Q3 2022 Advanced Energy Industries Inc Earnings Call
Greetings and welcome to the advanced Energy third quarter 2022 earnings call. At this time all participants are in a listen only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance. During the conference. Please press star zero on your telephone keypad.
Please note. This conference is being recorded I'll now turn the conference over to your host Edwin Mok, Vice President of strategic marketing and Investor Relations you may begin.
Thank you operator, good afternoon, everyone welcome to advanced Energy third quarter 2022 earnings Conference call.
With me today are Steve Kelley, our president and CEO and Paul Oldham, Our executive Vice President and CFO .
Before I begin I'd like to mention that we will be participating at several investor conferences in the coming months.
If you have not seen our earnings press release and presentation, you can find them on our website at IR dot events energy Dot com.
Let me remind you that today's call contains forward looking statements that are subject to risks and uncertainties that could cause actual results to differ materially and are not guarantees of future performance.
Information concerning these risks can be found in our SEC filings.
All forward looking statements are based on managements estimates as of today November <unk> 2022, and the company assumes no obligation to update them.
Medium term targets and long term aspirational goals presented today should not be interpreted as guidance on.
On today's call all financial results are presented on a non-GAAP financial basis, unless otherwise specified <unk>.
Exclude from our non-GAAP results, all stock compensation amortization acquisition related costs restructuring expenses and realized foreign exchange gains and gains from a one time sales of our non strategic technology Ah.
A detailed reconciliation between GAAP and non-GAAP measures can be found in today's press release.
Let me pass the call to our President and CEO , Steve Kelley.
Thanks, everyone. Good afternoon, everyone.
Thanks for joining the call.
Our third quarter was one for the record books.
With over $500 million of revenue.
And more than $2 of earnings per share.
In addition, we delivered strong cash flow.
This outperformance was largely a function of improved component supply.
Our part qualification and redesign efforts.
A good manufacturing execution.
Demand for our products remains strong.
Two thirds of our nearly $1 $1 billion backlog is shippable in the next two quarters.
That gives us opportunity for upside.
A critical component suppliers improve upon their current delivery commitments.
In the near term.
Our tactical focus.
It will be on operational execution.
Particularly the sourcing of critical components.
And the quick conversion of those components.
Into product revenue.
Strategically.
We are focused on accelerating new product and technology development.
With the ultimate goal.
Of achieving undisputed technology leadership.
In each of our target markets.
Now I'll provide some further color on the current supply environment.
Well, we have started to see some improvements the environment remains dynamic.
Deliveries of critical Ics.
Which are largely produce an older process nodes.
Are still the biggest source of uncertainty in our production planning process.
We continue to pay significant premiums for critical Ics.
And appreciate the continued support of our customers and helping to absorb some of those incremental costs.
Our strategic decisions to maintain search capacity.
And to aggressively mitigate parts shortages.
Have allowed us to quickly convert lumpy deliveries of scarce components.
Into revenue.
This in turn has enabled much improved financial performance in 2022.
Now I'd like to provide some additional color on market demand.
Currently.
Demand exceeds supply.
In many areas of our business.
Solid end market demand.
Coupled with the need to replenish channel inventories and safety stocks.
Are the key factors.
Driving our fourth quarter revenue forecast.
We do recognize however.
But the macro environment is changing.
Is it end market demand will be choppy or in 2023.
In the semiconductor market, we are working closely with our customers.
To adapt to changing market conditions, such as the recent tightening of U S export controls.
We have taken the necessary steps.
To ensure full compliance with the rules.
And have ceased shipments and support is required.
We derive only a small percentage of our revenue from Chinese owned semiconductor companies.
However.
Many of our non Chinese customers.
<unk> had been impacted by the new regulations.
And are currently reassessing their build plans.
Based on current market trends.
And the new export controls.
We expect that semiconductor end market demand will.
It will decline in 2023.
Over the coming weeks, we plan to work closely with our customers.
To fine tune.
Our medium term demand forecast.
Moving to our other markets.
Which now account for nearly half of our revenue.
The industrial medical.
