Advanced Energy Industries Inc (AEIS) 2004 Q3 法說會逐字稿

Good afternoon, my name is Dawn, and I will be your conference facilitator. At this time I would like to welcome everyone to the Advanced Energy third quarter results conference call. All lines have been placed on mute to prevent any background noise. After the speak's remarks there will be a question and answer period. If you would like to ask a question during this time, simply press star then the number 1 on your telephone keypad. If you would like to withdraw your question press star then the number two on your telephone keypad. Thank you. I would now like to turn the conference over to Mrs. Cathy Kawakami, Director of Investor Relations. Mrs. Kawakami, you may begin.

Thank you. Good afternoon everyone and thank you for joining us today. Doug Schatz or Chairman and Chief Executive Officer and Mike El-Hillow, Executive Vice President and Chief Financial Officer will be today's speakers and will provide an overview of the results before they open the call to take your questions. By now you you should have received a copy of the press release that we issued approximately one hour ago. If you still need a copy of the release, please call us at 970-221-4670 or you can view the release on our Website at www.Advanced-Energy.com. Before we get started this afternoon I would like to remind everyone that except for any historical information contained herein the matters discussed in this conference call contain forward-looking statements subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Such risks and uncertainties include, but are not limited to the volatility and cyclicality of the semiconductor and semiconductor capital equipment industries. The timing of orders received from our customers and our ability to execute the realignment initiatives currently underway. Other risks that are described in our forms 10-K, 10-Q and other reports we file with the SEC. In addition, we assume no obligation to update the information that we provide to you during this call. I'll now go ahead and introduce Doug Schatz.

Thank you for joining us this afternoon. Today we reported sales of approximately $93.6 million. Which is in line with the revised expectations we issued on September 29, and down 14% compared to the sales of $108.9 million in the second quarter of 2004. We were one of the first Companies in our sector to describe a leveling of orders back in April. We said in July that the environment has begun to decline for the foreseeable future and this view has been confirmed by several companies in our sector in recent weeks. Although there are a number of positive growth drivers that open windows of potential in 2005, no one has clarity around the patterns that this cycle could take. We continue to reposition the focus of our manufacturing sites. As part of our plan to streamline operations, reduce manufacturing and repair costs and strengthen our long-term competitive position, we identified Shin Zen (ph), China as our high volume manufacturing location. Given the local engineering expertise here at Fort Collins we determined that our local manufacturing site would focus on innovation and advanced manufacturing processes today we announced specific action we are taking to complete these transformations, (INAUDIBLE) completion timeframe of late 2005 we expect to refocus our Fort Collins manufacturing facility on new product design and launch programs. The core areas of focus will be agility and innovation, integrated services, legacy products, low volume products, and advanced quick turn manufacturing. As part of that plan we have communicated to our employees that our Fort Collins operations head count will be reduced by approximately 200 employees over the course of the next nine months as we continue to transfer production lines to Shin Zen.

This head count reduction represents about a 12% of the Company's worldwide employee population today. Once the transition has been completed nearly all of our manufacturing volume will be produced in Shin Zen and will reduce redundancies that have contributed to high labor and overhead expenses during the past year. China-base manufacturing is a long-term investment in AE's future. It increase our ability to compete by enhancing our ability to deliver high quality products at a lower cost. When we embarked on this strategy we set aggressive goals and aggressive timelines because we understood the importance of establishing a major AE footprint in the fastest growing region in the semiconductor industry. In our Q2 2004 conference call we talked about making significant product revs on the China initiative by the end of this year. By the end of 2004, we will have the operational capability to produce 70% of the Company's manufacturing volume and Shin Zen as a result of having successfully transferred 17 power and flow product lines. When we began the transition to China we focused on our established high volume production lines. These were predominately 200 millimeter related products they were more stable and represented the lowest transfer risk. However, because of the lower expected revenue level and product mix shift that is predominantly 300 millimeter related Fort Collins will continue to provide approximately half our actual production volumes until additional 300 millimeter production lines can be transferred. We believe that will see significant material cost savings from our tier 1 and Asian supply chain initiatives. Both tier 1 and smaller Asian-based suppliers give us cost and delivery advantages at the same high quality level we require, we are midway through our qualification process aimed at transferring the majority of our addressable material spend to tier 1 and Asian based suppliers. This program ties in well with the ongoing transitioning to China manufacturing as it increases the operating efficiencies in Shin Zen by synchronizing our power, our product, and supply based transfers in Asia.

