Advanced Energy Industries Inc (AEIS) 2004 Q4 法說會逐字稿

Good afternoon. My name is Kristin. I will be your conference facilitator. At this time I would like to welcome everyone to the Advanced Energy quarter four and year end 2004 financial results conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. If you would like to ask a question during this time. Simply press star and the number 1 on your telephone key pad. If you would like to withdraw your question, press star and the number 2 on your telephone key pad. Thank you Ms Kawakami You may begin.

Thank you and good afternoon, everyone, and thank you for joining us today. Doug Schatz Chairman President and Chief Executive Officer and Michael El-Hillow, our Executive Vice President, and Chief Financial Officer will be today's speakers. And will provide and overview of the results before we open the call to take your questions. By now you should have received a copy of the press release that we issued approximately an hour ago. If you still need a copy of this release you can contact us at (970)-221-4670 or 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 certain 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, semiconductor capital equipment and flat panel display industries. The timing of orders received from our customers, and our ability to execute the manufacturing and supply chain transitions currently under way. Other risks are described in our form 10K, 10Q and other reports we file with the SEC. In addition we assume no obligation to update the information we provide to you during this call. I'd now like to go ahead and turn the call over to Doug Schatz.

Thanks Cathy and thank you for joining us today. Today we reported sales of approximately 88 million which was ahead of expectations and down 6 percent compared to sales of 94 million in the third quarter of 2004. This decline reflects continued softness in sales to semiconductor OEM customers while the continued growth in flat panel display sales and other advanced thin film markets such as industrial coatings helped to offset that decline. Flat panel display sales were 22 percent of total sales or $19 million, which marks our highest quarterly sales to the flat-panel market to date. The growth was primarily driven by sales of our new Summit DC power system to OEM customers building PVD tools for Generation 6 and Generation 7 panel sizes.

We formally announced the Summit power system two days ago. It's A revolutionary way to provide operating flexibility and superior arc handling through a modular design intended for advanced thin-film manufacturing applications. Summit is also performing well on Gen 6 and Gen 7 flat-panel applications and we are currently targeting specialized sub 90 nanometer semiconductor processes. Over the past several quarters we've been providing the details for our plans and progress in moving volume manufacturing to our China facility and transitioning the majority of our supply base to the Asian region. These initiatives are being implemented in parallel because the benefits are interdependent on many levels.

China manufacturing gives us a substantial presence in a critical and growing region for our served markets including semiconductor and flat panel and provides an opportunity to reduce manufacturing overhead. A localized Asian supply base streamlines the procurement process and provides quality parts at a lower cost. We had steep learning curves as we pioneered these new critical paths for the company. The product line transfer and customer qualifications for China product and new supplier base required essentially the invention of new processes internally and with our external customers. We are the first in our sector to make these types of significant investments in the future and believe we are well positioned as the Pacific Rim's impact on the world wide economy continues to expand.

Our customers support these initiatives and have been working with us throughout the transition. Supply-base qualification levels have allowed us to accelerate certain aspects of this project. Many of your customers and all of our major customers have visited our China manufacturing facility and are impressed with the operation. All of the products included in the first phase transition to China are qualified like (ph) all customers. Those products are no longer being manufactured in Fort Collins. First phase products include primarily the high volume more mature product lines. Currently 19 of the 25 total planned product lines have already completed the transition.

The additional six products will be transferred by the third quarter of 2005. With regard to the supplier transition, all of our localized Asian suppliers have been selected and all customers have qualified all new supplier sites. Our plan is to procure the majority of all parts from a localized Asian supply base by the end of 2005 and we are on plan. Again we are seeing breakthroughs in the speed and efficiency of the qualification process now that we've moved further along the learning curve. In addition to the operational realignment under way we continue to reduce the complexities of our organization. Specifically, we have combined all product groups and operations into one operating unit, led by Steve Rhodes, providing us a heightened focus on critical growth opportunities and aggressive product life cycle program and fully coordinated sourcing, manufacturing and R & D efforts.

In 2005, the multi faceted transformation of our business model will show tangible results. Our expected return to operating profitability in the first quarter of 2005 on lower sequential revenues is a positive directional indicator. Our guidance also reflects expectations for continued softness in the semiconductor related orders near term as end year users continue to work down their inventories. We are well positioned to grow our market leadership as the industry continues to transition to more advanced processes. Our 300 millimeter sales continue to track in line with the industry and represent over 70 percent of the total power sales in the fourth quarter. As we have said in the past, we are well positioned in 300 millimeter.

Sales of our power related systems outpaced our total revenue growth year-over-year. The technology solutions we provide for advanced processing including next generation flat-panel displays, sub 90 nanometer semiconductors and double low emission architectural glass are unparalleled and bring our customers a critical competitive advantage. Summit is the latest advantage that our legacy of innovation continues and there will be more to come. Finally the board and I are working closely on the executive succession plan as part of my intention to become non-executive chairman sometime in 2005. I've been working with Woody Spedden our Lead Director to ensure a smooth transition.

As part of that transition I've set up an office of the President composed of Mike El-Hillow, Steve Rhodes and Linda Capuano. We've also established a search committee headed up by board member Joe Bronson. We're making good progress in establishing the framework for the search, as well as a larger succession planning process including executive development. I'd like to now turn the call over to Mike so he can review the financials with you.

Thanks Doug, and good afternoon everyone. I will review the results of the fourth quarter and full year 2004 and provide guidance for the first quarter of 2005. Revenue for the fourth quarter of 2004 was 88.4 million, ahead of our expectations and 5.5 percent lower from the third quarter 2004 revenue of 93.6 million. Fourth quarter 2004 revenue increased 18.3 percent compared to fourth quarter 2003 revenue of 74.7 million. Gross margin including 9 million in inventory-related charges was 14.6 million or 16.5 percent for the fourth quarter. Excluding these charges, gross margin was 23.6 million or 26.7 percent.

