Good day, ladies and gentlemen, and welcome to Keysight Technologies Fiscal Second Quarter 2024 Earnings Conference Call. My name is Sierra, and I will be your lead operator today. [Operator Instructions]. This call is being recorded today, Monday, May 20, 2024, at 1:30 p.m. Pacific Time. I would now like to hand the call over to Jason Kary, Vice President, Treasurer and Investor Relations. Please go ahead, Mr. Kary.

Thank you, and welcome, everyone, to Keysight's Second Quarter Earnings Conference Call for Fiscal year 2024. Joining me are Keysight's President and CEO, Satish Dhanasekaran; and our CFO, Neil Dougherty. In the Q&A session, we'll be joined by Chief Customer Officer, Mark Wallace. The press release and information to supplement today's discussion are on our website at investor.keysight.com under Financial Information and Quarterly Reports. Today's comments will refer to non-GAAP financial measures. We will also make reference to core growth, which excludes the impacts of currency movements and acquisitions or divestitures completed within the last 12 months. The most directly comparable GAAP financial metrics and reconciliations are on our website and all our comparisons are on a year-over-year basis, unless otherwise noted. We will make forward-looking statements about the financial performance of the company on today's call. These statements are subject to risks and uncertainties and are only valid as of today. We assume no obligation to update them and encourage you to review our recent SEC filings for a more complete view of these risks and other factors. Lastly, management is scheduled to participate in upcoming investor conferences hosted by Baird and UBS. And now I will turn the call over to Satish.

Good afternoon, everyone, and thank you for joining us today. My comments will focus on 3 key headlines. First, Keysight executed well in a market environment that was largely unchanged from the first quarter, revenue of $1.2 billion and earnings per share of $1.41 exceeded the high end of our guidance. Second, orders of $1.2 billion were in line with prior quarter. We saw pockets of growth and stability across multiple end markets even as customer spending remained constrained. Our base case scenario for the full year is unchanged with the revenue relatively stable from Q2 to Q3 and orders increasing modestly in the second half. Third, our deep customer collaborations and relationships are strong and continue to inform our future road maps. These engagements reinforce our confidence in the long-term secular growth trends of our markets. The pace of innovation is accelerating across multiple vectors, and while remaining disciplined, we are investing to increase our differentiation and to capitalize on the waves of technology inflection ahead of us. Now let me begin with a brief overview of Keysight's second quarter performance. Revenue of $1.2 billion and earnings per share of $1.41 were above our expectations. Revenue and orders continued to normalize from the strong prior year, but were stable on a sequential basis, excluding ESI seasonality. We delivered operating margin of 24% reflecting a healthy gross margin of 65% and the cost actions and discipline that we have exercised to date. Turning to our business segments. Communications Solutions Group revenue declined versus prior year, which benefited from robust backlog conversion. On the demand front, orders were flat year-over-year and grew 4% on a sequential basis. Investment in defense modernization continue to drive activity in aerospace, defense and government, and we were pleased to see commercial communications order growth for…

Thank you, Satish, and hello, everyone. Second quarter revenue of $1.216 billion was just above the high end of our guidance range and down 13% or 14% on a core basis. Orders of $1.219 billion declined 8% or 9% on a core basis. As a reminder, Keysight's historical first to second quarter seasonality was muted by the cadence of the ESI business with approximately half of ESI orders and revenue recognized in the first quarter of the fiscal year. Excluding ESI, orders grew 4% sequentially, and revenue was in line with Q1. We ended the quarter with $2.3 billion in backlog. Looking at our operational results for Q2, we reported gross margin of 65%. Operating expenses of $496 million were down 2% year-over-year even with the addition of ESI and Riscure. Excluding these acquisitions, SG&A expenses were down 10% or $29 million, reflecting the flexibility of our cost structure and actions taken to date. Q2 operating margin was 24% or 25% on a core basis. Despite a 14% decline in core revenue in the first half, first half operating margin declined 400 basis points, outperforming Keysight's downside model expectations and demonstrating the financial resiliency of the business. Turning to earnings. We achieved $247 million of net income and delivered earnings of $1.41 per share. Our weighted average share count for the quarter was 175 million shares. Moving to the performance of our segments. Our Communications Solutions Group generated revenue of $840 million down 10% or 11% on a core basis. Commercial communications revenue of $563 million declined 10% while Aerospace, Defense and Government revenue of $277 million was down 11%. Altogether, CSG delivered gross margin of 68% and operating margin of 27%. The Electronic Industrial Solutions Group generated revenue of $376 million, down 17% or 21% on a core basis.…

Thank you, Neil. Sierra, would you give the instructions for the Q&A, please?