We are also driving increase efficiency in the products group. We started to see the benefit of a much more focused R&D program in our Q2 results. We continue to reduce the level of R&D spend in the third quarter by focusing resources on high-growth opportunities around our core competencies. We are driving this focus on more careful R&D spending, as well as a much more aggressive end of life program that will help reduce manufacturing and support costs, while also reducing the complexity of our business. Product highlights in the quarter include continued success of the mass flow control business as our latest product introduction, the Transformer Mass Flow Controller continued to be accepted by key customers worldwide. In addition, our sales to flat panel customers grew sequentially as Mike will discuss in a moment despite an overall pause in that industry. We continue to see strength because of a new product introduction that's a revolutionary way to integrate DC power supplies. This solution is specifically targeted for flat panel display PVD processes we will be discussing this new product platform in the months to come, but expect it to drive flat panel displays higher again in the fourth quarter. Despite an uncertain industry environment, we are focusing on what we can control. We are very optimistic about our future as a market leader and technology innovator we see important changes taking hold through the product groups and throughout operations. That will have positive, lasting effects on future performance and market position.

And our innovation continues. Owe newer products are become a more significant portion of our sales volume, and will continue to increase as a percentage. For the first time the majority of our power product sales are for 300 millimeter wafer processing tools. We are holding our core market position and we are maximizing opportunity for share growth in critical applications. We've maintained a market leading position by delivering value and expertise and by enhancing the performance of of our customers' most advance manufacturing processes. We have much work do in the next few quarters to meet our goals financially, operationally and logistically, but I'm confident in our management team and I'm confident in our employees. We have the right plans with the right priorities and we are making progress. I will continue to update you as we reach critical milestones along the way. Now I would like to turn the call over to Mike El-Hillow to go over the details of our financial results.

Thanks, Doug, and good afternoon everyone. I will review the results of the third quarter and then provide guidance for the fourth quarter of 2004. Revenues for the third quarter 2004, 93.6 million, 14.1% lower than second quarter 2004 revenue of 108.9 million. Year-over-year revenue increased 36.4% compared to third quarter 2003 revenue of 68.6 million. Gross margin was 31.8% for the third quarter of 2004 compared to 34% for the second quarter of 2004. Third quarter 2003 gross margin was 33.7. Gross margins declined sequentially based primarily on the lower absorption of overhead, however margins continue to be impacted overall high volume manufacturing facilities we are currently supporting in Shin Zen, China and Fort Collins, Colorado near term. As Doug described we are significantly realigning our Fort Collins facility so that we can realize the benefits of centralizing nearly all of our volume manufacturing in Asia throughout the next year. Net loss for the third quarter of 2004 is $1.1 million or 3 cents per share compared to second quarter 2004 net income of 4.5 million, up 13 cents per diluted share and the third quarter 2003 net loss of 27.4 million or 85 cents per share. We had positive income from operations of 1.9 million and were essentially break even on pre-tax basis. However, despite the pre-tax break even we had tax expense of nearly $1million due to taxes on foreign based income without any tax benefit for our U.S. based losses.

As you may recall we took a full valuation allowance against our U.S. based the first half of last year and we will not be able to recognize any tax benefit on the U.S. based losses until we reduce that valuation to zero. The 2004 third quarter, we had $32.7 million weighted average common shares outstanding compared to 32.3 million weighted common shares outstanding in the third quarter of 2003. Semiconductor capital equipment represented 61% of total third quarter 2004 sales or 56.9 million, down 19% compared to 70.2 million in the second quarter of 2004. In the third quarter 2003, sales of semiconductor capital equipment customers represented 55% of total sales or $38 million. As Doug discussed demand from our semiconductor OEM customers declined during the third quarter due to a general market softening. We anticipate the lower booking rates to continue into the fourth quarter. Applied materials our largest semiconductor capital equipment customer represented 28% of total third quarter 2004 sales or 25.8 million, down 22.4% from second quarter 2004 sales of 33.2 million. In the third quarter of 2003 Applied was 17% of total sales or 11.5 million. Flat panel display sales represent 14% of third quarter 2004 sales or 13.5 million, this represents sequential increase of 4.3% in dollars earned compared to 12.9 million of total sales in the second quarter of 2004. Flat panel display represented 7.1 million or 10% of sales in the third quarter of 2003, a year-over-year increase of 88.8% in dollar terms. Demand for a new DC product drove the sequential increase in flat panel display demand and we expect to see a similar pattern for the fourth quarter as a specific customer takes additional products on an accelerated basis. Although there is some softening in this industry in general we are benefiting from our strong position as a major industry player and from an innovative new product platform that addresses the need of a larger glass panel manufacturing processes.