Computing.
Telecom and networking markets are.
Are important sources of profitability.
And growth for advanced energy.
They provide balance to our product portfolio.
And should enable us to maintain good profitability and cash flow.
Even through a dip in semiconductor demand.
We also expect that our service business, which generated $45 million of revenue in the third quarter.
We will continue to grow at a steady pace.
The installed base of advanced energy subsystems has grown significantly and.
And we now offer a much wider selection of value added services.
Finally, we are encouraged by an accelerating rate of design wins across our portfolio.
Which we believe will drive further share gains in 2023.
Now I'll provide more color for each of our target markets.
In semiconductor revenues were up over 50% year on year.
The $267 million, a new record for the company.
And we expected fourth quarter revenues.
Although down sequentially.
It will be up more than 30% year on year.
For the full year 2022.
We expect semiconductor revenue growth of more than 30%.
On the product development front, we are making good progress.
Ongoing customer evaluations of our new products and technologies for conductor etch.
Dielectric etch.
And remote plasma source applications are going well.
In the quarter.
We secured a key metal deposition design win.
For advanced logic applications.
In the industrial medical markets third quarter revenue grew nearly 50% year on year to $120 million.
A new record for the company.
Demand remains strong.
As reflected in our backlog.
Which remained roughly flat despite our over performance in the third quarter.
Within industrial medical.
We play in a wide range of specialized applications.
Many of which are benefiting from long term secular growth drivers such as industry 4.0.
Electrification.
Indoor farming.
In health care.
While the industrial medical markets as a whole.
It had been historically sensitive to macroeconomic conditions.
We believe that our strong design win pipeline.
Coupled with increased market reach.
We will enable us to outgrow the overall market in the coming year.
Medical is an important market for us.
Particularly after the acquisition of S L power.
We now offer a comprehensive suite of medical power products.
In a substantially increased our engagements with tier one medical equipment Oems.
This quarter in the medical market.
We won key positions.
In surgical equipment and life science applications.
In the industrial market.
We notched significant wins.
In electric vehicle charging.
In test and measurement applications.
And the data center telecom and networking markets.
We outstripped our forecast in the third quarter.
Largely due to better parts availability.
During the quarter.
We won several high value designs, which.
Which will help to drive long term.
Profitable revenue growth.
Overall, we performed exceptionally well in the third quarter.
We're forecasting a strong fourth quarter performance.
Looking forward.
We believe that our strong design win pipeline.
Solid order book.
Low channel inventory.
And balanced market exposure we.
It will enable us to outperform our markets in 2023.
In closing I'd like to highlight our focus areas moving into next year.
First.
We will accelerate revenue growth by bringing innovative products and technologies to our customers.
Second.
We will optimize our manufacturing footprint.
Seeking to maximize our efficiency.
Flexibility and quality.
And finally, given our strong balance sheet, we will continue to look for M&A opportunities.
Which make strategic.
Ant financial sense for the company.
Paul will now review our financial results.
And provide detailed guidance.
Thank you, Steve and good afternoon, everyone.
In the third quarter, we delivered extraordinary results across a range of financial metrics, demonstrating some of the pent up earnings potential in the company.
Increased supply of could've components combined with the ability of our operations team to respond quickly enabled us to deliver revenue of $516 million and EPS of $2 12 per share both well above our guidance ranges.
Backlog declined slightly to approximately $1.1 billion on much higher revenue, reflecting continued solid demand for our products.
We continue to believe our backlog position and multiple AE specific drivers should enable advanced energy to relatively outperform as our markets evolve over the next several quarters.
Now let me go over our financial results.
Third quarter revenue was a record $516 million growing 49% year over year and 17% sequentially.
Revenue in the semiconductor market grew 54% from last year, and 17% sequentially to $267 million.
Improved supply and great operational execution allowed us to deliver upside in the quarter and achieved record revenue levels.
Revenue in the industrial and medical market also reached a record $120 million.
Growing 48% from last year, and 14% from the second quarter.
Excluding S. L power organic growth was 29% year over year, and 12% sequentially driven by strong market demand and improved supply of critical Ics.