Gross margin was 31.8 percent of sales for the third quarter of 2004 and 35.6 percent for the fourth quarter of 2003. The previously discussed transition costs associated with our move to China manufacturing and Asian-based suppliers continues to impact our gross margin performance. However, we do expect initial benefit of these programs incrementally improved gross margin the first quarter of 2005 to 29 to 29.5 percent range on a 4 percent to 6 percent lower sequential sales amount of 83 million to 85 million. Net loss for the fourth quarter of 2004 was 23 million or 70 cents per share compared to the fourth quarter 2003 net loss of 2.4 million or 8 cents per share, and the third quarter 2004 net loss of 1.1 million or three cents per share.

The fourth quarter net loss included 19.8 million in pretax charges made up of the following -- 9 million for increased excess and offseat (ph) inventory reserves related to the Company's product life cycle management program, discontinuance of certain products in select markets, the product mix shift from 200 millimeter wafers to 300 millimeter wafers and the expected continued slow down of sales for the semiconductor industry. 3.7 million for employee severance and termination costs related to the realignment of our manufacturing operations. 3.3 million for intangible asset impairments related to employment agreements and customer list assets acquired in the Aera and Dressler acquisitions. The charge is based on our evaluation of the 2005 operating plan and the anticipated contribution of those assets.

3.8 million for a change in an accounting estimate relating to demonstration equipment. Historically we have amortized the cost of demonstration equipment provided to our customers over 24 months. Going forward we will record sales and marketing expense for the equipment as it is placed into service at our customers, or potential customer locations. Excluding these charges, the fourth quarter net loss would have been 4.5 million or 14 cents per share. Of this 19.8 million only the 3.7 million of employee costs is a cash item. Also the ongoing quarterly savings from the employee changes is approximately 2.5 to 3 million per quarter.

Looking at end market sales, semiconductor capital equipment represented 48 percent of total sales or 42.7 million down 25 percent compared to 56.9 million in the third quarter of 2004. Semiconductor sales were 46.3 million in the fourth quarter of 2003. Like other companies in the industry, we have experienced a declining order environment as end users have been working down inventory levels. We believe end users will continue to invest in leading-edge advanced processing equipment and we are well positioned to capture those opportunities. Although the timing of a pickup in demand is uncertain, current 300 millimeter build up and the move to sub 90 nanometer processing could potentially drive equipment spending later this year. Applied materials, our largest semiconductor capital equipment customer, represented 20 percent of total fourth quarter sales or 17.3 million. Down from third quarter sales of 25.8 million.

In the fourth quarter of 2003 Applied was 22 percent of total sales or 16.2 million. For the full year 2004 sales to applied were 105.7 million compared to 52.4 million for the first full year 2003, representing a 102 percent year-over-year increase. Flat panel display sales represented 22 percent of fourth quarter revenue or 19.3 million. This represents a sequential increase of 43 percent in dollar terms compared to 13.5 million of total sales in the third quarter of 2004. Flat panel display represented 13 percent of total sales in the fourth quarter of 2003 a year-over-year increase of 95 percent in dollar terms. As Doug mentioned, we formally announced our Summit DC power solution earlier this week and it has driven much of our late 2004 flat panel sales growth. We expect continued strength in the first quarter for this end market although we do see a pause in demand looking beyond that.

There are signs of continued growth later in the year, but much of it depends on next generation capital, spending decisions by at least two of the large flat panel display manufacturers. Our largest flat panel customer represented Alback represented 17 percent of total sales or 15 million in the fourth quarter up from 11 percent or 10.1 million in the third quarter of 2004. The data storage industry, which is comprised of the optical data storage market including digital video disks and compact disks and the magnetic data storage market was 5 percent of total fourth quarter sales or 5 million which represents a decline in dollar terms of 13 percent when compared to the third quarter of 2004. This market represented 7 percent of total sales or 5.1 million in the fourth quarter of 2003.

Advanced product applications represented 24 percent of fourth quarter revenue or 21.5 million, a 23 percent increase compared to the third quarter of 2004. Advanced product applications represented 18 percent of total sales or 13.5 million in the fourth quarter of 2003. In addition to architectural glass, this category includes a variety of applications such as our ICORE power supply for the high-end computing market, industrial coating and laser and medical applications. Looking at sales by geographic region, the United States sales represented 46 percent of total fourth quarter sales, a decrease of 17 percent in dollar terms, compared to 53 percent of total third-quarter 2004 sales. U.S. sales represented 50 percent of total sales in the fourth quarter of 2003.

Sales in Europe represented 13 percent of total fourth quarter sales, a decrease of 10 percent in dollar terms compared to 14 percent of total sales, in the third quarter, and 13 percent of total sales in the year-ago period. Asia Pacific represented 41 percent of sales up 15 percent in dollar terms compared to 33 percent of total sales in the prior quarter and 36 percent of total sales in the year-ago period. We ended the fourth quarter of 2004 with a total backlog of 33.9 million compared to the third quarter backlog of 44.4 million. R&D spending was 12.8 million of 14.4 percent of sales during the quarter. This compares to 12.6 million or 13.4 percent of sales in the third quarter of 2004, and 12.8 million, or 17.1 percent of sales in the fourth quarter of 2003. We are committed to continued technology innovation with a greater focus on key opportunities that leverage core competencies and highly differentiated technology.

