Prepared remarks
Good day, and thank you for standing by. Welcome to the MKS Second Quarter 2026 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Paretosh Misra.
Good morning, everyone. I'm Paretosh Misra, Vice President of Investor Relations, and I'm joined this morning by John Lee, President and Chief Executive Officer; and Ram Mayampurath, Executive Vice President and Chief Financial Officer. Yesterday, after market close, we released our financial results for the second quarter of 2026, which are posted to our investor website at investor.mks.com. As a reminder, various remarks about future expectations, plans and prospects for MKS comprise forward-looking statements. Actual results may differ materially as a result of various important factors, including those discussed in yesterday's press release and in our most recent annual report on Form 10-K and any subsequent quarterly reports on Form 10-Q. These statements represent the company's expectations only as of today and should not be relied upon as representing the company's estimates or views as of any date subsequent to today, and the company disclaims any obligation to update these statements.
During the call, we will be discussing various non-GAAP financial measures. Unless otherwise noted, all income statement-related financial measures will be non-GAAP other than revenue and gross margin. Please refer to our press release and the presentation materials posted to the Investor Relations section of our website for information regarding our non-GAAP financial results and the reconciliations to our GAAP measure. Our investor website also provides a detailed breakout of revenues by end market and division. Now I'll turn the call over to John.
Thanks, Paretosh, and good morning, everyone. Momentum is continuing to build at MKS with strong demand across all of our markets. Second quarter revenue and key profitability metrics came in at the high end or above our guidance ranges. Our Q3 guidance is supported by strong order activity that we expect will drive continued robust year-over-year growth. Against the backdrop of intensifying AI-driven investment across semiconductor and advanced packaging applications, we are demonstrating the strength of our foundational position, from vacuum, plasma and power products that enable leading-edge etch and deposition applications, to optical components and photonic subsystems for the lithography, metrology and inspection markets, to laser systems, proprietary chemistries and chemistry equipment for the advanced circuit boards on which leading-edge semi devices are integrated. We are a leading enabler of advanced electronics.
This is MKS at its core. Our performance reflects the benefits of investments we've made and continue to make in broadening our capabilities and expertise, deepening our relationships with customers across the electronics ecosystem and building out the global capacity needed to meet the unprecedented demands of this investment cycle. We're not only excelling in the current environment, but also generating new design wins that position us to capitalize on long-term growth opportunities. Now I'll review our Q2 end market performance and Q3 outlook. Starting with our semiconductor market. Revenue was above the midpoint of expectations as we and our supply chain partners continue to ramp our operations. Revenue grew 19% sequentially and 28% year-over-year, which accelerated meaningfully from the 13% year-over-year result in Q1. Growth was broad-based across deposition and etch products, including RF power for NAND upgrades and vacuum subsystems, plasma generators, reactive gases for advanced logic and DRAM applications.
Our photonics and optics solutions also continue to gain momentum in the lithography, metrology and inspection market. Overall, we continue to see strong order activity and very healthy order backlog that gives us good visibility through the second half of the year. We also continue to achieve design wins, including in advanced logic, where we are the process tool of record for dissolved gas applications and in RF power, where we have segment share leadership in high aspect ratio dielectric etch applications. Our semi outlook for Q3 implies year-over-year growth will accelerate to over 50% with strength across our entire portfolio of solutions. This anticipated growth is an indicator of MKS' long-standing track record of WFE outperformance during improving investment environments. Turning to Electronics and Packaging. AI-related applications are driving a meaningful increase in investment.
Revenue was above the high end of our outlook, up 19% sequentially and 44% year-over-year. Laser drilling system sales into the flex PCB markets for advanced smartphones and peripherals were strong, and chemistry sales remained robust as well. In chemistry equipment, we said last year that order activity had been elevated for multiple quarters. It has moved another level above that. Our chemistry equipment demand is easily the strongest it has ever been, supported by AI server investments, including optical modules. Our visibility now extends through 2027, and to meet this growing demand, we recently announced we are doubling the capacity of our Guangzhou equipment factory. And notably, in rigid PCB drilling, we're pleased to see increased order activity as the market embraces our differentiated capabilities and a compelling cost of ownership proposition. As we have noted in the past, our proprietary chemistry carries higher gross margins than equipment, and we have high chemistry attach rates with our equipment customers, so we believe the stage is set for continued attractive high-margin chemistry growth through the cycle.
