安捷倫 (A) 2004 Q2 法說會逐字稿

Good day everyone and welcome to the Agilent second quarter 2004 financial results teleconference. This call is being recorded.

At this time for opening remarks I would like to turn the call over to the Investor Relations Director, Mr. Hilliard Terry. Please go ahead, sir,.

Thank you and welcome to Agilent Technologies' second quarter conference call.

With me are Agilent's Chairman, President and CEO, Ned Barnholt; and Executive Vice President and CFO Adrian Dillon.

After my introductory comments Ned will give his perspective on the quarter and the current business environment. Then Adrian will provide detailed commentary on the financials and performance of each of our businesses. After Adrian's comments we will open up the call for your questions.

If case you haven't had a chance to review the release you can find it on our website at www.investor.agilent.com. In accordance with SEC regulation G, if during this conference call we use any non-GAAP financial measure, you will find on our website the required reconciliation to the most directly comparable GAAP financial measure.

Additionally I would like to remind you that we may make forward-looking statements about the future financial performance of the company that involve risks and uncertainties. These risks and uncertainties can cause Agilent's results to differ materially from management's current expectations. We encourage you to look at the company's most recent filings with the SEC to get a more complete picture of all the factors at work. The forward-looking statements, including guidance, provided during this call today are only valid as of this date. And the company assumes no obligation to update such statements as we move through the quarter.

Now, I will turn the call over to Ned.

Thanks, Hilliard. Welcome, everyone.

We're very pleased with excellent order and revenue growth across the company in the second quarter. We also had very good cash generation. We're pleased with the progress we are making in inventories and receivables, which is partly the result of completing the rollout of our ERP and customer support and service systems in February.

We experienced order momentum in virtually all of our major markets and geographies. We are clearly benefitting from the upturn in our markets, as well as from our continued R&D investments and a strong new product portfolio.

The recovery we are seeing started a few quarters ago in our semiconductor component and semiconductor test business. In the second quarter, while very good results continued in these areas, growth also accelerated in our test and measurement and life sciences and chemical analysis businesses. In test and measurement; wireless handset, consumer related products, and aerospace defense all helped drive growth. In life sciences and chemical analysis; the environmental food safety and pharmaceutical markets contributed to the results.

In addition to our strong order and revenue performance we came in at top end of our guidance for operating net income, 24 cents per share, which was 39 cents above last year and 3 cents above the first quarter.

While we are pleased with our very strong topline and earnings per share at the top of our range, we know we could have done better on bottomline performance. We had more costs associated with ramping to these higher volumes than we anticipated and our expenses were greater than the normal seasonal uptick for the second quarter. We are working hard to bring our costs back in line in the third quarter. In our test and measurement business, especially our support service and systems activities, we are not where we want to be in terms of operating profitability. We are implementing actions to bring Test and Measurement to double digit operating profit by the fourth quarter of this year. We are implementing actions to bring test and measurement to double digit operating profit by the fourth quarter of this year. Finally, we will achieve more benefit from further company wide reductions in expenses as our dependence on our legacy IT application diminishes.

Let me turn now to my thoughts on the future outlook.

I know some people are projecting that the economic cycle is at its peak or near its end and that the next downturn is just around the corner. We do not see any evidence of that in our businesses. Instead we believe the cyclical recovery that began last year in our semiconductor related businesses will continue to broaden and that business levels will remain strong through the end of '04 and into 2005. Therefore, with the market wind at our back coupled with our robust product offering we believe we are well positioned for continued topline growth.

With that as background let me provide guidance for the upcoming quarters.

We expect revenues, for the seasonally soft third quarter, to be in the range of 1.8 to $1.9 billion, roughly in line with the second quarter results. Operating earnings should be in the range of 25 to 30 cents per share. In the fourth quarter we anticipate revenues to be roughly $50 million above the third quarter and operating earnings per share to be up an additional 5 cents.

Now, I will turn the meeting over to Adrian.

Thank you, Ned.

Good afternoon, everyone. Let me give you a few perspectives on what was a mixed quarter for Agilent, a review of the performance of our business segments and what we are focusing on in the second half of the year.

As Ned suggested, it was a quarter marked by both strengths and disappointments. Certainly the highs were orders and revenues, which were at the highest levels in three years, with activity up double digits in all geographies and almost all markets. We had net orders of $1.892 billion, the highest level since the first quarter of 2001 and up 24% from last year. Up 9% from the seasonally weak first quarter. And again up across-the-board double digits geographically. Specifically, though, Asia-Pacific was very strong, up 37% from last year at this time.

Revenue at $1.831 billion was the second -- was the highest since the second quarter of 2001, was up 25% from last year at this time, up 11% sequentially. Now, currency was responsible for about $50 million of that increase year to year so adjusting for currency we were up in revenue terms 21% versus the 25% as reported. Quarter to quarter currency had about a $15 million impact so we were up 10% in constant dollars versus 11% as reported. Our book to bill at 1.03 suggests the kind of momentum that we have going into the third quarter.

