three-year compound annual growth rate of 6.5% and represented approximately 42% of third quarter revenue at 54% non-GAAP gross margin. In the last four quarters, recurring was $336 million or 41% of sales, delivering a profitable and resilient revenue stream through industry cycles. Our recurring revenue is primarily made up of test contactors and device application kits that are mainly IC design-driven and benefit from the introduction of new semiconductor products by our customers. The balance were approximately 43% of our recurring over the last 12 months comes from service revenue across 280 customers manufacturing facilities in 31 countries. Our service business unit manages a large volume of transactions through a cloud-based automated order management system, handling over 1 million parts shipments per year and provides on-site and remote assisted support to Cohu's 23,700 equipment installed base. This is not part of our customers' capital budget, but a necessary operating investment to ensure continued semiconductor production. And as such, we have many customers engaged in support contracts with an annual renewal rate of more than 87% in the first half of 2022.…

Thanks, Luis. Before I walk through the Q3 results and Q4 guidance, please note that my comments that follow, I'll refer to non-GAAP figures. Information about the non-GAAP financial measures, including the GAAP to non-GAAP reconciliations and other disclosures are included in the accompanying earnings release and investor presentation, which are located on the Investor page of our website. Now turning to the financial results. Cohu again delivered strong revenue and profitability in the quarter. Q3 revenue was $206.7 million and slightly higher than midpoint of our guidance range. During the third quarter, one customer in the automotive market accounted for more than 10% of sales. Gross margin in Q3 was 47.5%, about 100 basis points higher than guidance driven by Cohu's recurring business and differentiated products. Headwinds from cost increases for IC components used on our tester products impacted our gross margin by approximately 130 basis points. We expect these challenges to persist at a reduced level into mid-2023 as we increase sourcing directly with semiconductor manufacturers and component availability improves. Operating expenses for Q3 were lower than guidance at $52.6 million due mainly to lower labor costs from hiring delays and higher utilization of vacation. Third quarter non-GAAP operating income was 22.1% of revenue, and adjusted EBITDA was strong at 24.5%. The non-GAAP effective tax rate for Q3 was 23% and higher than guidance due to a shift of projected annual pretax income from lower tax rate jurisdictions to higher tax rate jurisdictions such as Germany. Non-GAAP EPS for the third quarter was $0.74. In summary, Q3 profitability was strong as gross margin and adjusted EBITDA continue to expand toward the midterm financial target. Moving to the balance sheet. Q3 cash flow from operations was strong at $39.5 million. And net of share repurchases totaling $17.7 million, debt…

[Operator Instructions] Our first question comes from the line of Atif Malik from Citi.

A nice job on the gross margins. Luis, I have a question on your comments on moderation in auto industrial demand. Is this something that you have been seeing throughout this year? Or is it incremental? And then I have a follow-up.

Atif, no, no, that's something that we talked about and expected to see happening, and it is. Just to remind, we think automotive will remain a growing market and frankly, a substantial portion of Cohu's revenue next year. We see some customers stepping the breaks for a quarter, but also part of the normal year-end seasonality. As you know, typically, Q4, Q1, things do slow down in the industry. At the same time, we do have a few other customers particularly on the power market, silicon carbide in electrification that sort of continuing the theme and adding capacity and having some strong forecast for next year. That's not just automotive, to be honest with you, a mix of that is a bit industrial. So, electrification is a major thing. We also have a few other customers that are driving hard on ADAS for automotive at the time. So despite the moderation, like I said in the remarks here, it's part of the normal seasonality at the end of the year in automotive. And we do think automotive are going to be kind of an interesting continued growth market and probably even slightly up next year.

Great. And Jeff, on the gross margins, nice job on the gross margins. If I look at your recurring business growth in the last few years, you talked about kind of 6%, 7% growth. How should we view that growth into next year with utilization potentially coming down? And then if you can talk about any steps that you have to take to move any manufacturing or any supply chain out of China because of restrictions, I understand you don't have any direct impact from restrictions.

Yes. Maybe I'll just address the first one. We don't really have any supply chain to speak of either in China. So we've been on a path to move out of China. We've essentially completed that. So no issues there to speak of, Atif. Recurring revenue, as you know, the reason why you like it and promote it so much, it's more stable. It's a stable revenue stream. And we typically look at it and it's performed over the years versus systems to react to a downturn, perhaps 1/3 of what we might see from the systems business. So -- so not expecting big changes ultimately either way, up or down for next year, just a pretty consistent revenue stream.