Improved supply also allowed us to grow data center computing revenue, 41% year over year, and 27% sequentially to $88 million on par with 2000 Twenty's record levels.
Telecom and networking revenue was $43 million up 40% from last year and 12% from the second quarter.
Third quarter gross margin was 37, 5% up 40 basis points from last quarter due primarily to higher factory output largely offset by continued premiums paid for scarce parts and unfavorable mix.
Higher material costs and partial recoveries from our customers continued to run at peak levels impacting gross margins overall by approximately 300 basis points in the quarter of which premium recoveries accounted for about half of the impact.
Although we see potential for improvement, we expect the higher material costs and related premium recoveries will continue to negatively impact our results in the fourth quarter and into the first half of 2023, given the timing of inventory sell through.
However, we expect these higher costs will gradually come down over the course of 'twenty 'twenty three based on our mitigating actions and normalization of the supply chain.
Operating expenses were $99 $8 million up approximately 6% from last quarter, mainly due to a full quarter of S. L power and higher variable costs on strong revenue.
Operating margin for the quarter was 18, 1%.
Depreciation for the quarter was $8 $5 million and our adjusted EBITDA was a record $102 million up from 78 million last quarter.
Our GAAP other income this quarter was $8 $9 million due to $6.2 million of unrealized foreign exchange gains.
And the one time $4 $7 million gain on the sale of non strategic technology from a prior acquisition.
non-GAAP other expense was $1.9 million, including $2 million of interest expense and $300000 of foreign exchange losses, partially offset by interest income and other items.
Due to the increased interest rate environment, we expect non-GAAP other expense to trend a little higher and to be in the two to two and a half million dollar range going forward.
Third quarter earnings were a record $2 12 per share up from second quarter EPS of $1 44, and last year's 89 cents.
Turning now to the balance sheet.
We ended the third quarter with total cash, including marketable securities of $411 million and net cash of $33 million.
Cash flow from continuing operations was a robust $65 million due to our strong financial performance.
Inventory turns improved from 2.8 times last quarter to three two times this quarter, primarily on higher revenues.
DSO improved modestly to 54 days.
N D P O disclaimed slightly to 61 days.
As a result, net working capital improved to 106 days.
During the third quarter, we invested $14 million in Capex made debt principal payments of $5 million and paid $3 $8 million in dividends.
In addition, we repurchased $2 $4 million worth of common stock at $69.39 per share as part of our opportunistic share repurchase program.
Now, let me turn to guidance.
Demand in many of our markets remains higher than supply.
As we continue to do reduce shortages of critical parts and improve our lead times, we expect to bring our backlog to more normalized levels over the next several quarters.
Given the strong performance in the third quarter continued parts constraints and the initial impact of headwinds in the semiconductor market.
We expect revenues for the fourth quarter to be approximately $470 million plus or minus $20 million.
The midpoint of our Q4 guidance reflects 18% year over year growth.
And would be the second highest quarterly revenue ever for advanced energy.
Our Q4 guidance assumes soon semiconductor revenue will decline sequentially, but increased by over 30% from last year.
Revenues in our other markets will be gated based on supply of components.
We expect Q4 gross margin to be in the 37% range on continued high material cost premiums.
We expect operating expenses to be up slightly on timing of programs in specific investments.
Based on our tax rate of 18% to 19%. We expect Q4 non-GAAP earnings per share to be $1, 55, plus or minus 25 cents.
Ahead of our targets set earlier in the year for our fourth quarter exit rate.
Before I pass the call to the operator, I want to make a few important points.
The outstanding financial performance in the third quarter illustrates the substantial earnings potential in our model as we are able to procure critical parts.
Looking forward, we believe our large order book multiple growth drivers and bounced market exposure can support revenues at a higher run rate than historical levels during times of market cyclicality.
In addition improvements in the supply chain combined with a focus on optimizing our manufacturing operations should allow us to lower material costs and improve efficiencies to achieve our target of 40% gross margin over time.