Another highlight is that we were cash flow positive for the third consecutive quarter generating $137 million of free cash flow from operations this quarter. Inventory days on hand improved by 21 days over the past year to 94, an all-time low for the company. Receivables days sales outstanding improved by three days from last year to 54.

As Ned mentioned the we are also pleased this quarter to have completed implementation of all of our major IT programs and without impacting the operating results of the company.

The disappointment in our performance was that we did not achieve better profitability on the increased volumes.

Gross margins during the second quarter were 44.8%, up over 5.5 points from last year at this time but down 1.2 points from the first quarter. Given the $188 million increase in sequential revenues and the mix of our businesses, our gross margins should have been two points higher or 47% rather than 45%.

As we will talk about later we struggled with margins in test and measurement and semiconductor products, despite the fact that the overall pricing environment seemed to improve somewhat in the second quarter.

Operating expenses, while still sharply lower than last year, also rose during the quarter. R&D spending of $237 million was right on our longterm target of 13% of revenues [inaudible] it was up about $18 million from the prior quarter. SG&A costs at $435 million were also at our long-term target of 24% of revenues. They were down 11% from last year. But were up $35 million from the prior quarter. So total change in operating expenses, $85 million below last year at this time, but up $53 million from the first quarter.

The bottomline is that compared to the first quarter operating profits were up only $12 million on a revenue increase of $188 million. Conventionally measured it looks like our cost structure went up $100 million during the quarter. On the other hand, our employment was virtually flat quarter to quarter which is what drives our fundamental cost structure. We think the truth lies somewhere in between these two extremes.

Comparing the first quarter and second quarter we had salary increases and FICA of about $15 million quarter to quarter. Foreign exchange increased the dollar measurement of our costs in the rest of the world by $15 million during the quarter. And the swing in vacation time off was worth $20 million from the first quarter this year when everybody was taking Christmas-related vacations to the second quarter of this year when there was virtually no vacation taken. So in that sense our fixed costs went up by $50 million. We also had the normal seasonal increases in seasonal costs related to trueing up vacation of about 4 million, higher commission costs with the great orders, and higher trade shows and other types of expenses summing to about $10 million. So what we know about is about a $60 million increase in quarter to quarter cost that are easily identified and that for the most part we had planned for.

There was another $40 million, however, that was not planned for. That incremental roughly $40 million of spending is purely variable. Unfortunately, it is not any one big thing. Rather, it consists mainly of a lot of the pent up demand for items like travel, training, consultants, manufacturing and operating supplies. Things that were postponed or eliminated in the really tough past two years and suddenly reappeared as times began to get better. By analogy, this company since its inception has operated at two speeds. Flat out and dead stop. Now, things are beginning to normalize for the first time in four years. And to torture the analogy we are learning how to use the throttle to modulate the speed.

But the bottom line is the company intends to meet our commitment to a $1.4 billion breakeven cost structure, adjusted for the impact of currency, by the fourth quarter of this year. For taxes, we had a slight adjustment to the pro forma tax rate reducing it to 29% for the half and the year from the prior expectation of 31%. That change was worth about a penny to our second quarter results.

Reconciling from operating earnings to GAAP results we had pro forma net income of $119 million in the quarter or 24 cents per share, up 3 cents from the prior quarter and compared to a 15 cent loss a year-ago. During the quarter, we had goodwill and intangibles of $7 million. We had $20 million of accrued restructuring costs. And then we had a tax benefit of about $12 million. Add it all up to a GAAP net income of $104 million or 21 cents per share compared to 71 million or 14 cents per share in the prior quarter and a loss of 31 cents a year-ago.

Our assumption for the GAAP tax rate remains around 15-17% for the year. Depending on the strength of our foreign earnings. For U.S. and UK profits we will continue to recognize essentially a zero tax rate as we write back on the deferred tax assets we had to write off last year.

And a note on the second half earnings per share calculation. Beginning on the third quarter, we will begin to treat the senior convertible debentures as if converted for purposes of calculating diluted earnings per share. This will add about 36 million shares to denominator, it will also add back $6 million per quarter of after-tax interest expense to the numerator. [inaudible] impact of this change is to reduce our quarterly earnings by about a penny per quarter.

Okay, turning to cash flow, as I said, the GAAP income of $104 million for the quarter, we also generated $68 million from net working capital and other operating uses of funds. So total net cash provided by operations was $172 million compared to $40 million in the prior quarter. After taking out $35 million of capital spending, the free cash flow from operations this quarter was a positive $137 million compared to $11 million in prior quarter..