Accordingly, R & D spend in the first quarter of 2005 will be approximately 10.5 million. SG&A was 12.5 million in the fourth quarter of 2004 or 14.1 percent. This compares to 14.4 million in the third quarter of 2004 or 15.4 percent of sales and to 11.3 million or 15.2 percent of sales in the fourth quarter of 2003. This lower sequential amount was primarily due to three weeks of shut down in the quarter and lower amortization of intangible assets. In the first quarter of 2005, SG&A is expected to be 12.9 million reflecting a full quarter of operations and certain reclassifications. Amortization of intangible assets was 538,000 in the forth quarter of 2004,. 1.1 million in the third quarter of 2004 and 1.2 million in the fourth quarter of 2003.

We expect quarterly amortization of intangible assets to be approximately $525,000 per quarter going forward due to the previously discussed 3.3 million intangible asset impairment charge. For the full year 2004 revenue increased 51 percent to 395.3 million, from 262.4 million for the full year 2003. Net loss for the full year 2004 was 12.7 million or 39 cents per share, compared to 44.2 million or a $1.37 cents per share for the full year 2003. Gross profit for the full year 2004 was 119.7 million or 30.3 percent. Gross profit for the full year 2003 was 87.9 million or 33.5 percent. R & D was 51.5 million or 13 percent of sales for the year 2004, compared to 51.6 million or 19.7 percent in 2003. SG&A expense is 58.5 million or 14.8 percent of sales for the full year 2004, compared to 49.3 million or 18.8 percent in the prior year.

Amortization of intangible assets 3.9 million for the full year 2004 and 4.6 million for the full year 2003. Head count at the end of the fourth quarter was 1,651 people of which there were 1,4086 full time and 165 temporary employees. That compares with a head count of 1,697 people at the end of the third quarter 2004. Our balance sheet continues to be strong with cash, cash equivalent and marketable securities of 108 million. We expect this balance to increase to approximately 115 million by the end of the first quarter 2005. Our accounts receivables were 72.1 million for the fourth quarter of 2004, compared to 74 million at the end of Q3. DSOs increased to 67 days compared to 66 days in the third quarter of 2004 and 60 days in the fourth quarter of 2003.

Fourth quarter inventory was 73.2 million compared to 91.9 million at the end of the third quarter. Included in this quarter to quarter improvement were the related excess inventory charges totaling 9 million and a reclassification of service related parts to other assets of 2.7 million. Inventory turns of 3.2 turns in the fourth quarter and 3 turns in the third quarter of 2004 and the fourth quarter of 2003. Total days inventory was 114 days down from 122 days in the third quarter of 2004, and 123 days in the fourth quarter of 2003. Our capital expenditures in the fourth quarter were 1.5 million down from 5.1 million in the third quarter of 2004 and 4.9 million in the fourth quarter of 2003. We expect CapEx in the range of 10 to 11 million in 2005, due in part to continued investments in our manufacturing operation as well as IT infrastructure. Depreciation was 3.3 million in the fourth quarter compared to 3.7 million in the third quarter And 3.2 million one year ago.

To summarize our Q1 2005 guidance, we anticipate a continued decline in semiconductor OEM demand. We believe first quarter sales could decrease approximately 4 to 6 percent compared to Q4 to the 83 to 85 million range. Regarding our sales guidance, some of our major customers require shipping terms at FOB destination points. When the majority of our shipments were made from Fort Collins the one-day shipping time in the United States was transparent. Given the volume of shipments coming from China to the United States beginning in 2005, we will be delaying the recognition of revenue by five to seven days on these certain major customers. The biggest impact will be in this transition quarter and that is reflected in our first quarter guidance.

We do want to point out that this has nothing to did with the acceptance of the product only with transfer of title. Gross margin will improve as we begin realize the initial benefits of the manufacturing supply chain initiatives and could range from 29 percent to 29.5 percent. R & D will be approximately 10.5 million on the first quarter and SG&A will be approximately 12.9 million and the amortization of intangible assets will be approximately 525,000. We expect to report operating income in the range of 250,000 to 1 million based on expense controls and improvement in cost of goods sold. We continue to drive to a quarterly operating break even level of 70 million to 75 million in the second half of 2004 once our major transitions are complete. Non-operating expense for the quarter will be approximately 2.5 million and we expect tax expense of approximately $500,000, given that we continued to provide a valuation allowance for our U.S.-based deferred taxed assets. Our loss per share will be approximately 6 to 8 cents. In summary we have made the right changes and on the right course to show improvement in our key operating metrics in the first quarter of 2005 and beyond. Our technology innovation continues to lead our served markets and our operations innovation positions us for long term competitive advantage. Doug and I will now be happy to answer questions, so operator please open the line for questions

As a reminder if you would like to ask a question, press star and then the number 1 on your telephone key pad or pause for just a moment to compile the Q & A roster. Your first question comes from Jim Covello with Goldman Sachs.

Good afternoon, guys, thanks so much. Mike. Quick question on the balance sheet. Can you give us a balance sheet update thoughts there and the strategy as you move to 2005? Thanks.

I assume you're referring to the convertible debt?

Yes.

Obviously we think we made significant progress in the fourth quarter change in the operating model, and given the expected first-quarter operating income from the standpoint of the company and the board, we are prepared to wait and see the impact near term in our improved performance. That being said we have the shelf registration still effective and our board could decide to act when they think it is prudent. But given the current state I would expect that we would wait near term to show the marketplace the significant improvements we're making in our operating income.

How do you balance, you know, the desire to, you know, want to do it internally, which would take a pretty significant improvement, versus the desire not to wait too long. What's sort of the decision-making process there?

Well, first of all, the debt doesn't become due, the first tranche becomes due in August, September, of 2006. So we've got 6 or 7 months there and the next tranche becomes due in November. You can watch it near-term. The important thing, Jim, is that we have any number of avenues we could pursue. And so we keep those avenues open day in and day out. You watch it day in and day out and you work with the board and we have a pricing committee, and Doug is in constant contact with the board. So it is not as if a window is available that could close soon. That is why we have a shelf registration in place. It allows us to act quickly when we want to move.