[Operator Instructions] Our first question today comes from the line of Rob Mason with Baird.

So I'm thinking -- it sounds like your base case for the year, obviously, is still intact. Just thinking through that more thoroughly, the orders typically in the third quarter maybe down -- maybe flat to down slightly sequentially. And then you have better order trends in the fourth quarter seasonally. Should we think this is, again, still tied more to book and ship as you think about the revenue upticking in the fourth quarter? Or any help you can provide just on the clarity for that slope?

Yes. So yes. So first of all, I agree with your assessment of the typical seasonality of our business as we typically move from Q2 to Q3, I'd say the small downtick in both orders and revenue would be typical for seasonality, admittedly hard to find over the last couple of years, COVID, recovery supply chain. But if you went back in time, that would have been the typical seasonality. Then with the mid-single-digit uptick into Q4 driven by [indiscernible] annualized sales cycle or second half sales cycle as well as the strength of aerospace defense business tied to the government fiscal year-end. And I think that's largely what we're seeing here this year as well as we -- in terms of our expectation for the remainder of the year.

Very good. And then just as a follow-up, could you dig a little bit deeper into your overall Wireline business, the AI data center piece, obviously, seeing some strength. I'm just curious with these new platforms that are rolling out, what stage of adoption are we seeing with those? And just comment more broadly on the Wireline business over and beyond the AI data center exposure?

Thank you, Rob. I think this quarter for the first time in 6 quarters, our commercial communications orders grew, and as a result of the inflection that we're seeing in the wireline business associated with AI. And it's still very early days as the world continues to look at all of the applications that could be launched leveraging AI at scale. And I would say it's still very early days even for Keysight's business. So what we're seeing is probably a first inflection, I would say. The big headline that we've seen in the last couple of quarters and that accelerated this quarter was the push from customers to lead in the hardware infrastructure space and how critical it's performance is for cost, for energy and in general for the user experience in the AI application. For Keysight, in our Wireline business, having the breadth of the portfolio that caters to networking, computing, storage, interconnects -- and we're able to make contributions that are broad, but we're just getting started is the way I would frame it up -- the heterogeneous environment there is helping us play a critical role, and we're also engaged in a number of these standards bodies. So we saw strong double-digit growth in the business for the Wireline business this quarter, and also sequentially a strong uptick in Q2.

Next question comes from Mark Delaney with Goldman Sachs.

This is Will Bryant on for Mark Delaney. So in your press release, you all reiterated that you are assuming modest order growth in the second half of the fiscal year. Can you give us some additional color on what gives you confidence that the orders will pick up in the second half?

Yes. Thank you. I think what we have said is the market environment remains unchanged. And as we said in the previous call, we're not -- our base case does not assume any significant market recovery, right? So barring that is just a seasonal uptick in Q4 as Neil just referenced coming from our aerospace defense business. But we are continuing to feel that the demand environment is stabilizing. I would say, as I pointed out earlier, Wireline inflections and demand remains strong. I'd say the aerospace defense is stable. And our ISG business, which had -- which had seen 4 quarters, including the current quarter of declines stemming from normalization and manufacturing is also starting to show some seasonal -- or starting to show some sequential growth, I should say, this quarter, all of which we view as sense of stability in the business.

That's helpful. And just 1 quick follow-up on just thinking about how you guys are managing OpEx as you guys are planning the business in these volatile end markets. Could you give us any additional color about what you want to manage OpEx?

Yes. First, I'd remind you of the statements we made a quarter ago that we do expect if excluding the additional OpEx from our acquisitions, our total OpEx spending to be down about 3% on a year-over-year basis with all of that savings coming from the SG&A line items as we look to maintain our investments in R&D to ensure that the business is well positioned to capture the upswing when it occurs. . I think we're looking in terms of the types of actions that we're taking. We're obviously always looking for ways to streamline operations and drive efficiency in our business. I think if you take a look, you'll notice that over the course of the last 4 quarters, our headcounts are down about 5% as we look to absorb attrition. We've provided some incentives for folks to transition into retirement, and been absorbing those during this period of time. In addition, we obviously have a very flexible cost structure -- cost structure has been flexing as expected, which is also contributing to the financial performance in line with our model.

Our next question today comes from Aaron Rakers with Wells Fargo.