During the quarter we also had cash restructuring costs of $36 million, about equal to the prior quarter, which means if we were done with the total restructuring we would have generated free cash flow of $173 million from operations versus about $50 million in the prior quarter.

Looking at the rest of the balance sheet. As I mentioned before we had capital spending of about $35 million dollars. We had depreciation of $67 million. Receivables at just under $1.1 billion were 54 days sales outstanding. Inventory at 1.05 billion, 94 days on hand, the best in the company's history. All in, cash in the quarter increased by $164 million. We ended the quarter at $1.842 billion of cash on hand. That is up over $300 million from last year at this time. Finally, 2004 Cap Ex should be around the $175 million and depreciation and amortization should be around $300 million.

Okay, turning to segment data.

First test and measurement. For the test and measurement segment, the highlight was certainly orders, which showed the first meaningful increase in over three years. Continued strength in consumer electronics drove growth in Asia. Pricing trends also improved as discount levels continued to ease. Net orders at $745 million were up 23% from last year and we saw double digit increases across each of the geographies in each of the sub-segments. Communications test, about 71% of the total, were up 27% from last year and 18% sequentially. General purpose test, 29% of the segment, were up 12% year to year and about 11% sequentially.

Revenue during the quarter was $705 million. Up 8% from last year. Our book to bill was 1.06 adjust the momentum building in the normally lagging business. The highlights for the quarter in orders for communications test we continued to benefit from the continued expansion of wireless handset manufacturing capacity and market shifts towards cameras and other highend phones. Our one box tester business had another record quarter, rising double digits sequentially and year to year. We're also beginning to see a pickup in wireless R&D spending while for wireless infrastructure we are seeing sustained growth in China and a modest pickup in spending for base stations, the first time we've seen that in many, many quarters. Finally, we believe that wire line test has basically bottomed at a very low level.

General purpose test, the market for general purpose test instruments continues to show steady moderate recovery with components and semiconductor food and the semiconductor food chain leading the way.

We have also seen a steady and pretty significant increase in aerospace and defense business as a result of accelerated equipment wear.

Operating profits for the test and measurement segment in the second quarter were $11 million or 2% of sales versus the $4 million in the first quarter or 1% of revenues.

While this was the second consecutive quarter of profitability, we are disappointed in the performance of this segment which has lagged behind our expectations, as well as, the performance of our peers and competitors. Specifically, we have struggled with the profitability of the systems, support and services businesses. As Ned mentioned earlier, we are now taking specific actions to address these issues which have to do with pricing as well as costs. We believe as a result that we will be able to achieve a 10% operating margin in the test and measurement segment by the fourth quarter of this year compared to the 2% currently.

Turning next to automated test, the automated test segment had another fine quarter with orders at the highest level since the year 2000. After the typical seasonal first quarter decline, the second quarter expansion in our semiconductor test markets was strong and it was strong across the board. Momentum shows no sign of slowing in the near term. Net orders were $286 million, up 31% from last year, up 43% from the first quarter. Revenues, $266 million, were up 74% from last year and up 21% sequentially. And our book to bill 1.08, again suggests the momentum that continues in this business.

Quarter highlights would include the fact that the 93K SOC test system has reached an installed base today of 800 systems since its introduction.

We recently announced a new solution for PCI Express in serial ATA testing. In fact, we believe that all PCI Express devices in production today are running on 93K test systems. Although volumes aren't significant yet, momentum is building.

During the second quarter we had another 150 SOC test design wins as well. Our strength in design wins is coming from our traditional leadership area of graphics and chip sets as well as from the continued penetration of digital consumer and wireless markets. About 12 of these wins were with new customers.

And orders for our flash memory test system were up 32% year-over-year as we added three new customers and new applications to the broadening business. Segment profits during of the quarter were $34 million, that is the fourth consecutive quarter of profitability for the segment. Up $71 million from last year or a 63% incremental year-over-year, 13% return on sales, up from a 9% operating margin in the first quarter of this year.

Return on invested capital was an attractive 16% in the quarter, up from 9% last quarter.

Turning to semiconductor products, semiconductor products also had a fine quarter. Especially on the personal systems side of the house as our mobile solutions orders nearly tripled from last year at this time. Total orders were down seasonally, but with the exception of Q1, they were the strongest in three years. Net orders were $523 million, up 25% year to year. Off 10% sequentially.

Personal systems orders of $392 million were up 35% year to year, but down 9% sequentially due primarily to a seasonal decline in optical mice orders after a record setting level in the first quarter. Networking orders were $131 million, about flat year-over-year and down about 12% sequentially.

Revenues at $527 million were up 40% from last year, up 12% from the prior quarter.

Looking at the highlights first at personal systems. As I said earlier our mobile solution orders were up 2% sequentially, but nearly tripled the demand of last year. VGA cameras have now overtaken CIF as the majority of our camera orders which grew 6% sequentially. Megapixel comes next with megapixel camera modules joining the product mix in the upcoming orders.