The data storage industry which is compromised of the optical data storage market, including digital video disc and compact disc and the magnetic data storage market was 6% or 5.7 million of third quarter 2004 sales which represents a decrease in dollar terms of 41.7% when compared to second quarter 2004 sales of 9.9 million. This market represented 13% of total sales or 9.2 million in the third quarter of 2003. Always seasonal we experienced an earlier drop off in sales (INAUDIBLE) as they completed their holiday season preparations. Advanced product applications represented 19% or 17.4 million of total third quarter 2004 sales. An increase of 9.8% compared to 15.9 million of advance product sales in the second quarter of 2004. This market represented 21% or 14.2 million of total sales in the third quarter of 2003. In addition to architectural glass advance product applications include a variety of ap cases, such as our eye core power for five (ph) for the high-end computing market, industrial coding and laser and medical applications. Looking at sales by geographic region, North America's sales represented 53% of total third quarter sales compared to 54% in the second quarter of 2004 a decrease of 17% in dollar terms. North America's sales represented 42% of total sales in the third quarter of 2003. Sales in Europe represented 14% of total third quarter sales compared to 18% in the 2004 second quarter, a decrease of 32% in dollar terms. Europe represented 22% of sales in the third quarter of 2003. Asia Pacific represented 33% of total third quarter sales, up from 28% in the 2004 second quarter an increase of 2% in dollar term. Asia Pacific represented 34$ of total third quarter 2003 sales. We ended the third quarter of 2004 with a total backlog of 44.4 million compared to the second quarter 2004 backlog of 53 million.

R&D spending was 12.6 million or 13% of sales in the third quarter. This compared to 12.8 million or 11.8% of sales in the second quarter of 2004 and 13 million or 18.9% in the third quarter of 2003. We have been successful in carefully managing our research and development spending by focusing resources on a critical few opportunities that can provide maximum impact. SG&A was 14.4 million or 15.4% of sales in the third quarter of 2004 compared to 14.1 million in the second quarter of 2004 or 13%. This compares to 12.5 million in the third quarter of 2003 or 18.3% of sales. Amortization of intangible assets stayed constant at 1.1 million for the third quarter of 2004, the second quarter of 2004 and the third quarter of 2003. Head count at the end of the third quarter was 1,697 people of which there were 1,471 full time and 226 temporary employees, total head count remained unchanged quarter over quarter although the mix continuous and temporary shifted slightly. Doug mentioned that we have planned head count reduction in Fort Collins, Colorado that will occur throughout the next nine months. We are evaluating the staffing needs of the China facility based on industry demand and will staff as appropriate during this transition. At the end of the third quarter our cash, cash equivalents, and marketable securities totaled 112.8 million, down from 124.4 million at the end of the second quarter.

Our accounts receivables were 74 million for the third quarter compared to 79 million in the second quarter of 2004. Days sales outstanding was 66 days in the third quarter of 2004 compared to our typical 60 to 62 days. Our DSO are higher than historical amounts due in part to an increase in sales to foreign customers and certain U.S. based OEMs unilaterally extending their payment terms. The increase in DSO is not indicative of any collectibility problems. Third quarter inventory was 91.1 million compared to 83.7 million in the second quarter of 2004. Inventory turns in the third quarter were 3 turns compared to 3.6 turns in the second quarter and 3.2 turns in the third quarter of 2003. Total days inventory was 122 days up from 103 days in the second quarter of 2004 and 115 days in the third quarter of 2003. Inventory has grown substantially as a result of the move to China and a response to higher than forecast demand earlier in the year and our aggressive focus on short lead time delivery for our customers. Given revenue shortfalls against our original second half forecast we implemented significant control measures in early July that have begun to show progress. In September we saw our first month of decline in inventory and have plans in place to exit the year with significant inventory reductions.

Our capital expenditures in the third quarter were 5.1 million compared to 3.6 million in the second quarter of 2004 and 7.1 million in the third quarter of 2003. We expect CapEx to be approximately 15 million for the full year 2004. Depreciation was 3.7 million in the third quarter compared to 3.5 million in the second quarter of 2004 and 3 million in the third quarter of 2003. Based on the expectations for continuing declines in booking rates we believe fourth quarter sales could decline 9-12% below the third quarter levels to 82.5 million to $85 million range. We anticipate a loss per share range of 15-20 cents. Fourth quarter gross margins should range between 27.5 and 28%. Gross margin will continue to be impacted by the lower absorption rates, the continuing duplicate manufacturing cost issues, and the higher cost due to the accelerated shipments of the new DC product. R&D will be flat compared to the third quarter of 2004 and SG&A will be down approximately $2 million, including the amortization of intangibles. We continued to take appropriate action to align our cost structure with the dynamic industry environment. We have notified our employee's that our U.S. base will shut down for 11 shut down days in the fourth quarter. The potential revenue impact and the decreased number of work weeks in the fourth quarter has been factored into our guidance range. However, actual shipments will depend on our customer's work schedules. We continue to evaluate demand patterns in our outlook and will make appropriate adjustments to our spending plans as necessary. Doug and I would like now to take your questions so operator, please open the lines for questions. Thank you.

(OPERATOR INSTRUCTIONS) Your first question comes from Chris Whinesmith with J.P. Morgan. Chris, your line is open.

Can you hear me now?