Long term, we believe demand for our proprietary products will continue to grow as our strategic programs start to deliver results.
And strong cash flow generation and liquidity will allow us to continue to pursue strategic investments to expand our position in our target markets.
Overall these factors should enable advanced energy to outperform our markets in 2023 and overtime.
With that let's take your questions operator.
And at this time, we will be conducting a question and answer session. If you would like to ask a question. Please press star one on your telephone keypad.
Confirmation tone will indicate your line is in the question queue you.
You May press star two if he would like to remove your question from the queue for participants using speaker equipment. It may be necessary to pick up your handset before pressing the star keys.
One moment, please while we poll for questions.
Okay.
Our first question comes from the line of Quinn Bolton with Needham <unk> Company. Please proceed with your question.
Hey, guys. Congratulations on the nice results I guess, you know a couple of questions looking into next year, obviously the W. Fi environment is changing and I think some of the big Oems in this sector have talked about Wi Fi down 20%. So my first question is you know given your backlog position and the need for restocking do you think you guys would do better than down.
20% WFAN environment within the semiconductor business and my second question is how do you see demand in the industrial medical Telecom and server are those businesses are you seeing demand hold up.
And those end markets are you starting to see some signs that orders in those markets are also beginning to trend lower thank you.
Okay I'll take those this Steve.
You know I think looking at 2023.
Without providing guidance, we definitely see 2020 three has been down over 2022 when it comes to the semiconductor equipment demand, it's clear with the new export control regulations and the.
The memory market correction and the softening in the advanced logic market that.
You know there are some issues there.
But you know as I look forward.
You'll also see some motions some some factors that are probably working in our favor.
First of all.
No, we usually work with our largest customers with a just in time inventory bins.
And those bins large needs to be refilled.
So that that's somewhat of a cushion or as we move into the next to the next year.
Are there other customers in semiconductor our nonjet customers.
Most of those customers have moved to a just in case approach.
They want to put in safety stock and again, that's going to help us.
Another key factor for US is our service business.
Service as I mentioned in the in the script.
It was a $45 million business worth last quarter. So it's grown quite a bit over the past few years largely because our installed base has grown and also we offer a lot more value added services.
Maybe talking about the semiconductor market in general.
I view it in in three basic categories, there's memory market theirs.
The leading edge logic market.
And then there's the trailing edge market.
And in the memory market, obviously goes through cycles.
Connected to a supplier investment and then consumer demand and I think we're going through now the latest cycle essentially.
I think that the big factor that people may not.
Fully appreciate is the size of the the trailing edge market.
That market continues to be oversold.
As reflected in the fact, we're still chasing part.
That's I think the one of the largest pieces of the pie when it comes to semiconductors. So I think that market is going to be strong throughout 2023.
And the other two markets will come back probably in the second half of next year.
So that's that's what I see is for semiconductors.
Now looking at the other markets industrial and medical and telecom.
The networking and data center and so forth right now we don't see signs of softening there.
Fact, you know, we we are still tackling a number of.
Parts shortages in those areas.
So you know, we we think there's a lot of upside there as our suppliers are able to improve their commitments.
We have a lot of current backlog the good ship over the next two quarters.
The other key point, you know with the rest of our business because we play in a wide variety of markets.
And they operate in different cycles.
So we're a one market may be down another was up and overall I think it's a much more stable environment than semiconductor.
Got it and then just a quick follow up for Paul If I think about 2023, you mentioned, the 300 basis points impact on higher material costs, including components.
And some of that goes away as you get into next year, but it looks like your product mix, probably becomes a headwind at semiconductor revenue probably gonna have declined more than the other end markets and so you know from the 37% level, how should we think about margins as they trend through next year do you think you know the.
Recovery of component costs more than offset product mix do you think about offsetting factors I mean, any any thoughts as you think about gross margins next year would be helpful.
That's a good question Quinn first as we talked about that a scarce component environment continues in this last quarter was actually our highest quarter ever for premiums that we paid as well as premiums recovered, but the point is we kind of thought earlier that might be starting to subside and we haven't seen it yet but that means is.