We continue to be actively engaged with customers on their future plans, which serves as a good leading indicator for strong equipment orders. Overall, the growth we're seeing in E&P reflects our long-held view that the trends driving device scaling in semi would ultimately come to the advanced PCB market as device integration becomes a core requirement for advanced electronics. That day has arrived and advanced PCBs are rising in importance as increasing layer count requirements and integration challenges extend to higher-end smartphones, AI servers and other advanced electronics. In Q3, we expect Electronics and Packaging revenue to be up over 30% year-over-year with AI-related investment partially offset by flex equipment-related seasonality. Our flex market is typically down sequentially in Q3 ahead of the next design cycles, and we are coming off a very strong first half. I'd like to highlight how we are scaling in our Semiconductor and Electronics and Packaging business to meet anticipated demand growth today and over the next several years.
Near term, we are increasing our working capital investments to address rapidly accelerating demand in the current cycle. Longer term, capacity planning is also key. Our new Malaysia supercenter, which opened in Q2, can be expanded at our option, and we are building out our chemistry equipment facility in Guangzhou, as I mentioned earlier. These facilities will play an important role in supporting our future capacity needs and their proximity to many of our customers will strengthen engagement as well as deliver performance benefits as the new facilities ramp. Switching to our Specialty Industrial market. We delivered a strong quarter, up 8% sequentially and 14% year-over-year. Revenue has not been this high since 2023, driven by our datacom and defense markets. Performance across our remaining Specialty Industrial markets was steady in Q2. We expect strong performance in our Specialty Industrial market in Q3, led by the markets I've called out.
We're pleased to see how our foundational enabling technologies extend beyond Semi and Electronics and Packaging into adjacent opportunities that leverage our R&D spend and deliver strong incremental cash flows. Wrapping up, MKS is executing at a high level financially, operationally and technologically. We further broadened our capabilities and expertise to address key opportunities across the ecosystem, resulting in deepening penetration in areas like lithography, metrology and inspection and advanced PCB at a critical time for the industry. We're also making strategic investments to support our customers and drive profitable growth well into the future. Our customer engagement and design win activity underscores our role as a foundational enabler of advanced electronics who looks ahead and solves ahead. Thank you to our MKS team, our suppliers and customers for your hard work and partnership. We're incredibly excited about what lies ahead. Now here's Ram to run through the quarter and our financial outlook in more detail.
Thank you, John, and good morning, everyone. We delivered an excellent second quarter and are seeing increased demand across all end markets. We remain focused on driving profitable growth with disciplined execution and continue to make the investments needed to capitalize on the growth opportunities that we see ahead. Let me begin by reviewing our Q2 results in detail. MKS reported revenue of $1.25 billion, up 16% sequentially and 28% year-over-year. Year-over-year growth trends accelerated through the first half of the year, and we expect that to continue in Q3 as demand increases across our end markets. Second quarter semiconductor revenue was $554 million, up 19% sequentially and 28% year-over-year. In addition to continued strengthening of demand in DRAM and logic, we saw increased momentum in NAND upgrade activity. Collectively, this demand is driving strength across our key product categories led by plasma and reactive gases and vacuum products, while also supported by robust growth in our power solutions, optics and photonics offerings.
Second quarter Electronics and Packaging revenue was $381 million, an increase of 19% quarter-over-quarter and 44% year-over-year. The very strong sequential improvement highlighted elevated demand across our portfolio, including chemistry solutions, chemistry equipment and flexible PCB drilling sales. The even stronger year-over-year comparison was driven by demand for chemistry equipment, which continues to inflect higher. We are also seeing very healthy demand for chemistry solutions and flexible PCB drilling equipment. As the chemistry business continues to benefit from accelerating demand for AI-related applications, sales in the quarter were up 21% year-over-year, excluding the impact of FX and palladium pass-through. In our Specialty Industrial market, second quarter revenue was $313 million, an increase of 8% sequentially and 14% year-over-year. The year-over-year growth was driven by datacom and defense applications, while the sequential improvements reflected continued momentum in datacom as well as seasonal recovery following the Lunar New Year.