Yes.

I wanted to get a feel for your amount of exposure to the Japanese OEMs versus North American OEMs?

There's one major OEM in Japan that we have very little power business with, but we have quite a bit of flow business with. We sell quite a bit of flow into Japan and then we have some major relationships with some of the large non-semi supplies in Japan in the flat panel space and into particularly the magnetic media areas. So Japan has been strong for us this year, and actually is strengthening.

One also question is you quit giving guidance on service and spares a few quarters ago, but I wasn't sure if you can give a ball park figure on where that is?

Depending upon actual sales on anywhere from say 9-12% of revenue.

So it's still tax -free linearly to what it was in the past?

Essentially yes.

Your next question comes from Alexander Paris with Barrington Research Associates.

Good afternoon,

Hi Alex.

I just wanted on the transition you said just now that you expect to hit your target of 70% of your manufacturing there by year-end 2004 and I think at your last conference call you said you had dropped that down to 60 to 70% did that kind of improve? Are you moving faster than you thought?

Well, there was two messages in there, one is the -- when we started off at the beginning of the year and the beginning of this plan, Alex, we targeted 70% based on a mix of products. And the simplest way to describe describe the mix of products has been the transition from 200 to 300 millimeter we also said that we were taking our more mature products back and so those obviously tended to be 200 millimeter products, so in the past quarter we have seen this really rapid uptick into 300 millimeter and this quarter actually went over 50% in terms of our power products. And so we wind up with manufacturing capacity that still will work for our initial target, our original target of 70%, but the product mix is changed away from that. So we're actually going to be at about 50% of realized utilization and that's prompting to us accelerate, as much as we can, the transfer of the products beyond the first 17 product lines, so that we can get more of the 300 millimeter capacity in Shin Zen.

Is the realignment in Fort Collins is this part, I think you said you also want to just realign the domestic products facilities is this -- the fact that you are starting this now and you are taking some of those products from Fort Collins are going to China, right?

Yeah. I think the easiest way to look at this and maybe even from a modeling point of view is that we started off with this enormous project that we were very aggressive about scheduling and so if you look at a project running at about 3.5 to 4 million a quarter for a number of quarters and now we are looking ahead into next year basically at that same run rate. That project is being used to transfer all of the products in Fort Collins, other than the few legacy products, those that are too inefficient or too early in their maturity where using that project at almost a constant dollar rate right now to transfer things as fast and as completely as we can. So what you're going to see over the course of the year is the realignment of Fort Collins into a specialty manufacturing, very high-performance product design and launch and service and repair organization for North America, and at the same time, you'll see the cost of having to run the duplicate logistics, the duplicate manufacturing and the added complexity associated with moving materials back and forth between here and China and you will see those costs starting to disappear.

Your original goal was when this was all done to get to $60 million quarterly break even level, right?

Alex that's correct. About a year ago we moderated that slightly to 70 to 75 million the real change is that when we looked at the opportunities available to us through our continual issue of technology we decided at least currently not to take the R&D level down to the level that would be necessary to meet that lower break even point. Of course as we move forward and we see those opportunities variable to us, we may change it, but as of today the intent to is keep R&D in the 11 to $12 million city/state range to get down to the much lower break even would require us to take that down to about 9 to 10 million other than that, the plans are moving forward as we thought a year ago.

Okay. To get to whichever the goal is to get there it's kind of two parts one, you have to finish the transition to the manufacturing in China and then, two, you have to start dismantling what was the duplicate facilities in the U.S., right?

And third, we have to, as Doug said in his presentation, we're about half way through with the tier 1 supplies we have to complete that transition and fourth, we have to slim down our product line, especially in the power area, which we are in the process of doing.

So Fort Collins is that step 1 in reducing the duplicate facilities so you're working on part two already?

Yeah, I mean these are all overlaid projects, but each one of them is separately managed and will get its own independent results. They -- a very positive thing is as you reduce the complexity in Fort Collins and you get over center with a number products that are not only being manufactured in China but are being sourced in China, then the speed, the inventories, everything really starts becoming much more efficient.

So if you got to the 70% by the end of the year in China, then how long would you guess it would take to completely dismantle your duplicate facilities here?

I think we are looking at that all through next year.

All through next year?

Yeah.

But you should see progressive gains in the margins.

Right.

For example the fourth quarter a year-ago now you had almost 75 million in revenues and you lost, I think 8 cents and now you're going to be higher than that now and you're going to lose 15 to 20 cents I would expect that aren't you getting some benefits as you move to China in terms of reducing margins?