FBAR were also up 28% sequentially as solid demand continued from a number of customers and strength in digital consumer also drove demand for out opti-electric products, with order growth for LEDs and [inaudible] up 21% year-over-year and 14% sequentially.

On the networking side we are seeing some signs of growth, but frankly not a lot. And our sequential performance in gigabit ethernet fiber optic performance was pretty flat because of a major product conversion at a major customer and because of inventory adjustments.

Our fiber channel controller [inaudible] did grow 8% sequentially quarter to quarter and we introduced the industry's broadest offering of 4 gigabit fiber channel solutions at Storage Networking World, spanning ICs, fiber optics, and storage area network best solution. We also received our first sample orders for 4 gigabit tachyon products from a number of our customers.

Operating profits in the quarter were $65 million, that is up $108 million from last year at this time or a 72% year-to-year incremental performance. Operating margin was 12% in the quarter, compared to 13% in the first quarter of this year. Sequentially profits were only up $5 million, because we transitioned from [inaudible] cameras to VGA where yields are not yet quite as good as with the mature [inaudible] processes.

We also saw particular pricing pressures in networking systems this quarter, that we were not able to completely offset with lower costs. Nevertheless at 34%, we believe we are achieving best in class returns on invested capital in this segment.

Finally, it was another good quarter for life sciences and chemical analysis with orders reaching another all-time high and with double digit order growth across all market areas and geographic regions. Net orders of $338 million were up 21% from last year, and up 10% sequentially. Both chemical analysis and life sciences were up 20-21% year-over-year. Revenue of $333 million was up 16% from last year and up 6% sequentially. Book to bill again above one at 1.02. Growth was driven by the need for test equipment in food safety and environmental markets. Increased spending by large pharmas and generic drug manufacturers and continued improvements in domestic and international economies.

Within life sciences products, which represent about 42% of LSCA, orders for our gene expression platform grew 29%. In chemical analysis continued economic expansion, particularly in Asia, drove growth. Asian infrastructure requirements for food and water testing, chemical and petroleum production were higher.

We also saw strong demand for our GC products designed for the Chinese markets and with higher demand from the governments of Thailand and Turkey for food safety testing.

Operating profits in the quarter were $39 million. Up nearly double from last year at this time. An incremental performance of 40% year to year. Operating margin of 12%, a return on invested capital of 21%. We have tried to emphasize that there is a heavy second quarter spending seasonality to this business and consistent with that operating profits were down $10 million from the first quarter. However, at 12%, the segment achieved its first second quarter double digit margin in memory with operating profits nearly double one year-ago. ROIC remained at an attractive 21% compared to 15% last year at this time.

Finally, turning to guidance. Ned provided the guidance for the third and fourth quarters so I won't repeat that. What I would emphasize is that last fall we said we would reach a $1.4 billion breakeven cost structure by the end of this year. We exceeded that target in the first quarter, but we did not fully retain those gains in the second quarter, in part because of expected increases in fixed and seasonal costs. In part because of the impact of the falling U.S. dollar that we are not going to try to offset and, in part, because of the unexpectedly high variable spending. The guidance that Ned offered is consistent with Agilent getting back to a $1.45 billion breakeven cost structure by the fourth quarter or to the original commitment adjusted for currency.

At this point let me turn it back to Hilliard.

Thanks, Adrian. Keith, at this time we are ready to take questions, and in terms of the first round of questions, if you could limit your questions to one question unless we cycle through the questions, we will not take follow-up questions..

Thank you, the question and answer session will be conducted electronically. [Operator Instructions] We'll pause a moment to gather our roster.

We will go first with Edward White, Lehman Brothers. Please go ahead.

Hi, I just was wondering if you could talk a little about some of the things that you can do in the test and measurement group to further bring the costs down there. You know, over time it has been a big effort and a successful effort to turn that business around from the losses that we were looking at before and I know that one of the objectives, you know, over time has been to really work on the SG&A there and I guess now with this quarter's performance and your comments, you really want to work on that. Can you talk about some of the specific things you do to make progress there?

Let me start off Ed and then I will turn it over to Adrian. This is Ned.

First of all, as we said, test and measurement has borne the major part of our ERP and our customer support systems implementations for the last year or so. So we have continued to see costs up through the second quarter, we expect those to begin to tail off in the second half of this year. As Adrian mentioned we have had particular issues in our test and measurement area in our systems and support area. If you look at just our box products, our RF and microwave and general purpose instruments we are actually doing quite well. But if you look at some of the services area, we have had some -- we have had some issues in cost structure. We have had some issues with -- in our systems area with some business that we took awhile ago that was not very profitable and also in here included in test and measurement is our OSS network management systems solution business, which is still ramping in volume and it is frankly running behind plan this year to get to the volume levels that we wanted -- that we want it to be. But the funnel looks very good and we are optimistic that we will see increased volume in the second half and we are continuing to take action in that business to make sure our costs are in line.