Turning to gross margin. We reported second quarter gross margin of 47.6%. In addition to higher volume, we also saw a benefit from certain discrete items in the quarter. Excluding these discrete benefits, gross margin remained very healthy despite unfavorable product mix and accelerated investments necessary to address rising demand. Second quarter operating income was approximately $320 million, yielding an operating margin of 25.6%, which was up 480 basis points year-over-year and well above our guidance midpoint. Operating expenses of $275 million were in line with our guidance. We are driving very healthy operating leverage in the business as revenue scales. Second quarter adjusted EBITDA was $358 million, yielding a 28.6% margin and also above the high end of our guidance. Net interest expenses was $33 million compared with $46 million in the second quarter of 2025, reflecting the full quarter benefits of our first quarter financing actions as well as continued proactive principal prepayments.
Our second quarter effective tax rate was 19.6% and in line with our guidance. Second quarter net earnings were $232 million or $3.30 per diluted share, up 86% year-over-year on a per share basis and above the high end of our guidance. Let me now turn to our cash flow and balance sheet. We closed the quarter with over $1.6 billion of liquidity comprised of cash and cash equivalents of $611 million and our undrawn revolving credit facility of $1 billion. We generated free cash flow of $188 million, about 15% of our revenue. We expect investments in CapEx and working capital to increase through the remainder of the year as we continue to prioritize our organic growth. Beyond that, we will maintain our focus on proactively deleveraging to strengthen the balance sheet. We made a $100 million prepayment on our term loan earlier this week. Our leverage at the end of Q2 was 3x based on a trailing 12-month adjusted EBITDA of $1.1 billion, which is down one full turn since Q2 of last year as we continue to make strong progress towards our target leverage ratio.
Finally, we paid a dividend of $0.25 per share or $17 million following the 14% increase in our dividend in Q1. Let me now turn to our third quarter outlook. We expect revenue of $1.35 billion, plus or minus $40 million, which represents continued strong sequential improvement and further acceleration in year-over-year growth. Our third quarter outlook by end market is as follows: Revenue from our Semiconductor market is expected to be $630 million, plus or minus $15 million; revenue from our Electronics and Packaging market is expected to be $385 million, plus or minus $15 million; and revenue from our Specialty Industrial market is expected to be $335 million, plus or minus $10 million. Based on anticipated revenue levels and product mix, we estimate third quarter gross margin of 47%, plus or minus 100 basis points. We expect third quarter operating expenses of $280 million, plus or minus $5 million.
We expect operating expenses will grow at a much lower rate than revenue. We expect third quarter operating income of $355 million with an operating margin of 26.3%. We estimate third quarter adjusted EBITDA of $395 million, plus or minus $28 million. We continue to expect CapEx for the year to be in the range of 4% to 5% of our revenue. We expect our third quarter tax rate to be approximately 20% and the full year tax rate to be at the lower end of the 18% to 20% range we provided previously. Based on these assumptions, we expect third quarter net earnings per diluted share of $3.58, plus or minus $0.31. As our Q2 results and Q3 guidance indicate, our business momentum continues to increase. Our focus is on meeting accelerating customer demand. We remain committed to making the investments necessary to support growth while continuing to prioritize our deleveraging efforts. We are in a great position entering the second half of the year. And with that, operator, please open the call for questions.
Questions and answers
Our first question comes from Steve Barger at KeyBanc Capital Markets.
I'm going to start on some of the NAND tool upgrade. You talked about that activity will contribute in coming years. But greenfield NAND, I think, is even better business. Can you update us on what the upgrade cycle looks like and how that bridges to greenfield projects you may see entering equipment planning?
Yes, Steve. So we did mention that we are seeing upgrade activity in Q2. We certainly expect that to continue. It can be lumpy, but the industry is trying to increase capacity in NAND. And then, of course, there have been some announcements of greenfields and those factories, as you say, will be even better for our power as well as the rest of our portfolio. Those fabs will be coming in towards the end of '27, beginning of '28, so that's the plan right now. So between now and then, we would expect continued upgrade activity.
Got it. Can you compare the magnitude of dollar spend for a new leading-edge tool versus an upgrade?
Yes. We haven't really disclosed that explicitly, but I would just say that the RF power part of that upgrade is the largest part of the BOM in terms of cost and therefore opportunity for MKS. That's why when there are upgrades, we benefit from that. Of course, if it's a brand-new tool, we would have the rest of the semiconductor portfolio around that tool. So that would be better, but our power content is large.