Alex, the benefits we're getting by the duplicate cost, number one, but the other thing that we faced year-over-year is we have had increases in our cost the cost of the base commodities, whether it's steel that's affecting us, we didn't have that a year ago, I mean the demand for commodities out of China is affecting commodity prices all around the world. That is impacting us. Our ability to take the duplicate costs out have not -- we haven't gone as fast as we thought and in fact it's higher than we thought. Another thing that;s happened we talked about this in the call earlier this year, the logistics cost issue. We've moderated the impact somewhat during the year, but we haven't reduced it from a year-ago. That's taking a percent to a percentage and a half out. So higher overall commodity costs have increased our prices offsetting our tier 1 savings, also year-over-year our sales in the semiconductor states are a little bit higher actual dollars and we have acknowledged in the past, that given the size of the semiconductor market for us and actually all companies that service this space, the margins tend to be a little bit lower. But we are also disappointed that year-over-year -- as you point out, a year ago on 74.9 million in sales a margin of 35.3% in this particular year on sales it would be a little bit higher, we're talking about margins being 27.5 28% range. The good thing is even though we have gone further that we had hoped, we do have the visibility and the ability to get our margins to the historic levels that we have talked about. It's just going much slower than we though th process itself was much more complicated than we envisioned. Execution that has occurred over the last 12 months quite frankly has been quite stellar by all the employees at AE, but we just didn't anticipate the length of the process.

Thanks very much.

You are welcome, Alex.

Your next question comes from Avinash Kant with Adams, Harkness.

Good afternoon. What should we be modeling for taxes in '05?

Avinash, it's a difficult thing to answer and we talked about the thing with the valuation allowance. If you are going to show and again, it depends upon what you are looking for the top line, but if you show profitability, pre-tax income of 5 to $10 million then I would use a tax rate of about 25%. If because of maybe a possible extended down turn that we may all face and all of us will go back to the same level of a loss which we faced the previous three years, then some profitability outside of the U.S. we are probably looking at 500,00 to about $1 million a quarter on possible tax payments despite the fact that it's a loss. So the long answer to your short question is if you are going to be modeling profitability I would use about 20% if not, then probably a tax provision of anywhere from 500,000 to $1 million a quarter.

And just to understand right, if I excluded amortization and the restructuring charges your EPS would have been 2 cents positive, does that make sense?

The restructuring, well, no. Because you still have the tax impact. You mean this past quarter?

Yeah, in the current quarter, Q3.

Amortization this quarter was about $1 million, so I'm not sure we get quite to 2 cents because we still have the $996,000 tax revision and we'd be at about $1 million of taxable income, but that would be amortization, we'd get really no credit for that because we wouldn't be paying taxes. We'd be closer to break even not 2 cents.

Okay, I wanted to understand the tax impact of the operations spot.

Even if you added amortization back, we would have had say a pre-tax income of about $1 million and we'd still have $1 million of tax and we'd be at about a 0 EPS.

Okay. Good. Now in terms of the, for the longer term industry view I know that you were quite prompt in terms of recognizing some weakness in the industry. Now, from what you are hearing from your OEM customers and even other customers at this point does, it look like this slowdown is going to be a short-lived one or does it look like more of a prolonged down turn at this point?

Well, we don't see a cliff. I think we have been fairly moderate in what we are looking at for Q4. We are probably doing better than most because we have this very large increase in the DC for flat panel business. At time we're not seeing any indication that our customers are starting to look at either a long-term down turn or kind of what we call a going out of business curve, where sentiment gets so negative that you see the bookings or the manufacturing preparedness starting to head towards zero. We see it just kind of remaining flat and actually maybe even a few upticks out of the quarter or so. So there isn't any sign of a continuous decline at the moment.

And just to check the final backlog number that you gave at the end of the quarter was close to 44 million?

44.4 million.

Thanks so much.

You're welcome, Avinash.

Your next question comes from Stewart Muter with RBC Capital Markets.

Hello, good afternoon. This is Nahesh Tandanay here for Stewart. My question is under operation I want to understand did you say that once everything is all settled and you have moved all your specialty manufacturing to China your (INAUDIBLE) revenue will be around 70-75 million range?

That would be true, as well as a bunch of other actions that we are taking in the Company would definitely take us in that range by the end of the year.

That includes the completion of the move to tier 1 suppliers, taking out all the duplicate overhead, those are the two key things and finally, getting rid of some of these higher logistic costs that we've talked about. Once we get everything centered in China we shouldn't have the shipping costs that we're incurring by sending products to and from the United States and China and visa versa but those are the three key things that Doug alluded to.

And we get another advantage that we had only thought about before, but we started entering into discussion with some of our larger customers where we wouldn't be shipping products back to the U.S. at all for some of their new products. We would be shipping directly to the installation site at their customer facilities, so we start getting a unique competitive advantage in actually being local to where the products are going to be delivered.

Okay. So as you going forward as you dismantle facilities or maybe even get rid of some buildings, will there be restructuring charges or any income associated with those?