Ed, the only thing I would add is that if you compare how we are doing in test and measurement today to our long-term operating model we are 2-3 points away from that model in SG&A. In R&D we're right there. The biggest gap is in gross margins where we are still 4-5 points away from where we should be and the reality is, as Ned suggested, we took some bad business over the past, particularly systems business and we have both cost and pricing issues that we are in the process of correcting.

So how do you -- so how does that get corrected? In other words, those contracts just run out eventually or can you re-price them or what can you do with that?

They just run out.

Most of these were things that were shipped in the second quarter. We have also, I think now that we have got a lot more visibility with our ERP systems we have much better visibility with backlog and what is in there from a pricing point of view, so we feel very comfortable we're going to be able to make progress in the third and fourth quarter. I would also say, that as we -- as we -- as we went live with our -- what we call Project Independence, our customer support systems, we frankly lost a little visibility for about probably about nine months or so on parts pricing and things like this, which we are in the process of correcting. We did make some price increases in May and we look -- again going forward we believe that those businesses are going to perform a lot better.

Okay. Great. Thank you.

We will go next to Deane Dray with Goldman Sachs.

Thank you, good afternoon.

Ned, if we could follow up, by just clarify the point you just made there regarding a price increase. So, for test and measurement, can you give us a sense of how much of the problem -- the margin shortfall is pricing related and how much is costs? And then within that cost, how much was variable and how much was fixed, just in terms of the shortfall this quarter?

Well, I will think the pricing issue I was talking about had to do with our parts pricing. And that is a very, very small part of the overall revenue and so, in general, our prices have been very stable. In fact, we really haven't done any significant price increases here for over six months. We -- and the instrument products. But we are continuing to look at some of these system business, particularly in the -- in the customer support area, the -- some of the custom solutions deals we do that integrate a number of our products with, frankly, some of our competitors' products, to try to provide integrated turnkey solutions to our customers, in those kind of businesses we just have to be a lot more selective about which businesses we take and not take. So it is not an instrument pricing issue per se. Its really more making sure we understand the costs and making sure we only take business where we know we can make good margin.

Dean, what I would add to that as well, is that our level of discounts has improved after being stable at a very high level for the better part of two years pricing has improved by 1-2 points in the last quarter and we expect that trend to continue as well for the remainder of the year.

The other thing I would add, again in the area of pricing, we are seeing a more favorable pricing environment. Part of that is driven by the fact that the gray market is finally drying up. If you look at things like board testers, a lot of the used test and measurement equipment out there, a lot of that is down to very, very low levels to where customers are having to order new stuff again and that is good news.

We will go next to Brett Hodess with Merrill Lynch. Please go ahead.

Along similar lines in your prepared remarks you also mentioned that the semiconductor side, I think, had some cost issues in the quarter. Were those yield-related or capacity constraint related? Can you share with us what is going on on that side? As well as what you mentioned that demand outlook for semis looked good. Could you talk about the segments within the semiconductor side and how demand looks for the sectors?

I think just a couple comments, Brett. First of all, as Adrian mentioned we are converting over from the, you know, from our CIF format into VGA, so we had our yields up at pretty high levels for the older CIF formats, but as we transition into VGA here in the last quarter, yields were lower and therefore the costs were higher. We will get back to yields, higher level yields here over the next quarter or so in the VGA area.

Also, as Adrian mentioned in our networking area, we count on some ongoing price erosion over time in our fiber optic transceivers and we have -- we've seen a reduction in the average selling price there. We have plans in place that will reduce the costs to keep the kind of margins we want to see in that business, but all those cost changes haven't kicked in yet. So we saw the price decrease prior to seeing the cost benefits.

If you want to add to that.

I would just add to that that this is a business that is growing rapidly and we are changing three generations of cameras, for example within a period of 18 months, so spending is rising. We are now the number two supplier of the camera modules worldwide and we intend to be the winner with the megapixel so there is some selected spending going on for this business which does have a very attractive return of 34% return on invested capital.

In terms of the segments, we continue to be very bullish about the mobile phone solutions. We are continuing to ramp in that area. We continue to win new designs in the -- both the camera area, FR as well as our [inaudible], so we are looking for continued strength there. The networking side has been relatively flat as Adrian mentioned this last quarter. I think [inaudible] we are going through a little bit of a transition in the market, but again we feel like we are in a very strong position, we have a large market share. We have been investing in areas like storage, our 10 gigabit ethernet and other areas where we expect to see improved outlook going forward.

We will go get to Ajit Pai with Thomas Weisel Partners. Please go ahead.