Got it. And then one quick follow-up. Really appreciate the commentary on visibility into '27 in Electronics and Packaging. As we've gone through earnings, some of your biggest semiconductor customers said visibility is the best it's ever been for their business. Can you talk about lead times and visibility into 2027 on the semi side?
Yes, sure. We are in constant communication with our customers. They have given us their plans and expectations much further out than normal. We are building capacity and inventory and scaling our factories and getting the labor in to meet those anticipated increases from our customers. So we are planning to make sure that we're not the constrained. Lead times right now for us are still kind of normal, so we're executing really well given we're already a couple of quarters into the ramp. We do have to manage many suppliers, but right now, our supply chain is stepping up.
Our next question comes from Bhavesh Lodaya at BMO Capital Markets.
Can you give us an update around the ramp-up of Malaysia capacities as you ramp up those things? And are you still comfortable with the $180 billion to $200 billion of WFE that you can support with those plans?
Bhavesh, yes, Malaysia has started ramping. In fact, the first revenue shipments have occurred there. It's still early days, of course. We've said in the past that we did not need Malaysia for 2026 to meet the 2026 demand. So Malaysia is ramping up to meet the 2027 demand and then beyond that. We had talked about capacity planning last quarter that we would need Penang as well as perhaps other sites. Right now, we have reconfigured things so that we believe that when we fill out Penang, we will be able to support a WFE in that $200 billion to $250 billion range, which is an incremental improvement from what we said last quarter. And of course, in addition to that, we announced the doubling of capacity in our MSP chemistry equipment factory in Guangzhou.
Got it. And a question on your specialty industrials platform. It's a nice step change in the earnings growth profile. Your guidance seems to indicate it's going to grow in the high teens in 3Q. Could you touch on some of the end markets or sectors that are helping? I know you called out a couple of them, but it looks like those have to be very strong for the overall platform to grow in the high teens. Maybe talk about the durability of those earnings. Are there any timing benefits? And how should we think about the baseline of this platform into the next year?
I think we called out two of the submarkets, and that was datacom communications and defense. Datacom is being driven by AI, so communications testing for AI data centers continues to be strong. We expect that to continue to be strong and follow, for instance, the AI investments for the industry. Defense has continued to be strong and grown over the last several quarters; that market probably depends on your view of defense spend, but those two markets continue to remain strong. That's why our guidance for specialty industrials in Q3 remains strong, so that's the color we can give you. The other submarkets: automotive is bouncing along with no material degradation or improvement, and industrial is seeing incremental improvement, but not to the same order of magnitude as datacom and defense.
Our next question comes from Matthew Prisco at Cantor.
I guess first on the E&P side, how should we be thinking about the chemistry growth potential moving forward given this continued equipment strength? Is this something we look for meaningful growth inflection in '27 and '28 as those systems move to high-volume manufacturing? And any update you can provide on the AI contribution as a percentage of those revenues?
Maybe I'll start with the AI contribution. We had said in 2024 it was about 5% of our chemistry, and then 10% last year, and last quarter it was about 15%. I would say it's incrementally better now, so think about 15% to 20% as the right number for AI as a percentage of our chemistry business. The chemistry equipment business is growing very quickly. We have visibility through 2027, which gives us the confidence to build that Guangzhou factory and expand capacity. Historically, the chemistry that attaches to every dollar of equipment sales has been in the 20% to 40% range. That's still true, but an update for modeling is that we're selling more higher-end pieces of equipment because AI boards are more difficult and require higher-end equipment. Those come with higher ASPs, so mathematically that 20% to 40% range would sit more toward the lower end now, just because the equipment ASPs are higher. The chemistry is still there.
Perfect. That's helpful. And then on the debt side, we're seeing strong sequential growth in 2Q, guided strong sequential growth in 3Q. Voluntary prepayment kind of staying the same. And I understand you're investing in supply to meet demand. But can you maybe give us updated thoughts on strategy around deleveraging? And at what point do the voluntary payments begin to move more meaningfully higher?