I'll just put them both out there right away. I guess on the EISG segment. I'm curious on the semiconductor space. Can you, first of all, help us appreciate the size of that or any kind of clarity you could give in terms of that piece of ESIG. And within that, how do we think about these fab projects being delayed into late calendar '24 and into '25 and the timing when that starts to turn more positive. And then I'd also be curious on the interconnect side, you mentioned chip-to-chip interconnect simulation stuff. I'm curious how much of an opportunity that presents? Who are you competing against there and just kind of framing that out as far as opportunities as we look forward?

Yes. So I'll take the first question, sizing of [semi and then] hand it over to Mark to make some comments on the market. What we've said is that our semi business is kind of 10-ish percent of total Keysight maybe a little less.

Okay. Yes. And then in terms of the fabs and the delays of timing, we've been watching that closely over the last several quarters, we have seen some movement. We've said before that our funnel gives us about 6 months of visibility out into market timing, and we're starting to see some activity that would suggest that some of those fab expansions that have been delayed the funding associated with them should be beginning to show some signs of CapEx spend towards the end of the calendar year. But we're watching it very closely. We have very deep relationships with the customers -- and certainly, the underlying drivers for advanced process technologies related back to AI are continuing to be very strong as these applications begin to grow at scale.

And then last point of you question was on interconnect -- last part of your question, I didn't want to miss it. It was our interconnect technologies. And as you think about data center coming from today's node sizes of $300,000 or $250,000 to $1 million and beyond. At some point, I think interconnect has become very important. The nature of those interconnects, the high performance requirement associated with them are critical, and therefore, interoperability testing needs are key and key sites, differentiated technologies across our core product line is playing a critical role already, and we'll continue to play a critical role moving forward to help our customers.

Our next question today comes from Meta Marshall with Morgan Stanley.

Maybe a couple of questions for me. First, just on ESI, -- any commentary in terms of ability to sell that product to other customers as you get it integrated in or just any commentary on early performance. And then just maybe as a second question, any update on long-dated orders or contribution of orders from long-dated orders worth noting? .

Thank you, Meta. Again, we're quite pleased with the acquisition. The performance in the first half has exceeded our initial plans, so which is good. Again, I view this simulation and emulation as a long-term strategic priority for the company and ESI was clearly -- gave us some differentiated capability to go pursue it. The culture fit 1, 2 quarters in is re-traded because our teams are working seamlessly, the collaborative culture, the focus on technology, all of those things are headed in the right direction. . And from a revenue acceleration perspective, that's the focus for the team, right? It's -- we're really prioritizing taking ESI's core products into aerospace defense in the U.S. and increasing our exposure with Asian auto manufacturers. I'll let Mark make some comments on how the sales team is doing on that front. But overall, quite pleased with the acquisition.

Thanks, Satish. It's been an exciting quarter and half for us as we've begun to work more closely across different geographies, really the plan that we put in place back in late Q1 continues to be the plan we're executing around our common areas of focus from a customer standpoint in North America, where ESI is underexposed with aerospace defense. And then in both directions around auto, especially in Europe, we're seeing opportunities open for both our classic business and working closely with ESI. So momentum. These are fairly long cycle, sales cycles many months to get to a point of closure, but we're already starting to see some progress in our funnel, and I'm encouraged with the way the teams are working together.

And just a quick comment on long-dated orders. The mix of long-dated disorders within the quarter were consistent with the recent past.

Our next question comes from Matt Niknam with Deutsche Bank.

Just 2, if I could. First, maybe big picture if you could talk a little bit about the Spirent deal, why now and maybe some of the strategic rationale behind that deal? And then secondarily, just as we think about operating cash flow, maybe for Neil, if you could just maybe talk a little bit about some of the drivers of relative softness this quarter and how to think about working cap and some of the other items that go into that for the second half of the year?

Thank you. As far as being a company we've known for some time, we used to have a partnership with them. And I think the rationale headlines are: first, it's a SAM expansion opportunity. You think about the portfolio aspirant with focus on service assurance, positioning really a good fit to that network analytics expansion opportunity I laid out at the Investor Day. And then when I think about the financial aspect of this deal, I think it creates value for customers and more scale and synergies inside the Keysight environment, but equally for our shareholders, it's a good deal from a point of view of -- it meets our hurdles, M&A hurdles internally and it's accretive to gross and operating margins post integration. So we feel really good about the opportunity. We're continuing to work through the regulatory process right now.