Good afternoon.

Hey, Ajit.

Could you add color on the networking systems, both in terms of demand as well as, you said, there was pricing pressure [inaudible] cost pressure, whether it was on the ASIC side and the fiber optics on [inaudible] side, and what you are seeing in those markets?

Yeah, let me start on the ASIC side, we are continuing to ramp business with Cisco. We are continuing to do very well with HP on the -- on the server side of the ASIC market. So we continue to see very good results in our -- in our ASIC business. On the networking side. I think the overall flatness that you are seeing in our numbers is really more of the price erosion on the -- on the fiber optic side and as a result of not having all of our cost reduction programs implemented yet, that, that impacted our margins. But, we do see a lot of opportunities still in networking components, fiber optic components. As I mentioned, storage is an area we've invested in quite a bit. We are having great success with our 4 gigabit rollout that we did a month or so ago and we are continuing to ramp additional ASIC business with people like Cisco and HP. So, going forward we continue to see very good growth there, but probably not at the kind of growth rates we expect to see in the personal systems area.

So you would say that the gross margin impact sequentially is driven more by test and measurement down about 1.2% than the semiconductor product group?

Yes, Ajit, simply by the relative math that would be accurate.

Okay. Thank you.

We'll go next to Steven Koffler with Wachovia Securities. Please go ahead.

Good afternoon.

So I think I will limit my first question to China. The results out of China for technology and communications companies was decidedly mixed off the Q1. I wonder if you could comment on your outlook for wireless handsets. The -- the first quarter results for the industry were overall a pretty big upside surprise, inventory sold through, there is good demand for new features, but with all of the concerns about the overall economic environment there is it prudent to be expecting, and I'm not saying that you are, but should we be expecting just flat or even down results? And what about pricing? This countered what I just said, there is some indication that prices are increasing in the consumer market. What are you seeing there and how are you thinking about that relative to your future results?

Well, just a general comment on China. Our business in China did very, very well in the second quarter as Adrian said. Our overall Asian business was up 37% and China is our third largest country in the world for us, so China did very well for us. Part of that is driven by multinationals. The multinationals that make wireless handsets and other products in China. It is driven by some of the new semiconductor companies that are building capability in China. So, overall, we do very well with the, you know, the tier 1, the top tier wireless handset manufacturers. I think it is -- it is probably fair to say that over the last year or so we have also increased our presence and increased our market share with some of the tier 2 and tier 3 players in China. But, you know, at this point in time, it is hard to predict exactly what the demand is going to be going forward and my guess is there probably is at some point a little bit of excess capacity there with some of the second and third tier players. However, that is a small part of our total business compared to the tier 1 players. Overall, we are not -- we are not concerned about China. China is not going to continue to sustain the kind of growth rates we saw this quarter, that is not possible. But we expect that China will continue to see excellent growth rate the rest of this year and on into '05.

Does that -- are you thinking more year on year or sequential when you make that comment, Ned?

I think certainly year-over-year was what I was referring to with the 37%. But, even sequentially it was up over our first quarter. Now, given all of the, you know, recent articles about inflationary pressure in China, that may moderate a little bit, the growth rate sequentially may slow down, but it is still going to be, we think, a very strong year-over-year growth rate for China, you know, going forward.

Thanks.

We will go next to Mark Fitzgerald, Banc of America Securities. Please go ahead.

Thank you. I was wondering if the exercise of options had any material impact on your free cash flow for the quarter or in the low tax rate?

Mark, no, no impact whatsoever on either free cash flow generation or on our tax rate.

And can you give us some idea where the 2005 where the tax rate would be?

At the moment we would be comfortable with the same kind of roughly 30% that we have been indicating for our long-term rates.

Okay. Thank you.

We will go next to Arindam Basu, Morgan Stanley. Please go ahead.

Hi, gentlemen.

On the semiconductor products and test and measurement businesses, are you struggling on the manufacturing of sales process side or do you need to better manage competitive bid situations? And, you're calling for 800 basic point operating margin improvement. And what would you say is the biggest component of that operating margin expansion.

I'm not sure I understood the first half of that question. But in the test and measurement slide where we are talking about an 800 basis point improvement it is about 4-5 points in gross margin and 2-3 points in SG&A.

Okay and then the first part of the question, I guess, was on the actual -- you talked about the test and measurement business in terms of taking some unattractive business, was that a sales process issue or just needing to better manage competitive bid situations?

I think part of it is lack of visibility. Again, we just -- we are just using -- learning to use a lot of the new tools that we have if place here, the new ERP system and we didn't have all of the capability turned on to allow us to look at the profitability of projects on a deal by deal basis. We have much better visibility today and are a lot more confident of our ability to bid the proper price going forward. But going back six months ago and nine months ago when some of these deals were taking we had not turned on all of our project management modules.