Matt, it's a great question. As we have said before, investing in organic growth and supporting our organic growth is the first priority and then strengthening the balance sheet is a close second. In the second half of the year, you will see our CapEx picking up and inventory growing as we prepare for the ramp. Having said that, we continue to make the prepayment of $100 million each quarter. We are also looking at making additional payments in Q3 and in Q4. So although it has not happened yet, further prepayments are high on our priority list.
Our next question comes from Michael Mani at Bank of America Securities.
To start on the semi market, nice to see that on a quarterly run rate basis, you've crossed the last peak that the segment saw back in 2022. If you were to compare it then versus now, could you give us an update on how much of the mix is NAND versus DRAM versus logic, so especially NAND, so we get a rough sense of how far it is off from the bottom? And looking ahead, how do you expect that mix to evolve, especially as you pick up more wins on the logic side?
I think the way we're looking at it is still largely logic and DRAM-driven for the semi market. The NAND upgrade was nice to see, and we expect that to continue. With NAND greenfields in 2028, NAND will become a bigger percentage of our semi revenue. As we said earlier, we're seeing outperformance of WFE during the ramp as we've done historically. Our guidance for Q3 implies we'll be over 50% year-over-year in Q3. To give more color, we are exposed to about 85% of WFE across segments. Depth etch is significantly higher than average, so the depth etch part of our business is growing even more than the overall average.
Great. Very helpful. And then on E&P, could you help decompose between this past quarter you reported and what you're seeing into Q3 and potentially into Q4? Where is the strength coming from between chemistry versus electroplating versus flex drilling? And is it fair to say that maybe some of the demand destruction related to mobile was more benign than feared? Or is it still too early to make that judgment?
Regarding the demand destruction that the industry feared earlier in the year, I think it has been more benign than feared. We can see it in our flex drilling business because flex drilling was very strong in the first half. There is seasonality to it, but new form factors and high-end smartphones have been fairly strong for us, and that's reflected in our flex drilling system revenue. The chemistry for other consumer products does have seasonality, but AI is driving the quarter-on-quarter growth; chemistry equipment is also a major driver. We are shipping chemistry equipment as fast as we can. As additional color to the prepared remarks, we've talked about the Guangzhou factory doubling capacity. We've also turned on our Germany factory to fill the gap between now and when the second Guangzhou factory comes online, so we are shipping equipment as fast as we can. This is positive for market share of chemistry in the future. Equipment has lower gross margin than chemistry, so the mix does affect overall company gross margin, but we're fine with that because it builds future high-margin chemistry sales.
Our next question comes from Shane Brett at Morgan Stanley.
I want you to help us unpack the gross margin portion a little bit. If my numbers are correct, your gross margin ex palladium for the June quarter would have been kind of in the mid-48% range. Just how much of your quarter-over-quarter decline into September is a result of some E&P chemistry weakness? And are you expecting palladium to be a tailwind or a headwind to gross margin in the September quarter?
Shane, on the last part of your question, we expect palladium to stay roughly flat in the third quarter at about $1,300 per ounce. Regarding gross margin, Q2's reported 47.6% included about 100 basis points of discrete items, mostly coming from refunds of tariffs and duties. Excluding those discrete benefits, gross margin would have been consistent with recent quarters despite impacts from some investments we're making to support growth. We're stepping up investments to prepare for demand—getting Malaysia ready for 2027 and similar activities—and those investments impact the P&L. Mix is unfavorable and will remain so as long as VSD and chemistry equipment ramp. As we've said before, these are good problems to have because higher VSD means higher operating income, and higher chemistry sales should follow equipment sales. Overall, gross margin remains healthy with all these puts and takes. The investments will continue and represent a temporary headwind to gross margin.
Got it. And for my follow-up, I'm actually going to ask another gross margin question. This is on VSD specifically, which I assume is a lot of semi. VSD gross margins were north of 46% in 2021, but as of the March quarter, we were at 42.9%. Where are we in the margin recovery path there? What do we need to have happen for margins to get above that 46% to 47% mark again?
VSD margins are slightly lower today, but where we benefit from a VSD ramp is on the operating income side. We have ongoing operational excellence programs that will help, but it also depends on the mix within VSD as to what will drive margins. What you're seeing now is that some of the VSD products that make up a large portion of sales are not our highest-end VSD products. Those mix dynamics are important to observe.