This impact of premium costs is going to continue certainly through the fourth quarter and into probably the first half of next year, because remember it will take us about a quarter or so for the full cost to roll through the P&L. Even after the you know the input cost start to come down. So I think Oregon has probably stay in this range.
Sure.
At least another couple of quarters, and then as those material costs subside. We there's no reason, we shouldn't pick up the vast majority of that 300 basis point, because you know I'll say over over time. So I think it's going to be a slower progression to see margins recover over the course of next year and I do think the material recovery well.
Outweigh any shift in that in the mix that we see.
Perfect. Thank.
Thank you Paul Thank you Steve.
Our next question comes from the line of Scott Graham with Loop capital markets. Please proceed with your question.
Yes, Hey, good afternoon. Thank you for taking my question.
A terrific quarter congratulations.
And you hear me.
Here, we go here, yet, but I'm unclear.
Okay, great great.
So I'm wondering as we head into next year I I think we all appreciate your views on <unk>.
Wi Fi and.
So your trailing edge logic.
Mark you're being oversold as very interesting observation.
It seems however that you know the memory side is.
No weakening.
By the moment.
And.
You know with some of the big memory makers you know.
<unk> 50 and some.
Some of them.
Are actually saying that just.
That it might move out later in the year.
As well it may be sort of.
Less than the first quarter, maybe more in the second and third depending upon who you speak with.
I'm just wondering can you give us an idea of how you guys are.
Your semiconductor businesses is exposed I I assume that your you know tilted toward memory versus foundry logic could you help us understand your business itself.
Yeah, I could talk in general about that I think our business is more tilted towards foundry logic.
Because of the intensity of conductor etch equipment is higher than in the logic side that isn't memory side.
So we.
We will certainly feel the memory slowdown.
But we have to remember that memories about I think roughly three.
<unk>, 35% to 40% of the total market today from a W. F E standpoint.
Yeah. So we're less exposed there than we are to the other part of the market, which is a logic, both leading edge and trailing edge logic together.
What we see in memory is.
Continued investment because they still need to invest for the next generation right they need to drive higher yields were complex structures.
And we're participating with those customers today to move to the next generation. So even though they may be pausing some of the capacity expansion there moving full speed ahead.
New product development and new process development. So it's a great opportunity for us to get some new technology.
And to those customers.
Okay. Thank you.
I guess my next question.
Sort of an extension of that one is you know your you have an extremely high backlog and I'm just wondering what those what those shipments schedules look like.
I assume that they are not.
Firm delivery dates and that customers could push them back could you give us a little bit of flavor for maybe what.
The backlog sort of shipments schedule looks like.
And then how.
Our firm is how are those needs.
Yeah. It's a good question Scott look we've seen our backlog be pretty consistent that the demand is is is close in fact, we've said and continue to see that our backlog from a customer request date, it's either they either want it now or if they would like it within the next two quarters, So box only five months.
Two thirds of that so its its current backlog, it's not backlog that's scheduled out over a long period of time that you know you know could could be subject to change now as a practical matter our customers can certainly reschedule backlog.
But to date, we've seen more expedites and people continuing to ask for backlog. Then then reschedule. So we feel like it's still very good quality backlog.
And and it's going to take US a few quarters to actually work that down to a more normalized level is.
As Steve said in many of our markets the back that demand continues to exceed that exceed the supply.
I appreciate that thank you both.
Yeah.
Our next question comes from the line of Krish Shankar with Cowen. Please proceed with your question.
Yeah, Hi, Thanks for taking my question I actually had a few of them close to one just out of curiosity on the $1 1 billion in backlog how much of that is for me.
We've said that the combination of semi and industrial medical represents about 80% of the total so.
We haven't broken it out specifically, but you know.
It's in the ballpark as you know.
50 50.
Got it got it fair enough.
Got it.
Sure.
You know in the past downturn clearly if you look at this year that outgrowing wf teeth in up cycle and typically in down cycles, we actually underperformed. The BSC. So I'm kind of curious why wouldn't that be the case next year. If you just assume that it's a normal cyclical downturn.