I would say it is sort after combination of that and you have to remember 6-9 months ago things were looking still pretty dark so there is more after temptation to take a deal, especially a big deal [inaudible] big custom deals that covers a lot of volume. And when you don't have the visibility and don't have the tools that you are absolutely positive you know what you are bidding on you can make a mistake and I would say we made a few mistakes in that regard that we have since corrected.

On the megapixel camera market were you talking about volumes or initial shipments next quarter?

We didn't say next quarter.

We haven't made any announcements yet on megapixel, but we expect that we do expect that we will be ramping our volume there later this year.

Okay. Thank you very much.

We will go next to Richard Eastman with Robert Baird. Please go ahead.

Hi, Adrian, could you just talk, I just want to stay on this -- the TMO segment for a minute here and just talk about this margin issue, but can you just define,you know, the size of the cost overruns that we are talking about? It if we are working off an op profit of $11 million, just can you put some feel, give us some feel for what kind of cost we absorbed here in the quarter that should go away in the next quarter?

I'm not going to get into the specific quarters and I think I did give you those numbers if you think back to the ratios that I just gave you. It is a 4-5 point problem in gross margins and it is a 2-3 point problem in SG&A.

Okay.

That will -- do the arithmetic and that will get you the numbers.

All right, let me also ask you on the ATG side of the business. With orders kind of running up here at about the 240 million dollars range, I'm just sure curious as to how you view that number relative to, you know, the last peak and if there is some market share gains to be had here or?

Well, the order number was 286.

Just on the semiconductor side.

Oh, on the semiconductor part is 240.

Yep.

Yeah, remember, you know when we had our last peak in 2000 our market shares were probably about a third of what they were -- are today. So -- so, you know, we did -- we did pretty well in the last up cycle, but expect that we will do a lot better at the peak of this up cycle given the fact we have a much bigger presence.

Okay.

Richard, we don't think we are even close to the cyclical peak. The manifestation of our being at peak levels [inaudible] great market share [inaudible] net over the past 4 years, we really believe we are still in the third or fourth inning of this game.

Okay. Very good. Thank you.

By the way, congratulations.

Thank you.

And just another comment about market share, too. On semiconductor test, market shares going to move around in this business based on who has what installed base. You know, because -- because some of our competitors have been in the market a lot longer, have a bigger installed base, particularly with some of the IDMs, you know, they do very well when the business turns back on again. But we are continuing to win new business. We are very pleased with the number of design wins. And I think we are continuing to build our strength and our presence in the market.

Thank you.

We will go next to Paul Coster, J.P. Morgan. Please go ahead.

Yes, gentlemen, could you just give us sense of which industry segments surprised you in terms of the strength this quarter and/or in terms of the orders that came through? Any industry verticals?

Well, actually, I wouldn't say there is a huge surprise. Again, we have been expecting to see an upturn here expand from the semiconductor side into some of the broader industries. And that is what really happened this quarter. We didn't know exactly when that would occur. But the fact our test and measurement business is up 16% sequentially I think is really good news. And that is the first -- first time we really seen a good strong sequential increase in our test and measurement side. So, we -- we knew that was probably going to happen. We didn't know when so we were pleased that it happened this quarter. We are also pleased that we have continued to see strength in our LSCA business and are getting stronger business there as a result of the overall strength of the economy. So those are the probably the two positive surprises. We have expected that we would continue to see strength in the -- in the semiconductor component, semiconductor test businesses and, as Adrian said, we don't believe we are done with this cycle yet.

Can I just follow up on those two points then on the test and measurement sides, can you give us the latest thoughts on the gray market? And on the LCSA side, what is the -- the sort of component that -- where is the growth coming from, is it from consumer boards or from the platform sales?

Well, in terms of the gray market in test and measurement, as I mentioned earlier, it is getting down now to a very, very low level. In fact, in the -- in our board test area or automatic test business it is virtually zero so customers are now are starting to order new systems again. If terms of general purpose instruments, it is also at very, very low levels. There still are a few optical products out there but, again, compared to where it was a year or two ago it is fraction of the level it was. We are actually beginning to see some upturn even in our optical physical layer test and measurement business, as some of these gray market competitors are running short of supply. In terms of LSCA, it is, you know, it is pretty much related to broad economy. We've got upturns in the environmental markets. Food safety is a big deal, particularly in Asia. We are seeing pharmaceutical spending turnup this year. So it seems to be pretty much across-the-board in virtually all of the LSCA related businesses.

We will go next to Richard Chu with S.G. Cowen. Please go ahead.

Thank you very much.

One of the -- certainly one of the key commitments that you have been making on this managing through this cycle here is the commitment to cost expense disciplines and the operating leverage in the business so you had a terrific quarter with huge volume I find did not have the commensurate operating leverage and you are now recommitting to cost levels that you had previously discussed for Q4. I guess my question is when did it become apparent that gaps were developing in the execution side? When did you start taking some of the corrective measures that are required to converge towards the reaffirmed billion four plus Q4 cost target that you are now talking about?