Thanks so much.

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

Thank you. Good afternoon, couple of quick questions for Mike. R & D spending is getting cut pretty sharply in Q1, do you expect it to kind of snap back as the industry recovers? Is this a kind of triage action here, or is it more as your product based on your product development cycle?

I'll pick that up for Mike, Stuart The part of the engineering expenses, that big reduction, represents a lot of focused effort that we had on transitioning products to China. So we had a large amount of engineering. Some people, a lot of outside services . And what you're seeing is our ability to start pulling that away as we get closer and closer to completion of this transition. So we aren't taking away from our ability to innovate. We're really just recognizing the structural changes that we've been making in the company.

We also have brought a tremendous amount of focus in R & D and I think Mike mentioned that earlier, where we're looking at the critical platforms that we need over the next two or three years, and rather than just spending R & D dollars to basically react to every customer request, which was a success model for the previous number of years, we're really much more carefully targeting exactly what we need to do to win in each of the critical applications. So you're seeing a combination of a change in the application of our resources and then a focus of those resources into critical programs.

Okay. That is helpful Doug. And a question for Mike on gross margins. Any change in your target gross margins or your target business model, now that you're well into the transition of Asian sourcing and manufacturing in China?

There hasn't been a significant change in the target, but to give it to you directionally, you know the guidance we're giving in the first quarter of 2005 of sales of 85 million and margin of 29 and 29.5 percent, is we keep making these changes throughout the year and get to that lower break-even. By the end of the year, if sales are still at 85 million we would expect to improve that margin by at least 6 percentage points, so north of 35 percent. And that is the highest schedule we have talked about in the past. One other point of clarification on the R & D, the second part of your question, is this a one-time thing? No, it is not a one-time thing. In fact, in many dimensions it is the cornerstone of us being able to get down to the 70 to $75 million break-even point by the end of the year. So the changes that Steve and the team have made, it is a near-term but a long-term benefit for us.

What we would expect to do, as we exit 2005, we talked about this before, that going from that lower break-even number we would want to provide our share holders with at least 55 cents of incremental gross margin on every sales dollar and 45 cents of incremental operating margin. In order to do that we are going to have to continue to maintain strict control of all operating expense levels, whether it is direct labor and over head and cost of goods sold or operating expenses.

Okay. One more quick question. In terms of tax rate going forward you think about 500K per quarter is the right way to model it here for this year?

This is an interesting situation we face, Stuart as you know us, like many other companies in the space, we took that full valuation allowance a few years ago. If we have a couple of quarters of I'd say significant profitability in the United States, we would restore that tax valuation allowance and then we expect a steady state tax rate to be above 30 to 35 percent. But I can't give you any more guidance other than it depends when the industry flips. So the 500,000 has to do more with (indiscernible) still towards break-even. As we go toward higher profitability, I would use just for (indiscernible), 32.5 percent.

Got it. Thanks very much.

You're welcome.

Next question comes from Gary Sway with Smith Barney.

I want to try and better understand gross margins particularly in the fourth quarter. It looks like flat panel display basically kind of up-sided revenue numbers, but then again it sounds like gross margins are slightly disappointing. Does that imply that flat panel display product gross margins are actually lower then the average? I think before you said it was actually above the average.

Gary, if you go back to our last quarter's conference call, we talked about this new product that Doug and I talked about, Summit, and we explained at the time that it is a revolutionary product and we had accelerated development to meet a marketplace need and, yes, in the fourth quarter of 2004, the margins were lower than what our historic margins would have been in flat panel. We have made changes in the cost structure. As we go through 2005, we would expect to replenish that negative - - that lower margin with that particular product.

Just to give you a little bit of my point of view on that, as Mike said we accelerated the product because of customer requirement. We did everything we could to meet their delivery demands which were some of the fastest delivery uptakes in the history of the company. In doing that, we were shipping units out early into the learning curve and certainly into the low volume manufacturing price negotiations. The product itself, by the time we get out to Q3, Q4, has extremely good gross margin profitability and it has just taken us time to get there and work all these pieces through in the face of making all of these other changes. So, you know, the whole team just did an amazing job on this, but there is only so much you can do on getting down your parts cost, when as you're ramping up a product, before the original plan date.

Okay. I've got a few more questions here. Second question is about long-term supply agreements or contracts with your large OEM customers. Are you guys able to kind of interject any provisions for these customers taking specifically China-built products, or is there a specified ramp plan in accepting China-built products with your OEM customers?

We really haven't gone to that level of specificity. Our customers have been accepting products now for 6 months. It doesn't get down to that level. What our customers do is they visit the location like they would do any new manufacturing location anywhere in the world. As Doug said in his part of the presentation, the customers have walked out and commented on the world-class nature of the facility. So we have not run into that issue and we don't expect it to be an issue going forward.

Yes, there is no pricing issues. They have now built up so much confidence in the process that we use that they're starting to use that as a model for any other companies that want to go to low-cost regions. So basically we're getting wind at our back now for what we've been able to accomplish.

Okay. So you guys are going to be able to recognize all the up side to gross margins with the move.

With inside of normal –- the normal pricing environment.

Right. And one last question, Mike. What are your cash-flow targets for '05.

We gave you the first quarter. We said 115 million. To go beyond that it would really be giving forward-looking forecasting. So I don't want to go any further than that

Secondarily, is there--is it reasonable to expect inventory turns working up into the 4X range in '05, can we get there.

Yes, we can get there. As we get further down the year we'll probably start separating out manufacturing inventory versus service inventory. We're making some good progress in both areas, but the service inventory becomes a little more problematical. What the operations people are doing in the manufacturing area is some really great work. So on a corporate average we would expect to be north of 4 by the end of the year but breaking it up between manufacturing versus service manufacturing should be much higher. .