You know your customers are going to end up using up their inventory versus what you're seeing from you, but why would the behavior will be different this time at all.
Yeah, I think the biggest differences just just a lack of inventory out there krish.
So as.
As we as we look into our direct customers and to their customers.
You know, there's very little inventory of our critical sub systems out there.
So first of all they're still pulling for immediate needs installation needs and second of all they're going to pull from us to refill some of those gip bins that had been depleted over the past year and a half. So I think it's a different type of correction for us.
And I think if you combine that.
With some transitions that are occurring.
As people move to new technologies, we have a very good position there and that that also serves to to counteract some of the.
The down part of the cycle.
Got it got it Okay fair enough and then just a final question for Paul.
Hum.
Can you just help us quantify what is the impact from the pass through costs in gross margin.
Is that thing normalizes next year into the next few quarters, but you.
Your revenue details is it further in the <unk>.
The negative leverage because of the revenue deceleration would overwhelm any kind of tailwind you get from some of the supply cost easing.
Yeah. It's a good question I guess, you know we had quantified the impact of both.
The premium recoveries, which is essentially revenue that we're getting that that's a zero margin.
That's about 150 basis this quarter and if you go back over the last two or three conference calls has kind of been in the 150 to 100 basis point 80 basis point range.
You can do the math on that Chris, but that's that's essentially you know calorie free revenue, which means.
That revenue, we would expect to go down but gross margin Wouldnt change that's going to make our model look better and that will be a headwind to revenue next year that won't won't change gross margins.
In addition to that we have about an equal amount of premiums that we're paying that we're not getting any recovery for.
Those should also go away that's not normal pricing from the supplier that's premiums were paying to brokers or other third parties to get the parts you know wherever we can that.
That will be real improvement to gross margin that will not only improve our model, but improve earnings.
And so the it's going to be some trade off clearly there's some.
Yeah, you know they'll be negative leverage from lower revenue some of that comes for free and some of it will will.
It will impact our margins, but I think the better way to think about it is we should get that entire effectively 300 basis points back at some point in time as the supply chain normalizes, but we've also said there is 50 to 100 basis points of.
And factory inefficiencies in our model I think it's fair to say with the higher volumes. This quarter, you've probably got an equal amount of leverage this quarter. So it's kind of offsetting the inefficiencies the higher volume. So I think what you'll see is maybe we don't get as much back on the efficiencies.
That we would expect that 50 to 100 basis points.
Because of the negative the negative leverage.
And that's maybe the way to weighted the way to think of it.
Got it Super helpful. Paul If I could just squeeze in one more thing if I heard you right on A&M revenue itself.
Paul what I sort of thought about $7 million in the quarter.
No. It was much higher than that I think the number is about $17 million.
Got it. Thank you very much thank you.
Our next question comes from the line of Mehdi Hosseini with S. E T for C with you.
Yeah. Thanks for taking my question.
How are you.
You said Opex should be up did you mean to imply like one to 2 million dollar range.
Yeah, it's it's it's up nominally.
Right right.
Okay.
Go ahead Mehdi.
Okay.
No.
It's kind of a downturn.
Goodbye.
Throughout 2020, especially.
<unk> seen that pick up in business in the latter part of 'twenty three.
Yeah, I think what Youll see is it'll be flat, maybe even down a little bit at the beginning as we focus on some efficiencies and whatnot, but as.
As you go across the year, we're continued to battle inflation, which we continue to see on the horizon and we intend to continue to invest particularly in our critical engineering programs and in strategies that will drive growth. So in an extra obviously will be with the softer market will be focusing on where we can improve productivity.
Ensure we are delivering synergies.
And improve efficiency.
And so I would expect to see you know spending flat to up but not not up much.
Gotcha and then one question for Steve given the current valuation in the public market. How are you thinking about potential acquisition targets is there any area.
And that means data centers telecom industrial that you ask for better value or are you just focused on strategic fit or is a combination of the two any color will be great as we try to better understand how you're thinking about the M&A strategy.
Yeah, I think in general I think our 2023 is going to be a favorable environment or environment for us in M&A.