Yes. And then getting to your question on free cash flow and working capital. So obviously, free cash flow is a little bit softer within the quarter, but pointing out north of $350 million through the first half of this year. . In terms of within the quarter, as I mentioned in the prepared remarks, we do have seasonably higher tax payments in the second quarter of the fiscal year. That was expected. And then the timing of revenue over the past couple of quarters was not conducive to high collections within the quarter is the best way to say that. We actually entered the quarter with about $90 million lower accounts receivable than we entered the prior quarter. And then because of Lunar New Year and other things, we got off to a bit of a slow start in February. And so that meant that the -- those Q2 revenues that otherwise would have been collectible within the quarter was -- we were off to a slow start. I think your question about working capital, just a couple of comments. So while collections were lower within the quarter, we do not have any material increased risk around accounts receivable, our allowance for bad debt is very low, and we tend to not have issues in that area. We do, however, have significantly increased inventory over the past couple of years, largely stemming from various things related to the supply chain. We delayed for a long time, the refresh of our demo portfolio so we could take new products and get them to customers. when supply chains normalize, we did refresh our demo portfolio and took the existing demo equipment and put it under a used equipment pool, which is a benefit now because it gives us yet another opportunity to serve customers. And we also had to make some investments because some of our vendors were cleaning up their part list, we had to make some longer-term investments in the assurance of supply -- in inventory. So I feel pretty good about it. I think there is a path to reducing inventory over time, but it's going to be hard to market recovery.

Our next question today comes from David Ridley-Lane with Bank of America.

Several competitors have pushed out their own recovery time lines. You're obviously sticking with yours. What are the 1 or 2 things that you would point to in the results that give you the most confidence in that outlook?

Yes. Thank you, David. I think, look, we look at it 1 quarter at a time. And so far, our focus has been on execution in our discussion with customers, I would say that's the most relevant 1 as many customers have commented that they are going through the bottom. -- has their own economics improve. They've come back and they have doubled down on the programs and projects that we've been in discussions with. So that inflecting nature that correlation to their business is perhaps the most important 1 that we look at. Big picture, when we start to look at macro factors, I would say, SIA, you look at even smartphone sales, PC sales, other things, you start to see some improvement along with the PMI indices that are growing. So while not calling for timing or magnitude of recovery at this point, we remain focused on execution. The 1 tactical area that we -- the data that we have in-house is on our pipeline, and I'll have Mark make a comment on the pipeline.

Yes, David, I would just simply say our pipeline supports this expectation of the modest improvement in H2 orders driven by the seasonality in Q4. Funnel intake, which is growth of new business into the funnel is up in pockets with the green shoots that we've already spoken about with AI and wireline memory, and continued demand in the longer-term secular businesses that we've spoken about with aerospace, defense and EV. We have not yet seen the lift from the U.S. defense budget being signed in the middle of March. So we hope to see some of that come through as well. And again, velocity is key, and we're starting to see some of that pick up, which shows some confidence in our customers.

Got it. Okay. And just a quick follow-up. Obviously, you have your internal plans in terms of the cost actions you're taking. I was a bit surprised that the sort of the magnitude of the restructuring cost in the quarter though. Did you take expanded actions? Or is this all part of the plan as envisioned 3, 6 months ago?

No expanded actions. I think if you're looking at the reconciliations that were provided -- the category is actually listed as restricting other and there was a modest legal settlement that occurred within the quarter as well that's skewing that number higher.

Our next question today comes from Adam Thalhimer with Thompson, Davis.

In the EISG segment in the ESG segment, do you see revenue -- do you see further weakness in revenue and margins in the back half? Or do you think things improve versus Q2?

Yes. I think I would say the answer is twofold, right? One is on the order line, we think the demand environment improves a bit as we go into the second half, especially Q4, driven by some of the semiconductor spend that we're expecting to land in Q4, but again, revenue would be offset because some of the business that we book in the EISG does have a bigger percentage of long-dated sort of backlog items. So it is twofold. We expect that Neil can give us -- we would expect that revenue would be -- would face some headwinds in the second half even as orders improve. .

Yes. As you think about the margin situation in EISG, I highlighted kind of 3 factors, right, the seasonality of ESI, which is strongly profitable in Q1 in a modest loss position in the remainder of the year, that is impacting ISG profit. But by far the biggest -- the biggest driver is the revenue decline, right? So revenues down sharply here in Q2. And I think as long as we're operating in these revenue ranges, it's going to be reasonably range-bound in the current operating margin vicinity.

And just want to add on the order line. The EISG business in Asia went in about 2 quarters after CSP. So that was just lapped at the end of Q2. So that gives us some confidence that the comparison lease will be getting easier in the second half.

Okay. And then 1 for commercial communications on -- can you help us frame the AI data center opportunity for you guys versus 5G at the peak?