That will do it. Thanks a lot.

You're welcome.

Next question comes from Jay Deahna with J.P. Morgan.

Thanks very much, good afternoon gentlemen. A couple of questions here. First of all, if orders turn up in the June quarter for your customers, like Applied, [inaudible] will you start to see that in 2Q as well or will that be more likely a 3Q event, and then secondly, given the progress in China, is there any expectations to change the PP & E footprint in Fort Collins?

Of course it depends on when their actual ramp begins, but if you assumed an upturn within a month, we're shipping products into their tools, so, yes, statistically we would see the rise within the same quarter. The--what we're doing in Fort Collins is it is really the world center for technology development and power. We do some other development outside of Fort Collins but the concentration of our efforts is here. This is the key product design and launch center and at the same time we're handling all of our North American service. So the other thing that Fort Collins represents, just so that you can see the -- how we're looking at this from a strategic point of view, is that it is a backup in case there is any kind of problem with shipping anywhere in the world, we're maintaining the manufacturing capability and systems inside of the Fort Collins facility. If anything goes on, of course including even peak demand, we can float products back into Fort Collins in an extremely rapid manner so we're keeping contingency infrastructure here.

One other thing, we don't tend to focus on it,Jay. You've been out here to our facility at say our corporate headquarters but we have another building in the southern part of Fort Collins, that over the next year we will be closing as we consolidate further in this area. So from about two years ago till the end of '05 we will have reduced about 25 percent of our square footage in Fort Collins.

Okay , alright the other question I had is, I know that the--there is a search for new CEO, but Doug I'm sure you're still going to be kind of the driver of the company strategy over time. What would you say as of today, right now, are AE's top 3 strategic initiatives. in order of priority.

Well I think its location, location, location. I mean, it is really, Jay, what we're doing is executing this plan to make sure that we get the benefits that we have in front of us, and we are. And so there is no shift in focus at all off of, number one, getting these products transitioned into China; number two, is making sure we get the other benefits of the products now being in China, to lower logistics, materials costs, et cetera, because that just keeps reinforcing this unique leverage that we have. And the other one is to identify and to deliver on unique technical platform developments that we've determined are winners for the next three to five years in this area.

You've seen Summit. You'll see other products coming out where we can really leverage the technology into solutions for the customers. We were just a side bar on that, two or three years ago I think we were all a little bit concerned that with the talks of consolidation, concentration, commoditization, that there wouldn't be a role for high technology products. What we're seeing is almost exactly the opposite is happening. As the nodes get smaller and smaller, the work gets harder and harder to solve a lot of the technical problems. So although a lot of OEM's would like to simplify products, would like to be able to commoditize them, they found out as they attempted to do that, that you just can't do it and keep your yields up and go on to these new processes. That is good news for us because it means there is justification for gross margins that help pay the R & D. But I think those are the three primary issues. But really the huge one we have to get out of the way, is this transition, and I think you can tell we feel like we're making pretty good progress.

Right. I guess the fourth one could probably be considered capital structure over time. Right?

Yes, we don't talk about that right now.

Thanks very much.

Yes we don't talk about that right now. Exactly..

Next question comes from Ali Irani with CIBC World Markets.

Good afternoon, gentlemen, sounds like you're really making the turn into the first quarter. I'm hoping you can share with us a little bit the percentage of revenues that your phase one products, the 25 that you speak of, would represent coming out of the first quarter, and perhaps you could share with us what you see happening after phase one going into phase two.

Okay Ali I'll say part of it and Mike can fill it in. We talked about 25 total products this year, and so if you take those product lines at the end of the year, you would have 85 percent of our total manufacturing in Shenzhen. As far as phase one, what we originally had told everyone that we were looking at 70 percent of all of our products, as we exited Q4 last year, we actually had the capacity to do that, but as there was this huge product mix shift from 35 percent to about 70 percent through the year, toward 300 millimeter, we didn't have the mix of products to transfer, to get that level of manufacturing. So I think we left the year at about 50 percent of our total production and I think by mid-year going into second quarter we're going to be somewhere around the 70 percent area.

Okay. In terms of phase two , it sounds like you're hitting the 80-20 rule, kind of an ideal situation by year end. What happens in phase two?

Essentially we're there in -- you know most of the products are there. There is a bunch of product that we left in Fort Collins that don't make any sense to transfer. And so we are going to be optimizing, then manufacturing for the products here. Reoptimizing manufacturing in China. But the big deal is going after the position that we have, which is now we can do localization of the supply chains, and it doesn't mean just China. But everything in the Asian region gives us both access to tier 1 suppliers, higher volume with those suppliers, lower cost with the -- on the logistics on the inbound freight. And if you notice, we've got 50 percent of our volume of shipments in the U.S., we think that that is going to continue to shift into Asia over time, and so we're going to have a much lower outbound cost and freight as we leave 2005, as we start directly shipping to customers in Asia that are going to be using the products. So there is a whole series of positive things that just keep building on each other over the next probably 8 to 10 quarters.

Doug, two more questions for you. One, again to the logistics as you're speaking of. On the inventory management since last year had a couple of short pockets that emerged, at what point at this time are you linking your ERP and the product numbers with the tools--tool numbers to track excess inventory. And then I'm hoping you can also give us an update on the ICORE product. I'm wondering how much that contributed to your industrial application rise this quarter.