With high interest rates and.
M. A e-commerce market market I think that favors our strategic buyers like advanced energy.
It allows us to pay reasonable prices for quality assets.
Our strategy is the same you know we're still looking for power.
Power companies.
In the semiconductor industrial and medical markets.
We like companies with.
Hi.
A portion of sole sourced products.
We we like companies that operate in the market for a while and have a good base of customers and have a strong engineering mindset, so that dovetails nicely with the.
Advanced energy.
I guess I was looking for something more specific is there any end market that offers you a better value.
Or opportunities equally distributed.
For different markets.
I think the you know what we like about semiconductor industrial medical is a the ability to to create customized product for our customers.
So you know the very very very high percentage of products. We shipped in those markets are sole source and they're long lifecycle when they're sticky.
And we think that is that is our primary business, we're kind of at a high mix low volume business.
But these these design wins.
Turn into 15 year annuities essentially.
Got it thank you.
Yeah.
Our next question comes from the line of Hans Chung with D. A Davidson. Please proceed with your question.
Hi, Thank you for taking my question congratulation on the strong reach out.
First question.
<unk>.
A follow up on that.
The margin I remember it took about redesigning it for and that could help the they need to get the the supply chain costs.
Therefore, the availability of components.
So you pay so I just wonder how high how does that play out so far I think.
Helping a lot.
Based on your commentary around the <unk>.
Have fun.
On the call premium.
Wanted to know what.
Now and then how should we think about that.
Tell we go into next year.
Yeah, but let me just clarify what Paul mentioned earlier and.
And the bottom line is the effect of the PERC charges continue to to shave about 300 basis points off our gross margin percentage. So instead of 40% were operating at 37% roughly.
Now.
Our our Redesigns and alternative park qualifications are a different matter they've they've allowed us to actually.
Drive much higher revenues this year than last year, but were still incurring significant costs for these scares parts and you know the the the list of scares parts is shorter than it was a year ago.
But all it takes is one missing part we can't build the.
We can't build the box.
So as we move into 2020 three there's two primary factors going to drive a higher gross margin first is the dissipation of these.
Extraordinary what we call peace variance charges.
The second is a continuing improvement in our product mix.
So all of our efforts in the past year and a half had been.
Focused on sole source products in all of our markets and we think this will drive a better a better mix moving forward. So that we can operate.
Above 40% gross margin in good times and bad, but that's our basic financial objective as a company.
Got it Okay and then.
So what about the operating leverage on the Opex side, I'd say going into 'twenty three as we are.
We see that declining semi business.
Should we think about the model.
Next model to that during a downturn.
Yeah, I think as I've as I mentioned earlier.
This is the first quarter, we've had a full quarter of that cell tower, and we were right just under a $100 million and I think it will be up.
Very modestly in the fourth quarter.
We will do some things to help moderate those costs, but we're also fighting inflation and we're going to continue invest in our strategic markets. So and generally you should think about operating expense as you go into next quarter as flight flat to up from the current the current run rate.
Got it Okay and then.
On the industrial.
Marquee I think they're seeing some.
Pockets of softness.
Just overall in the industry and just wondering if you see any signs of weakening trends or changes in customer behavior.
Yeah.
Deep trend.
Sectors.
Good market.
Yeah, we haven't seen that in fact, you know where were seeing.
The backlog stayed very strong.
And even though we out shipped by a significant margin our forecast denying them last quarter Q3.
<unk> was.
It was roughly flat so that means we have new orders coming in to replace all of the the shipments we're making so that's I think that's impressive.
What we're seeing is that in the markets, we operate in I like test and measurement.
Horticulture and other specialized markets.
The demand is strong and much of it is pent up demand.
You know what we have under shipped into those markets for the past year and so we're still playing catch up.
And we're going to be playing catch up for the next couple of quarters in those markets.
But I think in general we see industrial medical.
<unk> is very strong areas for us moving into 2023 and.
And we think we can grow faster than the market.