Over the next say 12 months, we expect to incur separation cost of approximately 2.5 to $3 million that will be gradual over that 12-month period depending upon how the transition goes, but that should be effectively completed by say the third quarter of next year Other costs that we could incur are facilities costs, currently we don't envision it to be significant. We are going to consolidate facilities, but we are also looking at ways maybe to sublet those facilities, we haven't quite quantified it, we think we have some visibility to sub leasing the facilities, at the end if I had to give an estimate of what that could be, it might be another 1 million to $1.5 million of the charge, but again that would be a noncash charge and then we'd just be paying that capital over the rest of the lease. So the actual cash restructuring that should go out over the next 12 months is about 2.5 to 3 million.

And do you have a gain of about 165 in restructuring is that reversion of-- .

That is reversal of some earlier restructuring charges, correct.

And one last question, you talked about that in 200 and 300 your mix, mostly 300, is it, can I say it's like 90% 300?

Right now?

Yes.

No, it's just going above 50 right now.

What time do you see 300 versus 200 going forward?

You know that is a good question. What we are sensing is that people are not going to again expand capacity in 200 millimeter. That the design rules are getting sufficiently small. A lot of the yield problems have been solved. So that most of the investment for capacity now is going to be toward 300. So I don't know how fast the transition will be made, but if you just said on average it was 50 to 60% right now, that it would probably be another 24 months before it became say 85%.

Okay. Thanks a lot.

Your next question comes from Tim Summers with Stanford Financial Group.

Good afternoon. Michael, just a housekeeping question, could you please repeat the reasons why the gross margin declined this quarter over the prior quarter. It sounded like the microphone was being slided.

You want to know the actual third quarter reduction?

I want to know the rationale for the decline?

Okay.

It was something about overhead absorption.

Overhead absorption, sales are down a bit obviously, being down 14% so less absorption of overhead and we started to do it for the cost and in fact as Doug said earlier we are trying to drive more product to China we're going to incur a few more duplicate costs there, but basically quarter-over-quarter it's buried in overhead absorption.

Good and my other question was regarding the linearity of business through the third quarter, did you see business decline or shipments out the door decline through the quarter and what does the linearity look like in the fourth quarter?

Actually shipments were fairly steady during the quarter and our order book has been, I'll say, fairly linear, but obviously a bit of a down side to Doug's point there's nothing precipitous. In the fourth quarter we're looking to be down the percentage that we are talking about and we're not seeing anything there that is out of the ordinary, but what always happens in the fourth quarter in this industry is, companies decide are we going to shut down or not shut down and so you all of a sudden you can see a shift in order patterns, but that is more due to availability of shipping and receiving then it is to actual order patterns in the industry. So as we said in July or as we said in actually in April, we saw linearity beginning then when we got to July, we did talk about a gradual down slope and that down slope has continued, but just slightly?

Okay. Thanks, Michael.

You're welcome, Tim.

Your next question from Ted Berg with Lehman Brothers.

I had a question on the working capital you know that days inventory and day sales outstanding were both up and one of the explanations on the day sales outstanding was that the I didn't catch all of it, but something about an extended payment by your U.S. based OEMs could you go into a little more detail on that. And then on the days in inventory why would that have to increase to keep lead time short for customers when you have more of adjust in time model and demand is slowing also so why would you need to keep additional buffer inventory?

Ted, let's talk about the receivables first. You know, we have talked in this industry, we get about 60% of our sales from 10 different companies we deal with very major customers, very large customers, especially to us and they have their own working capital management technique. We get letters saying effective we are going to pay you at this rate. It comes from obviously their working capital team. Over the next quarter or so, I'm sure I'll be making some phone calls to our customers saying that we're really not in the business of funding your receivables it just doesn't make sense it's unilateral and we have to address it. The thing on the inventory and over the last -- earlier this year, lead times were critical you look at the order books and all the OEMs and you know, we have talked about this, you and I have talked about this and I've talked about it on my trips around the country that there was a lot of positioning by the OEMs to take market share among themselves and they're -- what they were trying to do is talk about lead time. They were driving lead time it was important for us to meet our customer's lead time needs. With that being said, it's hard for our customers many times to decide exactly what products their customers are going to be ordering. So as an industry we are not very good at forecasting. We as a Company decided we were going to support our customers and quite frankly overinvested in inventory in hindsight, but we believe we further reinforced our strong commitment to our customers so it was a strategic decision, lead time was critical and we wanted to get there and we think we helped our customers and, in fact, I think you and I may have talked about this. At a employee meeting that we have quarterly, this is Doug and the rest of the senior leadership team has with our entire Company, we had a representative from one of our major customers get up in front of our entire employee base and thank them for the hard work that they did and also explain to them what we did at AE to help them meet their needs. So that happened during the year. The other thing that drove up inventory was the situation with China. We talked about, we've moved product to China we thought that's what the parts were going to be, but then as Doug said all of a sudden the demand comes back here so we've had to have duplicate investment in inventory. As we said in the presentation, September we did see good progress and I don't even mean marginal progress the inventory went down in that month by seven figures we do expect in this quarter we'll make significant progress, assuming the demand for the product stays fairly linear.