Okay. Inventory is -- back when we first started dismantling Fort Collins manufacturing it was back in 2003, and if you remember the ramp as it started to pick up in August, September, October, of 2003, we didn't have the ability to ship the volume of products, at really what turned out to be the highest rate ramp that the industry had seen. And so aside from organizational changes we made in the company, one of the first decisions that we made was to unbound the incoming materials because it just drives or drove all of the inefficiencies in the plant. You would have 99 percent of a product ready to ship and then you couldn't ship it because of a $10 part. So what we did was we raised the inventory levels in Fort Collins, and frankly we raised them too high and we built a lot of inventory and that inventory was so we could meet the ramp. We have been continuously burning that down. That is where a lot of this excess inventory comes from.

We think we're pretty well matched with our customers right now, except in a few small areas, and, you know, I won't point out what those are, but they are not really material from a numbers point of view. The effort going on in the amount of intent to really start managing inventory is a lot tighter than it's been in the recent past, is -- you're seeing the results of right now. And, again, Steve and his team, they're just focusing on all the aspects of not only cost containment, but cash preservation, too. At the same time the whole organization is working better. But in this period of time, when we made the decision to increase the inventory, our on-time deliveries went up, and as far as we can tell, we were some of the stars of the industry. And at the same time we were driving quality up and had great performance during the year, as well. So it is a little bit of an advertisement for a lot of extremely hard work delivering results.

And your second question on ICOR, over the last eight quarters it has been 3 to 4 percent of sales.

Has that been gathering any kind of trend, Mike?

It has been growing somewhat but it has pretty much tracked the rest of the business. It is a profitable part of our business. It is profitable, it's healthy. It continues to grow; it is just small.

Okay great. Thank you.

Your text question comes from Ted Berg with Lehman Brothers.

Thanks a lot. I have a few questions. On the Summit product it sounds like you're getting some pretty good results in the FPD space. What's your expectation for this particular product line to, you know, result in potentially market share gains in the semi-equip space and how does this particular product differ from what your competitors offer?

If you look at one of the key advantages with these higher-powered products, is that as you put higher power in to either get reduced cycle time as what you would look at in 300 millimeter wafer or the larger areas and decreased cycle time in the flat panel displays, you're putting in more and more power so you've got a higher and higher probability of an arc occurring somewhere that the power supply doesn't create.

If you look at the value of what is being processed, the cost of that arc is phenomenal because you can lose a whole panel or you can lose a whole 300 millimeter wafer. With a 300 millimeter wafer, of course you've got multiple levels of metal and you've got multiple passes with copper. It is a --statistically you start building up a lot of risk. So the largest technology advance right now is the ability to either suppress arcs or to keep them from happening at all.

And as you go to more and more refined processes in the semiconductor area, and you start going below 60 nanometers, these are all very advanced processes and you've got to have a power control and conditioning of this output power, so that it is very gentle, yet creates very high performance as far as laying down these very thin films in very small dimensions. So the applications in semiconductor get to be higher and higher value, because you're taking away risk, and the applications in flat-panel display, besides just the higher power that you're dealing with, is you're also reducing the risk of damaging, you know, flat panels that have even lower margins than semiconductors.

Okay I had a question on the balance sheet, as well, Mike. What do you anticipate being the minimum level of cash that you think you need to have on the books to operate the business?

Well, the minimum level of net cash, Ted, we would want to have say $40 million. This is minimum. Plus the working capital line of credit of (ph) 20 to 25 million.

Okay. Is there any--it doesn't look like there has been any drawn down on that. Is that 25 million still intact.

Yes it is. We typically just use it to do foreign exchange contracts.

Okay. So 40 million plus the line of credit of 25. And on the last call it looked like there was some shortfall in the cash expectations that you had for the end of the fourth quarter. On the last conference call you targeted 120 million in cash on the balance sheet and it came in at 108. What made up that variance.

The biggest part Ted is that we paid down our payables. We talked about the shutdown we had the three weeks in the fourth quarter. We shut down the last two weeks of the year. Well the fact is the inventory is still here but our suppliers wanted to be paid. If you look at the balance sheet change Q3 to Q4 you'll see a significant reduction in accounts payable. So we just paid off our suppliers.

That was something that you hadn't anticipated having to do at that point.

No, because we didn't really figure we would be shutting down that much and the difference is $14 million and so we finished the year at about 107, 108. And that accounts for the majority of the difference Just paying down the suppliers.

Okay. Okay. And in terms of the transition of product to China, how many of the, if you look at the top 5 OEMs are they all qualified at this point for the product that you're shipping out of China?

Every OEM has qualified.

Every OEM, okay. And the last question on the 3.2 million charge that you took for the impairment of the value, you mentioned certain employment agreement and customer lists, that was Aera and Dressler.

Aera and Dressler. We bought both of those companies in early 2001, and three years later, because we have done some pretty good integration, we know the customer set. They've been integrated into the sales force. You look at the value on a go-forward basis and the customer list, doesn't make a whole lot of sense. The employment agreements, it gets down to consolidation. Those companies are now part of AE and so look at the true value of those. When you look at the other intangible assets we put on the book, like trademarks, those things are still fully valued, and quite frankly are valuable in the marketplace. So it is a changing circumstances.

Does a write-down of the customer list have anything to do at all with Aera losing any key customers at all.

No, and actually the customer list is really related to Dressler. It has more to do -- we've integrated Dressler and we understand the customers.

And the comment on that is Dressler has been a very high performer for us but we shifted them away from where their customer list was aimed into some of our core opportunities and they performed really well going after those.

The write-off of the employment agreement, what does that pertain to? Were there any executives running either Aera or Dressler that left for some reason?

No, It had more to do when you buy these companies and you just do the allocation of the -- call it the excess purchase price. The employees are still here, but it has more to do with we've reassigned responsibilities.

Okay. Thanks very much.

You're welcome.

Next question comes from a Kevin Vassily with Susquehanna.

Hi, good afternoon. Couple of questions. First on Q4 income statement. Mike, can you break out the split between selling expenses and G & A for the quarter?