Thank you. One moment for our next. Our next question comes from the line of Michael Mani from B. Riley Securities.

This is Michael Mani on for Craig Ellis. Thanks for letting us ask a couple of questions. My first question is just on seasonality. So I know 1Q is typically a weaker period for the business. Given the kind of contracts we're seeing in mobility testers but also in auto and industrial, how should we think about sequential growth into the first half of next year?

Michael, this is Luis. So we -- you're correct. We typically see seasonally low fourth and first quarter of the year. We are expecting sort of the same this year around Q1. Hard to predict right now, I'm going to peg it at somewhere between 3% to 5% down sequentially from Q4, which is generally in line, I think, with what we've been saying. Generally speaking, sort of a softer half of the year, like we talked earlier as well a quarter ago, mostly because of the way the markets are in consumer and mobility, also PCs. And then we're forecasting more of a pickup in the second half of the year. We do have already some orders on the books for Q2, Q3 delivery related to mobility market process for test actually. We do have some strong forecast now for the server market ramping in the second half of the year, much stronger than the first half. As I said in the prior call -- in the prior question, sorry, expect industrial and automotive to be strong next year, probably also stronger in the second half as that continues to grow. And as we put on the slide deck and in the remarks, we do run a pretty strong recurring business, which in the last 12 months is about $336 million, and it's been growing over the years, and we think that that's going to continue as more systems that we have shipped over the last 12, 18 months start coming out of warranty. So hope that paints a general picture for Q1 and the expectation for next year.

Very helpful. For my follow-up on gross margins, as we look out into the first half of next year, you mentioned something that's giving margins of boosts product differentiation. So as you have these new products coming online, ramping up the first half of next year and as headwinds season as we get the benefit of more in-house manufacturing, where do you think margins could trend relative to the 40% -- 47% target levels we've seen this quarter or for the next quarter, rather?

Yes, Michael, it's Jeff. So margin will trend with revenue as well, but it's less susceptible to changes in mix. And that's because we've done a good job of expanding gross margins in our handler business. They've delivered in the 43% to 46% gross margin range. Contactor gross margin, we talk about all the time, expanding into the mid-40% range. And so with that improvement there, it really reduces the volatility we have when we have a mix shift. And then on with respect to volume, as you probably know, we're sort of manufacturing light on systems, if you will, we outsource quite a bit. We do final assembly and test in-house. And so really have a limited infrastructure in-house infrastructure and fixed cost. Most of it's or a high percentage of it is variable. So we're feeling pretty good about the gross margin resiliency. As Luis said, if first half next year is lower as we've talked about in prior calls, I'm still expecting to be in that 46% gross margin range. And then probably for the full year, something similar to where we are today, looking at about a 46.5% gross margin for the full year.

[Operator Instructions] Our next question comes from the line of Robert Mertens from Cowen.

This is Robert Mertens on for Chris Sankar. First, could you just take me through some of the cost controls in place through the end of the year and into next year, and along with that, maybe just some of the progress on in-sourcing the contactor business?

Overall cost control is not just gross margin, but operating expenses as well. Okay. Yes. Well, I think you probably are aware of the gross margin story. I just touched on that. We've made a lot of progress over the last 12 months with respect to reducing product costs. Also with respect to pulling in work that we would have outsourced to suppliers in the U.S. and Europe into the Philippines for contactors and so that has done two things. It's increased utilization there. We've improved in the manufacturing efficiencies. And so it's driven costs down overall, expanded gross margin for contactors. We also increased handler prices second half of last year, so we had full effect here in the last couple of quarters. So with respect to operating expense then, in the quarter, we mentioned hiring delays. What we typically do, should we roll into a soft period. We would freeze hiring. We would eliminate temporary personnel. We would encourage utilization of vacation. We would reduce travel, sort of the normal leverage that we have when we run into a soft spot. And so we're forecasting OpEx to be about 52.5, which is flat over last quarter. If I look back over time, over some soft periods, we've been down to $50 million a quarter. So I have no doubt we could get back down to those levels if necessary.

Rob, just going to add a little bit more on the contactor in-house manufacturing. I think you asked that, too. We did about 65% of in-house manufacturing in our Philippines operation in q3, and we're targeting to be just sort of a high -- just shy of 80%, about 78%, 79% in Q4, which is right in line with what we've been saying all along to get to about 80% by the end of the year.