Maybe to add a little bit: in the prior cycle when we hit that 45%–46% range, a larger share of VSD sales were China direct sales, which had a gross margin tailwind; that business is much lower now. Also, there was more RF power for NAND greenfields in that prior cycle, which was accretive to VSD gross margins. Third, we're investing in labor and CapEx ahead of the ramp now, which impacts margins. Over time, those investments should normalize and stop being a headwind. Volume will also help drive margin recovery.
Our next question comes from Melissa Weathers at Deutsche Bank.
I was hoping to talk a little bit about 2027. The second half seems like you guys are off to a really strong start. But I was hoping to get your thoughts on how you're thinking about 2027 growth rates. What do you think will grow faster between the semis and the E&P businesses? Clearly, both are doing well, but which one do you think grows faster next year?
Thanks, Melissa. I don't think we know definitively. Both are seeing historic growth rates and, importantly, they are coupled. Investments in WFE and semi lead to higher demand in packaging—if you make more chips, you have to package them. The equipment orders we're seeing in packaging are on the same order of increase as WFE and maybe even higher. There are differences: semi has shorter lead times, which is why we typically guide one quarter out; chemistry equipment lead times are much longer, historically 6 to 9 months, and those down payments give us visibility through 2027. So the markets are coupled; if one grows, the other must support it.
I'll take that. And then maybe along those lines, from a pricing perspective, you're expanding capacity to serve strong demand. Is there any change to how you guys are thinking about pricing? Is there any opportunistic leverage that you can get across either business on the pricing side?
Our strategy on pricing has always been to get fairly paid and to do it continuously. We're always assessing each product line for whether pricing is appropriate. We operate in a competitive environment and value our long-term relationships with customers, so we are not looking to take advantage of short-term dislocations. We remain focused on sustaining fair pricing over the long term.
Our next question comes from Sreekrishnan Sankarnarayanan at TD Cowen.
John, when I look at your semi revenues this quarter and the guided one and given that it has to grow into December given the strength, it seems like you're going to easily grow over 35% this year in semi revenues compared to some of your peers talking about 30-plus. A, is that a fair characterization? What does that imply about how inventory is managed by your semi cap customers?
Yes, Krish, I think that's the right math; it may even be a little north of the number you cited. We are seeing strong growth in dep-etch, which is higher than the litho/metrology/inspection part. Regarding inventory management, I don't expect a different behavior compared to prior cycles. Some of the large semi cap customers may be holding slightly more inventory because they must have higher inventories to ship the revenue they want to ship. Turns are better, so there's no evidence of broad excess stocking; rather, it's a ramp in production and associated supply chain scaling.
Got you. And then a quick follow-up on the E&P side. It looks like when you look at the chemistry business, some of your chemistry customers, especially the substrate folks from Taiwan and Japan, seem to be capacity constrained though they're raising CapEx in the short term. Is that happening? Or do you think chemistry is going to continue growing? Will that have any impact on your chemistry growth?
Like in semi, people are finding ways to utilize tools better and faster, so chemistry revenue should continue to grow. Equipment being installed and turned on increases chemistry consumption. We expect chemistry to continue to grow even though there are capacity constraints, which is why equipment orders are so high for us. That bodes well for future chemistry revenue.
Our next question comes from Vijay Rakesh at Mizuho.
Good quarter and guide here. Just looking at the June and September quarters, obviously very strong growth in semis. You mentioned up 50% year-over-year. What is driving the acceleration into September? Can you give color if it's dep-etch or etch or inspection? Or would you break it out differently by foundry, memory or something?
Both dep-etch and litho/metrology/inspection are contributing to the acceleration. Dep-etch is growing much faster year-over-year, and the average for Q3 is above 50% year-over-year. Each subsegment grows at its expected rate depending on lead times, but dep-etch is a key driver of the acceleration.
Got it. And then as you look at 2027, your semis are growing faster than WFE, and packaging is also seeing a massive increase versus WFE. How should we look at the growth there as you look at 2027 relative to WFE, given all these trends seem to persist or accelerate into next year?
We do see acceleration and are planning for it. Our customer conversations indicate capacity expansion and preparation for an accelerating environment into 2027. If those plans come to fruition and our preparations meet demand, we would expect continued outperformance versus WFE during the ramp. Historically, outperformance is common during the early ramp phases; eventually, ramps peak and the dynamics change. But right now, everything is pointing up and we are preparing to meet that.