Yes, I can. Selling expenses were about 8.5 million and G & A was about 4 million.

Is that a ratio you expect to hold at least for the next couple of quarters?

No, the reason that were putting them together, Kevin – we've made a lot of changes in this organization in our last 12 months, especially OpEx, and that is why in--this is the first time we combined them. And I think it is best that people who are analyzing our company look at them together.

Okay.

And so that's why we have combined them. Quite frankly if we were to continue breaking them out, the G & A portion of that would probably be higher. That is where we were taking a lot of the shutdown benefit in the fourth quarter.

That's fine. I wanted to make sure as I model forward we're looking at the right stuff. Second on the flat panel market, a couple of questions. Mike, I wanted to make sure I heard you correctly in your prepared comments. Did you say you expected continued strength from that sector this quarter but some pause following Q1, or did you say following Q3?

We said following Q1.

Q1. Okay. And then with regard to the products you're selling in the flat panel, do you get any revenue from your product lines outside of power right now?

Yes. It is all--I think it's –- yes, it is almost all flow, although we're looking at some other applications as well. We have a little bit of our source business in there..

Okay. Okay. Great. Thanks.

Thanks, Kevin.

Your next question comes from Andy Blackstaff with Touchstone Investments.

Hi, this is Wade Smith with Touch tone. I had a couple of question questions. Last year there was kind of a similar situation here, or it related to the fourth quarter where you put up a sales number that was pretty lousy when most guys were putting up really good numbers and then took the guidance up strongly for the first quarter. Here we are a year later. And you guys are taking a lot of charges here in the fourth quarter to clean up what is left of this restructuring apparently and raise the guidance again here in the first quarter. It doesn't seem like you have any visibility past the first quarter. I am just wondering,I mean can you give me any sense as an investor, or any comfort here going forward that we're not going to have a repeat of what happened last year?

You mean from the top line?

I mean from just the business in general.

Well, I think we're trying to communicate that we are rapidly improving our operational performance and the underpinning reasons for that we're trying to be clear about. Of course, we--I wish we could put 20 percent more salesmen on the street and go out and sell more stuff. But the--we actually, most of our revenues, like all of our peers, are heavily driven by the OEM's that we supply, and so what you're really looking at is whatever the mix is between the semiconductor industry, flat panel-display data storage, industrial, how they all fit together and what the demand is in those businesses. Historically no one can see, at least recent history, there is no one I know that has a very good read on things beyond about 90 days. So we'd love to give you comfort if we had it. We, you know, personal opinion, and that's all this is, and it's a combination of inputs we get from a lot of people, is that there isn't any cliff that we're all looking over. And I think everybody, as Mike said earlier, is anticipating that if things go in a reasonable direction, there could be a reasonable lift in the second half of the year.

Okay. Can you talk a little bit about the AMAT sales, looks like in the quarter they were about 20 percent of your revenues and they have been running about 25 percent for the year in general. Is there any trend in that number, I mean, you know, with this transition you had to China. They're not second sourcing somewhere else or you're not losing any share at AMET, are you?.

No, Mike can talk to this, too. I think we had the highest – or amongst the highest growth rates both in percentage and absolute dollar terms at AMET last year. We wouldn't talk about customers except for what's published. If -- we just think our relationship with them gets stronger and stronger; this whole transition to China has built a lot of respect and a lot of mutual support. They're just--no, there isn't anything going on that I know about. I think it is pretty positive.

If you look at our first quarter guidance, we're not going customer by customer, but we said we're going to be down 4 to 6 percent, and that is including the fact that we're starting to defer some revenue because of SAB101 and transfer of title. I think you will see that we are -- compared to some other companies in the space -- we have pretty good guidance in the first quarter on sales. To Doug's point, looking quarter by quarter is difficult, looking year-over-year we doubled our sales with Applied year-over-year and if you look at other companies in the space, that is at the upper end of what anyone has done.

Okay great thanks guys

You're welcome

Your next question is from Mark Fitzgerald with Banc of America Securities.

Thanks. Can you give us an idea how much of your costs are going to go offshore at this point with the China manufacturing strategy?

Well, Mark, when you are talk about--I mean, just the manufacturing type costs?

Well, I assume you'll also have suppliers now that you're pulling from over there. So I guess what I'm trying to get to, are we building into this model some exchange rate issues here?

We're not building any exchange rate issues. We talked a little bit about that in the past, whether the Chinese will let the R & D float, obviously they keep pushing back on that. The other thing is the supplier base we're talking about, some are based in China, but we have to (indiscernible) they are Pacific Rim. But many of those locations the currency is similar to the R & B are pegged to the dollar. We don't see where the currency issue is going to be anything affecting us over the next 12 months. Stranger things can happen but that is not part of our planning process.

So the components making up these power supplies being made in China don't have a significant offshore content, is that what you're saying.

No, what I'm saying they don't have a significant just China content. Your question was leading to believe on a foreign currency situation and the discussion typically has been the dollar versus the R & B. All I'm saying is that we have sources outside of China.

That adds, given that that is being driven by the China strategy doesn't that add some exchange rate risk? I don't know if it is coming from Thailand or Malaysia.

We always face exchange rate risks. It is there, we just don't focus on it.

And a lot of is the transactions are in dollars, anyway. And we got the question. So, no, it is not something that we think about day in and day out. The other point is, as Doug said earlier, with the Fort Collins situation, if producing out of China for whatever reason, economic reasons, financial reasons, became so difficult, we still have the fallback position of the United States location if need be and that has always been in the back of our mind and we have a recovery plan that says we could ramp up this facility in two to three months back to the prior production levels and when I say two or three months we don't expect anything to specifically happen to us, vis-a-vis China. If something happened in China on a macro level where we would have more than enough time to do what we've got to do while the rest of the world economy adjusted to it, we'd be the largest economy or the second largest economy in the world right now.