Okay. So what would the implications be for cash flow then over the next couple of quarters because it looks like free cash flow was down about 12 million and operating cash was 7 million CapEx 5 million so negative numbers so negative 12 million where do you see the cash flow, you know assuming you cannot improve the working capital.

Obviously we are disappointed with the reduction this quarter, we do expect that we're going to be able free up something out of receivables. For the fourth quarter we would be very disappointed if our cash wasn't around the $120 million range or higher.

Okay. And then I had a question on some comments that you made earlier in a different topic on the qualification process of suppliers in China, you said you were midway through that process could you go into some detail when you expect to have that complete and what types of suppliers you are looking at and what types of potential to the extent that you can comment on maybe, what kind of savings you think you can extract ultimately from shifting the supply base?

Well, it's interesting. If you back to the fourth quarter of 2003, we have made some good progress in that direction, but then we slowed it down because the ramp. Now that we are going into what appears to be a bit of a pause or a slowdown we should have some more flexibility to get that driven by say mid next year. Rather than going into specifics as to how we think what the different savings might be, we still feel comfortable saying that when we are through with this process, reducing the facilities, putting most of the manufacturing in China, but having a very important facility in Fort Collins for new products and new product launch and development. Getting tier 1 suppliers and then localize suppliers in Asia reducing the logistics cost, if you look at an operating model we talked about our last peak quarterly sales of about 140 million and assuming that we get to that type of sales activity in the next up cycle, whenever that might be, we expect to be able to deliver 45 to 46% gross margin and about 23% operating margin. Essentially in line where we were a few years ago, (INAUDIBLE) but still really strong performance and as we have said we have line of sight for all of those things it's more the timeline of execution and also the vagaries of this industry. By the same token, as we said earlier we expect to our our break even down substantially over the next nine months and then once we get to that level, we'll have a leverageable operating model that meets or exceeds other companies in the same space.

Okay and then one last question on the, you mentioned the new transformer MSC product? Could you talk about the -- you said it's seen pretty good acceptance could you talk about how much of your business is transitioning from that from your other MSCs and where you see to the extent that you can quantify your market share in that segment this year versus the prior year and the pricing environment there?

Okay. Let's see we don't have a lot of ready answers for that, but I can give you an idea of the trend. When we started getting really engaged with the Aero product line, we saw that their prime focus had been service, reliability, incredible repeatability and so that's how they picked up the world leading market share. The problem was that they had so many products that it was incredibly difficult to manage it and drive costs down. At the same time the customer base was looking at, and I'm talking about end user customer base primarily was looking at cutting down their inventories and their number of parts because it was so costly to try to manage the Fab. And so the theme became this multi-gas, multi-function flow meter which is the transformer and it cuts down the number of part numbers literally from like 100 to 8 and so that is the only way to be in the game. We were -- Aero was a little late to get started on that when we bought them we accelerated the programs. We were pretty poorly positioned on 300 millimeter when we first introduced that product and now I believe we are back into leadership position. So there has been a tremendous gain and there is obviously, the only way you can do that is to get acceptance. And we anticipate even more and we have the next generation of innovation with that product. It's being submitted to the top customers now and it goes beyond transformer and we have just been told by a major OEM that we have had the best introduction of a this particular type of a product that they have seen from any suppliers. So right now we are able to take some of the innovation that AE is known for, first correct a product line. Then start injecting new technology. At the time really pushing the legacy of fantastic support and reliability and repeatability so we're very optimistic about the momentum we are gaining. I think we'll find out next year what the market share changes have been.

Okay. Great. That's great to hear, that's your digital product then a what you're referring to?

Well, the set of digital products and the new innovations are centered around what's called the pressure and sensitive MFC. So there is a lot of fluctuation upstream in the gas lines and pressure and that affects the not just the average flow rate, but the transition flow rates. And it makes having a pressure and sensitive MFC means that you can provide gas very continuously independent of all the (INAUDIBLE) up and down the system and actually it lowers both the -- well, primarily the OEM's costs, because as their confidence builds they don't have to have upstream pressure regulators.

Thanks a lot.

Your next question comes from Timothy Arcuri with Smith Barney.

This is actually Dan Berenbaum for Tim. Two quick questions on the pricing environment, and maybe you could elaborate a little bit more on what the pricing environment is at OEMs in general and how that is affected by the shift you are seeing from 200 to 300 millimeter and also maybe how it's affected by your increasing revenue from the FPD area?