Thank you. One moment for your question. Your next question comes from the line of Tyler Burmeister from Craig-Hallum. Your line is now open.

Could you hear me? This is actually Christian Schwab. Can you hear me?

Christian, yes, we can.

Okay. Great. Sorry about that. As you know, Ty works with me. So we just said I have a few quick questions. On the -- when you guys are looking at your tests utilization going through calendar '23, and we're going into the softer period, do you expect that utilization rate to meaningfully change from where we are or given some of the growth areas you're not expecting a material difference?

Christian, this is Luis. Yes, like I said, utilization is about 82% at the end of Q3. It is weaker at OSATs and stronger at IDMs. Now what you expect going forward? Yes, seasonally slow period in the fourth and the first quarter. I would venture to say this utilization could drop another couple of hundred basis points to about 80%. Hard to say, to be honest with you, but that's just a gas here that will hover at about 80% a quarter from now.

Okay. So that being the case, you don't think there doesn't appear to be despite some of the things that we mean in the marketplace. There is significant overcapacity of your testing products out there. Is that fair to say?

I think that's fair to say, particularly on test. And as you know, our biggest exposure is around analog ICs and then end market exposure, mostly around automotive and industrial. I think that's faring pretty well. And analog ICs have a very broad distribution of end-market users. So you're not really pegging it to a specific customer or a specific small node manufacturing for a high-end processor or any of that. It's a very, very broad market distribution of semiconductors that we serve. So yes, I don't expect it should be a major issue in the test area, which has been growing tied more so to end market demand. And I wouldn't -- I would just be careful and caution everybody to be careful not to tie too much our correlation with wafer fab equipment spending that has a different dynamic.

Right. Right. And then lastly, can you give us some -- just some greater color on the new win in the server CPU area is expansion with an existing customer? Is this a new customer calling it out? Is this something that over time could be a substantial annual run rate business for you?

Yes. It is -- realistically, it's an existing customer. We've been doing business for years. It's hard to really get on to too many new customers in the space. But there is an existing customer who we've done some level, but not substantial business over the last decade. And here, we're seeing an opportunity to expand, have qualified new products. It's really very much tied to this T-Core thermal technology that we have. As you know, it's one of our core IPs in the Company. It's very differentiated. It helps them achieve faster test times, less power issues, less thermal issues, higher yields. And if you look at our computing business, it has actually been growing on a quarter-to-quarter basis. Revenue in computing systems for computing grew 50% Q3 over Q2 and 80% relative to Q3 of last year. So it's been a nice ride. There are a couple of new customers as well at smaller revenue levels. These are companies that are now designing their own server chips and getting the manufacturer outside. They don't have operations themselves. But largely, the revenue growth is tied to an existing customer that we've been increasing business over the last few quarters.

Thank you. One moment for our next question. Our next question comes from the line of Hans Chung from DADCO.

This is Linda on behalf of Hans. Thank you for letting us ask question. So I guess my first question, given all that is going on in the macro environment, heading into 2023, I would love to hear how you're thinking about 2023 semi unit growth? And maybe how we should tolerate that with system business?

Linda, this is Luis. So I made some comments on a prior question, maybe just go back to that. We do see seasonally slower for from first quarter. So not surprising we're expecting Q1 to be a soft start of the year. In fact, I would venture to say probably first half will be a bit of a soft start for the year. With that said, we do have sort of consistent -- consistent and strong expectations here in the automotive and industrial market with a forecast of continued growth in the market, maybe a few hundred basis points growth for the overall TAM for next year in the auto and industrial. We do have orders in the books for mobility already in the second and third quarter. We do have a server ramp forecast, which is quite steep in the second half of next year. We are doing device test program development for certain applications in mobility with deadlines that support, again, incremental business starting in Q2. So if you put it all together, well, I guess -- and I touched on recurring as well, which has been on a last 12-month basis, about 42%, I think, of our business, 41%, 42% at $336 million and growing and should continue growing as more of our recent shipments start to roll out off of warranty periods. So you put it all together, what do you expect for the market for next year? It's were maybe a little early, maybe almost a quarter too early to make that call. But I'm going to venture to estimate that the test and inspection market could be about mid-single digit down next year realistically speaking, because of a softer start for the year.