No I'd just based on our shipment improvements, but also based on our design win pipeline, which is much stronger than it's been in quite some time, because we we kind of we refocus as a company about a year ago on the industrial medical markets and our sales team has done a great job winning a lot of new designs.
Got it thank you.
Our next question comes from the line of Steve Barger with Keybanc capital markets. Please proceed with your question.
Thanks.
Going back to the backlog you said you don't have a lot of direct exposure to Chinese owned companies, but do you have an estimate for what percentage of the backlog could be affected by restrictions on U S customers.
Yes, if you look at the backlog overall, it's probably in the mid to high single digits that would be.
Currently allocated to those direct customers. So we'll see how that works out as we get more clarity about what can and can't be shipped but if that all things else equal you could think about our backlog around $1 billion ex any Chinese exposure.
Got it.
And if I look at <unk> revenue and the midpoint of the <unk> guide the averages almost $500 million per quarter. You have you know as you.
<unk> $700 million of shippable backlog, if you get the parts orders still seem good, especially on the industrial medical should we be thinking that the average two half run rate that almost $500 million could be more of a base case for the first part of next year.
We're not providing guidance at this point, but I just think if you look at the relative mix of our business with semi and W. F E and our customers have said WP down 20%, we should be down as Steve articulated you know less than that but still it's still down.
And in the general.
I'll say.
The broader macroeconomic environment.
Yeah, I think that would probably be a be a little high for a base case so.
Obviously, there's a lot of moving parts in the economy right.
Right now I think however, our markets perform and that's maybe the first thing for you to form a view on is we should do we should do better than that.
We're entering the softer point from a supply constrained environment and so we'll have an opportunity to fill in some inventory we have new products and other things that that should help us to relatively outperform the markets, but I think that that's the tough thing right. Now is is looking at how the markets will perform in 2022 2022.
Two.
And I think there's still a lot of moving pieces there Steve.
Got it I'll ask one more.
I know that securing wins in industrial and medical has been a big focus have you as you've increased your sales and marketing are you getting more inbound inquiries from new customers or can you talk about the percentage of customers that are finding us through marketing programs versus your direct sales channel.
Yes, Steve I can make some general comments, but.
I mean, the first thing we did was we we.
Looked at our sales force.
And roughly 40% of the people in our sales force are now solely incentivized on industrial medical design wins and revenue. So we didn't have that before and that was a key change.
The second thing we did as a company was.
Transfer a number of development engineers from our high volume programs, which we're focused primarily on hyperscale and networking customers and we've put them into the industrial medical group.
And so that's a really opened up the pipe for engineering bandwidth.
And we've been applying that that horsepower, yeah to new opportunities across the world really.
And so I think you know the company kind of refocused starting in about 12 months ago on these applications and we were able to engage with the customer with a pretty broad portfolio today.
And and basically customized products to their needs.
And so it's it's a it's a powerful playbook.
I continue to play out in the coming years, but it's you know it's a it's a great business because most of these design wins are last a very long time and the customers keep buying the product for as long as we make.
To make it.
Understood. Thanks.
Thank you Steve.
Our next our next question comes from the line of Mark Miller with Benchmark. Please proceed with your question.
Let me add my congratulations on your record results.
Just had a question about your large backlog how would you look at the margin profile of that backlog in terms of your recent margins would it be higher or the same.
Yeah, if you look at the backlog being 80% industrial and medical and semi it's a generally margin up.
The company from.
Our current run rate I think the wildcard in that is how quickly do the premiums for.
You know that we're paying to get for parts abate.
But generally it ought to be the same or better in the backlog.
You indicated that that's the power of the sales were slightly less than 100 million what was the profit for myself power.
Contribution I think what we said I think we said S. L power was $17 million in the quarter.
Of revenue.
Yeah, we haven't talked about the specific performance of SL power, but it's a business that operates in the mid to high teens of EBITDA and it continues to operate in that are a little better.
Thank you.
Yeah.
And we have reached the end of our question and answer session and also this concludes today's conference and you may disconnect. Your phone line at this time.
Thank you for your participation.
Yes.
Okay.
Okay.
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