Okay. Well, pricing over the past 12 months has really, the pricing pressure really got to be pretty bizarre. But I think that from what, of course we can tell with ourselves except in a few areas maybe 11 or 12 months ago we just decided that we couldn't change the economics of our business that significantly. And that created a lot of real healthy discussions, what turned out to be healthy discussions with our customers and down to the point where they are really understanding the unique value that we contribute and which is a push away from being completely viewed as commodity suppliers at our tier level. So I think we basically hit a little bit of a revelation with our customers that we're really providing some unusual value. I'm sure our piers are finding the same thing. We found ourselves in a position where we had to increase some prices and we have been able to do that. So I think if you asked me that question 12 months ago, which you probably did it was pricing pressure was terrible. It's always hard, at least for the past five years I expect it to remain incredibly central to what our customers are looking at. But of course, we have a way now to be able to have longer range pricing road maps that don't erode our margins.

One other thing is that we have found and that is our customers are still prepared to pay for value and if you meet their needs and you can meet their lead time and their quality I'm not saying they won't push back, but if your product does what they need, then you will be able to get the price that gives you a fair return.

Maybe this is a good time too to bring up the product, this DC product that we are just introducing that has much higher power, very high-performance, it's exactly what they need in the flat panel business, but the acceptance of that product was so great in such a short period of time that we hadn't gotten them all the way down the cost profile. So in Q4 it will probably pull down as it did in Q3 the margin a little bit, but then that product returns to very solid margin in a very short period time in the beginning of the year.

So will that flat panel product ultimately be higher margins even than some of the semi equipment product?

Definite it will be higher margin than the average margins you see that we have today. It will start pulling things up, yes.

Is that just because of volume of the product or is that because of the ASPN just inherent cost of the product.

It's exactly what Mike said, it's like the risk that a flat panel display manufacturer has for one arch, one mistake the risks they have and the cost to that panel where they have got more and more power and a larger and larger panel with more and more dollars involved with it, they turn around and they look at who is going to give us both the greatest through put, and the greatest yield and it all becomes economics and we are always in the lead with the right answers for that questions. So value, price, they are willing to pay for it and these are enormous systems and this really helps the customers get higher yield, higher through put and better economics.

Okay. And you'd also talked earlier about you're now shipping product direct to some customer site's without going through the OEM manufacturing, if I understood correctly. Could you maybe elaborate on that a little bit? Is that reducing your costs at the same ASPs? How is that helping you out?

Well, I'm sorry, I must not have been clear. We are having our first discussions about doing that.

It's just not being done yet.

Not being done yet, but what both we and our -- both largest OEMs no matter where they are in the world figure that about between 60 and 75% of all the products that we and they make wind up somewhere in the Asian area. Which is one of the reasons why we chose Shin Zen. It wasn't just a manufacturing site in a low cost region, but it was kind of the heart land of where everyone expects a lot of this growth to take place. So not only do we get the better relationships and early relationships with the Asian customers, but at the same time if you're manufacturing a few miles away from where the products are going to be used then both the cost of getting those products there and the cost of supporting it goes way down. And so our customers' for example in the U.S. are now looking at -- it doesn't make sense to take all of these products that they get from all of their suppliers, no matter where they are in the world, pay all the inbound freight, assemble all of those products, and integrate them into a tool. And them take them all off of that tool and put them in a box and ship them somewhere to Asia. At the same time, 70% of all the parts were made in Asia in the first place, so there's huge waste in the supply chain which they're aware of. So basically this is an opportunity for them to lower the cost, reduce the waste in the supply chain, decrease the response time, and that's one of the reasons why we made the strategic decision to go to China.

Okay. Great. Thanks.

Again, I would like to remind everyone, if you would like to ask a question, press star then the number one on your telephone keypad. We'll pause for just a moment to compile the Q & A roster. We do have a follow-up question with Tim Summers with Stanford Financial Group.

Hi. If you guys saw this down-turn extend into say the first quarter or the first half of next year, are you constrained in any way to do lay-offs at your China manufacturing facilities. Either through government regulations or other issues?

No. We're not Tim.

Okay. And just to follow-up, you mentioned that you hit the cross-over point, that 50% of your, I think, power supplies were for 300 millimeter. Some of the tool guys are saying that 70% of their business is 300 millimeter. How do we reconcile the two?

One of the things that we have in our product mix, Tim, we have certain products that are specific for 200, some that are specific with 300, we have some that quite frankly go on both tools. And it's not within our wherewithal, we could try to figure it out but we don't. And so at the end of the day, if we were to slice that a little bit finer, we would be able to tie our 300 millimeter.

Okay. Thanks.

You're welcome. At this time there are no further questions, Mrs. Kawakami, Mr. El-Hillow, are there any closing remarks? Well, thank you very much for listening to our quarterly report, we look forward to talking to you next quarter.

Thank you. This concludes today's Advanced Energy third quarter results conference call. You may now disconnect.