Well, I think, you know, we started to see a little bit of an upturn -- February is always a difficult month because it as short month. We started to see a little bit upturn in our expenses in March and took immediate action there. But probably the bigger thing is it was clear that we were falling behind our plan and what we wanted to do in test and measurement and we have taken immediate action in April and early parts of May here to get back on track in Q3. So, I think as soon as we saw the, you know, the broad across-the-board expenses increasing we have taken action to get those under control. There is all kinds of new messages going out about that over the last month or so. But the most important thing is we have got to get test and measurement back to a much higher level of profitability in Q3 and those are the -- the additional plans to make sure that that happened were put in place in April.

And to clarify, I think Adrian's comments about margin issues, you said there were many, many smaller factors. I wondered again in looking at semiconductor products in particular, you focused on the VGA transition in the image sensor side and some of the [inaudible] transitions. Were there no other comparable issues of size? Was it literally those two that overwhelmed the other contributors to the margin?

No, Richard, we could sort of dissect where the big increases occurred. There were large increases in travel. There were large increases in employee training. There were increases in materials and supplies. Some of which are lumpy when you are going from sort of flat on the bottom. Everything isn't quite smooth and you have to increase in chunks. And we had a lot of of R&D material, for example, as well. So, it was not pretty. And to take semiconductor products, there was some investment in order to make sure we got the yields up for the new generation of cameras, as an example. But, I think more generally what it is is what we suggested earlier, the tide is rising and spending is increasing and it is difficult at the time in realtime to figure out how much of that is justified, how much will be reversed and how much of it is going to accelerate. You only know after of the quarter for certain whether you made the quarter, whether the commitments were made or not. But, I can tell you as soon as it became clear, as Ned suggested, the test and measurement and other areas that we were not going to get control back on some of the expenses that action was taken.

Is it $1.4 billion or 1.45.

They are the same -- Richard they are the same number. The 1.45 is currency adjusted. When we made that commitment last fall the dollar was at a certain level. Since that time we have had a $50 million measured increase in our cost simply because the dollar has dropped. So, our commitment, assuming the dollar stays where it is is today, is 1.45 billion, which is the same in real terms as the 1.40 that we committed to last fall.

Okay, thank you.

And remember the -- the dollar drop, even though our expenses are higher we also get higher revenue so the net on the bottomline is a zero impact. So that is why we feel that the higher expense breakeven is appropriate given the fact that there is no net impact on the bottom line.

You had been segregating unusual costs on the IT side in recent quarters. Is that now or was that all behind you in Q2?

No, Richard, it was about $25 million in Q2 as we mentioned. We had a climatic implementations in February, so there was a surge of spending, actually a little bit higher than the first quarter, but we will be now dialing that down so that it is eliminated by the end of this year from a level of about $25 million of extraordinary costs in the second quarter.

Thanks, Richard, operator at this time we have time for one more question.

Thank you. For our final question, will be taken from Terrain Cona with Wellington Management. Please go ahead.

Hi. Just two quick questions. Just on the share count. We saw that increase and I'm wondering is that related to the convertible that you were referring to earlier in the call?

No, it was not. The convertible will add $36 million and it will be added to the current share count beginning in Q3.

Okay.

36 million shares.

Okay. Great, and just one more follow-up question. I guess, you know, you guys have done a good job in terms of the whole restructuring, but as I look out, you know, this is more of a philosophical question you are still very closely tied in to Hewlett Packard and I guess that can be good news and bad news. I guess the bad news is you continue to lose share to Dell. I'm just curious as to how, you know, this impacts you guys on a longer term basis, in terms of your ability to go in and chase the likes of Dell for business because you do have long-term contracts in place with Hewlett that, perhaps, prevent you from doing that.

Terrain, I would disagree with you really emphatically -- the percentage of our business with HP is well below 6%.

Yeah, I think if you can look at when we first launched the company, you know some where around 10% of our revenue, or 8--10% of our revenue came from HP and it is now down -- I think it is well below 6%. And, we sell -- we sell ASIC so we sell ASIC into the high-end servers. We sell ASIC and solutions -- component solutions into some of the printer products. I guess the calculation now is it is 4%. So we have gone from 8-10% to around 4% of our revenues with HP. So we have been -- we have been quietly weaning ourself from HP. I don't think we have anywhere near the dependence we did. It is a smaller smaller part of the company. They are still a very large customer and important customer, but we have lots of important customers for our company.

Thank you. At this time we will conclude the conference call. We look forward to you joining us when we report the third results in August. Thanks for joining us.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect at this time. We thank everybody for their participation.