That's very helpful. Thank you. And so on to supply bottlenecks, A lot of companies are seeing improvements in that and if I missed this in your remarks, but I was wondering, in your view, impact our supply chain issues having on your company, especially in the third quarter, and maybe to what extent do you think softening demand might help mitigate the supply chain issues?

Yes, I can comment on the supply chain. And Jeff, maybe you can add someone what we expect for headwinds on that on the P&L. But you're right, it has been improving. Frankly, we have now two quarters of actions around it as well and working to go direct with certain suppliers and source material. So it is a situation that is improving. There was still a headwind in the third quarter. We expect it to remain although that's a much smaller headwind in the fourth quarter, and maybe Jeff can put some numbers on that. But the plan here is we should be able to eliminate that by the middle of 2023. That's the plan. When we look at our customers, there's also a supply chain challenge there with that limits when we can ship products and it generally has to do with availability of wafers. Our automotive customers are starting to get more wafers and some of them have new fabs, as you're aware, TI with our Fab 2 and the Lehi acquisition and some of the silicon carbide companies having new fabs launching now in the first half of next year. Other's talking about expansion of fabs in Italy with some capacity coming online in the second half of the year. So I think, in general, by middle of next year, we expect supply chain issues for us and hopefully here true as well for our customers on the wafer side to abate so that we can get this behind us.

So with respect to the Q3 impact, it relates to a higher cost for ICs that we use on our tester products. And so just having to pay just because due to availability or lack thereof, we've had to pay a higher than standard cost for those ICs. We had an impact in Q3 of 130 basis points, and -- but thankfully, the availability is loosening and we're working directly with semiconductor companies many of which are our customers. And we see a much reduced impact in Q4. So it's 50 basis points is the forecasted impact in Q4. Now this will dribble into Q1 and Q2 of next year as well, but that likely less than 50 basis points for each quarter.

And lastly, could you also give us some color on the lead times for your different products, testers, handlers and contractors?

Sure, Linda. We -- let's say, handlers are running approximately 20, 22 weeks lead time. testers approximately 14 weeks, contactors about 10 weeks. And like I said, those are on average, right? I mean there are products that we can ship faster and some configurations will take a little longer. But that's about where it stands.

Thank you. One moment for our next question. Our next question comes from the line of David Duley from Steelhead Securities.

Louis, you mentioned something about a silicon carbide opportunity in Q4. I'm sorry, if you could just elaborate a little bit more on which product that is? And what sort of opportunity that might be over time, that would be great.

Yes. David. Well, obviously, I can't tell you the customer, but it is -- we have -- we do have a multiunit order already from that customer. It's essentially for test automation, inspection and metrology and contactor interface products. So it cuts across quite broadly. Being silicon carbide, obviously, very high voltage application, we'll be shipping the products in the fourth quarter. Maybe, maybe not, we got acceptances in the fourth quarter as well. And there's a pretty decent forecast for the next two years from that particular customer. They are ramping capital expenditures. I think that's public knowledge. And we hope to be enjoying a significant portion of that CapEx from that customer. They have spent quite a bit on the front-end side recently. And I think they're essentially back-end test and yield bottleneck at the moment. So we're hoping to help resolve that.

Excellent. And I don't recall you mentioning silicon carbide on conference calls before. Is this kind of the first big opportunity in that segment of the power market? Or have you just not have -- or could you just elaborate on -- are there more customers come? Or how should we view this overall opportunity?

Yes. They're not the only ones actually, David. We have had some business in the space predominantly with the two European customers, the two large European customers, one in Italy, one in Germany, but -- but that -- now we're talking about this other one that I elaborated before, was essentially a new customer in the U.S., and we have some business already in Europe in this space. So, it's not new. It's been migrating from sort of older MOSFET technology into silicon carbide over time, and it's starting to pick up momentum. It's still a relatively small number relative to over $207 million revenue in the third quarter. But it is a key part of our forecast for ramping over the next few years.

Thank you. I would now like to turn the conference back over to Jeff Jones, Chief Financial Officer, for closing remarks.

Thank you. And before we sign off, I'd like to mention the investor conferences we'll be attending over the next few months, including the Stifel Midwest Growth Conference in Chicago on November 10 and the Needham Virtual Growth Conference on January 12, 2023. If you'd like to attend either of these events, please reach out to your respective banking and conference contacts to arrange a meeting with Cohu. We look forward to speaking with you soon. Have a good day.

This concludes today's conference call. Thank you for participating. You may now disconnect.