Our next question comes from James Ricchiuti at Needham & Company.
You may have said this, did you provide the chemistry growth in the quarter?
Yes, Jim. Year-over-year chemistry sales were up about 21% excluding the impact of FX and palladium pass-through, so we saw healthy growth in chemistry.
Any way of knowing of that 21% growth how much is coming from new capacity versus higher layer counts within the existing installed base?
It's hard to precisely separate, but part of the growth is coming from new capacity of equipment we and our peers have shipped. However, most of it today is still driven by previously installed capacity; some customers are bringing tools out of mothballs or using existing capacity more intensively. So the majority of chemistry growth currently is from existing installed capacity.
And the timing on the new capacity in E&P, you mentioned the new factory in Guangzhou. When do you expect that to be online?
Q3 2027 is our expectation for the new Guangzhou factory to be online.
Our next question comes from Yiling Sun at Citi.
I guess my question is on E&P for the flex drilling equipment part. I'm trying to understand which part of PCB or AI PCB or AI substrates those flex drilling equipment are more exposed to?
The flex drilling PCB revenue is primarily targeted to the smartphone and peripherals markets—flex used in foldables, smartphones and peripherals like earbuds. Most flex drilling demand is from consumer products and not AI. For rigid PCB drilling, we are starting to see more momentum tied to AI and other markets like low Earth orbit, so rigid drilling is increasingly relevant to AI applications.
Got it. And then on the chemistry side, are you starting to see some of the revenue coming from the new capacities that got in on the chemistry equipment side? When do you expect to see more of the chemistry revenue that is attached to equipment you shipped in the past two years?
It will be a continuous ramp over the next couple of years. Lead times can be in the 24 to 30 month range before a piece of equipment starts generating high-volume chemistry consumption. We're shipping equipment every quarter; installations and turn-ons depend on customers' schedules. Equipment revenue this year will be significantly higher than historical levels. We expect chemistry revenue to continue to grow as installed equipment is brought into production, which is why we committed to expanding Guangzhou.
Our next question comes from Joseph Quatrochi at Wells Fargo.
On the E&P equipment side, the capacity ramp—are you expecting to be somewhat constrained in your own capacity to fulfill demand until that facility opens in Q3 of next year? Or does it ramp more modularly?
We are not constrained. We have the Germany factory available to meet shorter-term demand before the second Guangzhou factory comes online in Q3 2027. We've increased activity in Germany and are also optimizing current Guangzhou capacity by finding incremental space. We have been able to take every order that our customers needed and are managing capacity across sites to meet demand.
As a follow-up, your services revenue was particularly strong this quarter—one of the highest levels we've seen. What drove that?
Utilization at our semiconductor customers is driving services revenue. Fabs are running at high utilization, and when utilization is high, equipment needs more service. We're seeing an elevated level of service revenue, reflecting that higher utilization. This feels like a new, higher base for the foreseeable future given how intensely customers are running their fabs.
Our next question comes from James Schneider at Goldman Sachs.
Given the factory ramps in Malaysia and Guangzhou, can you talk about how the expenses are loaded into cost of goods sold versus OpEx? As those factories get qualified and production ready, should we expect start-up cost headwinds to abate? Would that improvement accrue mainly to the gross margin line?
Jim, the costs related to ramping these factories are recognized in cost of goods sold and will impact gross margin; there's not much OpEx impact. The magnitude today is roughly 50 to 80 basis points per quarter and will continue for a few quarters. Once the plants are up and fully loaded, we should start to see improvement flow through gross margin. Most of these investments are expected to be self-liquidating and will come back as margin improvements in the future.
As a follow-up on pricing and input costs, do you expect that over the next 12 to 18 months, billable pricing increases can more than offset the level of input cost pressure you've been seeing?
We always strive to offset input cost pressure through pricing and supplier management, and historically we've been successful. The two levers are: working with suppliers to gain scale and lower costs, and ensuring we deliver valuable products customers will pay for. We expect to continue to manage pricing and inputs to preserve margin where possible.
This concludes the question-and-answer session. I would now like to turn it back over to Paretosh for closing remarks.
Thank you all for joining us today and for your interest in MKS. Operator, you may close the call, please.
This does conclude the program. You may now disconnect.