Well, first of all, from a timing perspective, it's very early days for the AI opportunity primarily because there are obviously logical areas where we engage with customers, but we have several active collaborations underway around silicon, 1 on real-time training of clusters, interconnects, testing methodologies for benchmarking AI, protocol aspects of the new standard [EUEC] transceiver manufacturing interoperability. So while we are in booking some business today, and we have some several active collaborations underway which are quite promising, and the ecosystem of customers that we serve will expand over time. Very hard to compare and contrast with 5G or wireless side. But I think -- the key for the commercial comps business has always been to increase our emphasis in early R&D because we know that it makes us much more strategic and critical to customers. Second is to maintain diversity in application sets. So we have both equal focus on wireless and wireline that give us ways to drive growth by market. And then we feel really good about our competitive position on our portfolio strength and it's only going to grow as we -- as the industry adopts AI at scale.

Next question comes from Mehdi Hosseini with Susquehanna.

Two follow-ups. Satish, I'm trying to better understand how you're managing business beyond the second half -- and I want to go back to the Analyst Day, you talked about the 5% to 7% longer-term revenue growth. And obviously, 2023 -- fiscal year '23, turned out will be a lot worse. So it helps you with a lower base. And if I even think of the low end of that longer-term revenue target range, your revenues in FY '25 and '26 would need to be up double digit. And what I want to understand, as I noted earlier, I want to see how you're planning how you're running the operation. I don't see any 1 killer app on the horizon. There are several smaller killer app. And to what extent M&A is going to be part of your strategy to hit that revenue target? And I have a follow-up.

Yes. Thank you, Mehdi. So I know you asked several questions in one, but let's make sure I hit all of them. But I'll start by saying, look, we feel really good about our long-term growth expectations for the business. And as we laid out the 3-pronged growth strategy at Investor Day, we see these technology trends are accelerating. We see transforming industries increasing our ecosystem of customers we can serve, and we see market dynamics with governments around the world investing for organic IP. So none of those have fundamentally changed, and we feel like we're in a good position. And if you look at our strategy through this downturn is to continue to invest in R&D in a prudent way, but really focus those investments on where our customers need the most help, especially in the R&D labs of our customers making us more strategic and the cost actions that we've taken in navigating this downturn has been largely on the SG&A line. So we feel good about the opportunity that we see ahead. . As far as the -- our ability to deliver to those results, clearly, while we feel good, it is possible that the time line pushes out a bit given the decline that we've had in '24. And so a lot depends on the timing of the recovery. But if history is any measure, every time we've had strong pullbacks, we've had stronger uptrend as well in terms of orders. So we continue to watch that strategically. Software and services has been an area of focus for us. Software and Services now is roughly 40% of the total company, which is a good trend, and we want to keep driving that higher -- and as I've reiterated before, we look at several deals. We've looked at over 350, 400 deals in the company, and we've only done about 20. So we're very selective in our strategy. It's not about revenue. We look strategically at the areas where we feel like we want to make a bigger contribution and where we can bring value to those assets when they come inside Keysight. So there is -- from that point of view, there's really no change. We're an organic first company. We believe in investing with our customers to create long-term value.

Great. And then maybe follow-up and put the question to Neil. As you think about these longer-term targets and inventory cash flow normalizing, should we assume that your free cash flow would go back to the historical average of like high-teen percentage of revenue that was very significant when we were going through the up cycle a couple of years ago?

Yes. I think over time, Mehdi, but I think in the short run, the way we think about free cash flow internally is we look for a relatively high conversion of non-GAAP net income into free cash flow. And we've talked about running that in the 90% or higher range. And so while we don't have a specific free cash flow guide that we put out there, I think that's how we think about it over the longer term. The 1 thing that I would say, and you can see this by looking back in our history, is that there are periods of time where we have kind of nonstandard cash flow items that can reduce that level of free cash flow conversion. And specifically, I'm thinking about things like restructuring costs. And most notably, given where we are right now, M&A costs, either integration or transaction costs associated with M&A. So as you start to think of about us now working on the integration of ESI and hopefully in the not-too-distant future, beginning to work on the integration of Spirent, those things will be short-term drains on free cash flow conversion. I think the good news is the ability for us to drive future benefits. We talked about Spirent being ultimately accretive to operating margins, it's ultimately going to drive higher free cash flows going forward once we get through these periods of integration.

Thank you all for your questions. That will conclude our Q&A session for today. I would like to turn the call back to Jason Kary for any closing comments.

Thank you, everyone, for joining us, and we appreciate the opportunity to speak with you today. We'll turn it back to Sierra just to wrap up and close the call.

Thank you. That will conclude today's conference call. Thank you all for your participation. You may now disconnect your lines.