How do you guys protect yourself? We heard all sorts of horror stories over there about technology being ripped off and the low -- not a court system that is friendly to IP protection at this point. How do you deal with that?

We're dealing with it pretty carefully. We break up the manufacturing of the product, between the supply chain and between us, and that was one of the reasons why we decided it was important to do the total integration ourselves. We have--we do all of the test generation, all the product development in Fort Collins typically. And the amount of knowledge that resides in China is maybe enough to give someone a head start but at the same time it is not enough for them to how to design a product. So we don't think it's that big of an issue right now, but we're working it really carefully.

And I think that probably the biggest threat anyone has is not losing IP, it is a matter of China reverse engineering of the people's products after they get hold of them anyway and they're getting a brighter and more capable work force, and I think that's one of the reasons we decided that we had to be in China or be in Asia is because it's going to be extremely difficult for companies to compete in the future if they're headquartered and all manufacturing is in the U.S. And also from, Doug answered it from the technology standpoint. Let us talk MRIL bit about the business circumstances. You can't protect against reverse engineering. We faced that for years. Let us say someone comes out with a power supply. Doug pointed out, power is so critical to the process. It is a very small industry, whether it is at the end user level or OEM level. If someone wants to buy, "Business Week" had the article two weeks ago about face coming out of China. You won't buy a fake power supply first of all. If all of a sudden OEM machine goes down for a couple of days, who do you call for service? So near term we have protection because of infrastructure. and the need to have copy in the industry. But longer term we will look at it.

There is another piece, too, which is one of the natural barriers to entry, is we have a hard enough time keeping our products running. I mean, there is--we're at the edge of performance in an awful lot of areas and it takes incredibly skilled people, whether it is in manufacturing or engineering, just to cope with the changes that our suppliers make in their components and if you don't understand this stuff pretty deeply, it just stops working. So it is a--there is a natural barrier to entry, and that is of course one of the reasons why it is justifiable to get the higher gross margin.

Okay. And then just one detail question, was there any impact in gross margins in the quarter just reported from written down inventories, written down inventories that you went back and used?

No, everything was isolated this quarter. We had $9 million of inventory write-down but nothing beyond that.

But what I meant is in terms of in the product shipped and stuff.

No.

Thank you.

You're welcome

Your next question comes from Tom Difily[ph] with Merrill Lynch.

Hi, this is Mike Loden for Tom. Question on the data storage segment. Looks like the revenues in the fourth quarter there were the lowest they've been since the March of 2003 quarter, so wondering what kind of outlook you guys had for that segment going forward in 2005 and also when you might think that can return to more normalized levels. Thank you.

Obviously it is slow. And they wish it was better and we do, too. There has been a lot of talk about the smaller disk drives really being a new piece of leverage for the market, and that we'll see them in all of the appliances and much wide wider application of small disk drives to consumer products. I think some of that is starting up. We don't know when it hits capacity requirements but I guess the earliest would be late 2005, and as far as DVD's, which is the major driver of the other part of the business, I think this issue between Blue Ray, et cetera, and whatever the formats are, that has got to be resolved. But it seems like the ordering for this year is going to be fairly muted. Most of the business usually picks up in the second to third quarter and it is all for Christmas shipments. And so we have, you know, it is just a little bit too early to see what's going to be happening with those kinds of issues right now. We don't have that much visibility.

Okay. Thank you.

You're welcome.

If you would like to ask question, press star and the number 1 on your telephone key pad. Your next question comes from Gary sway with Smith Barney.

Quick follow-up. I wanted to ask about your Arab business unit. MSC is kind of a different animal. I was wondering if you could talk about where the products are in terms of pressure and sensitive offering and about gross margins. Are gross margins tracking at slightly different path? I see in the press release that you guys might be taking restructuring charges for the High Gochee. Where are gross margins today for Aera and where can they be at the end of '05. Thanks

We don't break out gross margins by product line. The history.

Can you give me a range?

We can tell you Gary is this. The gross margin for the flow products tend to be in the power product. The power investment is lower for the power. So they give similar contribution. And I'll let Doug answer the question. The expected share out of the charge at high [CHOECHEE,] it has nothing to do with the product line itself whatsoever. Doug, if you want to address.

If you look at Aera's focus was a service business in an extremely high reliability, very, very good performance product. they built a lot of loyalty on that basis. And so they got--have a great brand name but they didn't emphasize technology, which is one of the points of contribution that AE could make. And so the first thing that we did was to spend about a year and a half bringing their technology up to what we call the transformer, which is you reduce hundreds of part numbers down to 8 or 9 which makes it easier on the customer, and easier on our own manufacturing, et cetera. So that is the first stage of the transition that we made. Now we're injecting our technology into the second stage and that's just exactly what you said, it is the pressure sensitive. We started late, we made some phenomenal progress. We're optimistic about where this can go. Both of those actions stop market share slide and we're pretty optimistic, as we should be, as to where this is going to go.

Okay. When do you expect to release the PIMSC.

It is out for evaluation for some customers now. We're getting positive feedback.

Thanks.

No further questions at this time.

Okay. Thank you for joining us today. I want to take a moment to remind everyone that we're going to be holding our analyst and investor events in New York on March 1, and in San Francisco on March 10th. And in addition to Mike and me, Steve Rhodes our Executive VP of products and operations will be one of our featured speakers and will go over more specifics about how our new and differentiated products, as well as the latest updates on our key initiatives. More information is available on our investor relations website. We hope to see you in New York or San Francisco, or both, in the coming weeks. Thanks again for your time today.

This concludes today's conference call. You may now disconnect.