Advanced Energy Industries Inc (AEIS) 2005 Q1 法說會逐字稿

Good afternoon. My name is Venetia and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Advanced Energy Quarter One 2005 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. [Operator Instructions] Thank you. Ms. Kawakami you may begin your conference.

Good afternoon, everyone, and thank you for joining us today. Doug Schatz, our 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 an overview of the results before we open the call to your questions.

By now you should have received a copy of the press release that we issued approximately 45 minutes ago. If you still need a copy of this release, please contact us at 970-221-4670, or you may 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 on the manufacturing and supply chain transitions currently underway. Other risks are described in our Forms 10-K, 10-Q and other reports that are filed with the SEC. In addition, we assume no obligation to update the information that we provide to you during this conference call.

I'd now like to go ahead and turn the call over to Doug Schatz.

Good afternoon, everyone and thank you for joining us. First, I am pleased to report that the first quarter 2005 results marked our return to bottom-line profitability with net income of 734,000 or 2 cents per share on slightly lower sequential revenue of 86 million. Improved gross margins to 33.8% of sales, driven by the acceleration of our China manufacturing and supply base initiatives and also by favorable product mix. We grew cash and short-term investments in excess of 13 million, essentially driven by a 10% reduction in our inventory.

The lessons we have learned in undertaking the major transformation of the company are now driving increased momentum in these final stages. We accelerated most of the product transfers to China slated for Q2 into the first quarter, which enabled us to downsize volume related operations in Fort Collins ahead of schedule. By the end of the first quarter, 50% of our power volume shipped from Shenzhen and we currently have a total production capability of approximately 85%. There is more work to do, but the majority of the cost and the risk associated with this project are now behind us.

Over the next nine months, we also anticipate continued momentum in shipping our supply base to localized agent suppliers. Our customers are working closely with us to quickly move and qualify critical parts from our new supply partners. Currently, we anticipate moving approximately 75% of our total materials to suppliers in Asia, and we are about halfway there. These critical initiatives have been a major focus and priority over the past two years, and yet throughout all of the challenges we faced and overcame during this process, they didn't deter us from our other critical focus, which is to drive technology leadership through ongoing innovation.

One measure of leadership is market share. DSOI (ph) Research just this week published its 2004 data for critical subsystem sector. In both 2003 and 2004, we grew market share in DC and RF Power Systems. Although we are over eight times as large as our nearest DC competitor, we were able to grow market share through new product introductions and strong our position in flat panel display. In RF, we continued to benefit from the transition to 300-millimeters and smaller geometries based on the designs, won in the past two to three years, leveraged our Advanced RF Solutions. Overall, our share of the markets we serve is 50% and growing.

We are expanding our leadership position by delivering superior performance value for our customers and enabling the process technology advantage in the marketplace. We continue to see some pressure on our Mass Flow market position, which has decreased about 2 points from the 23% share in 2003. We are in a strong number two position, about 25% larger than the next largest MFC supplier, who also saw a slight share decline last year.

Transformer MFC continues to increase its own market share after introductions just last year, and we are experiencing a good deal of end user pull through, based on the reliability and process efficiency and cost of ownership that it provides. This year we are driving another new technology innovation through the product line. The window of opportunity is still open for that innovation, and we are aggressively pursuing design opportunities that will require this latest MFC technology.

In terms of our industry view, we continue to take a cautious stance on the semiconductor demand environment. We expect second quarter sales to be flat to up 4% compared to the first quarter. Although, inventory levels, utilization rates and the transition to 300-millimeter are trending in the right direction, the current macroeconomic environment does not appear to signal a meaningful new term improvement in demand.

We believe there are significant opportunities for growth within the semiconductor industry through Advanced Energy, but the timing of the acceleration is not clear. Innovation is the lifeblood of our company, and continues to propel us into new opportunities regardless of the trajectory or direction of each industry cycle. We have been able to leverage our strong position in high growth areas to develop unique solutions. We then refined those solutions to address similar challenges in other industries. Sometimes even before our customers anticipate the need for them.

We continue to see positive trends in designs win across a variety of product platforms, as we pursue a focused set of opportunities that meet our internal model for growth and profitability. We are well positioned to continue on this unique path of technology leadership and innovation. The strength of that position grows every day as we put the final pieces of our business model transformation into place, and we further extend our marketplace lead, and start to redirect our energies from the China project to an increasing and broad range of performance metrics.

I want to thank our employees across the globe for the vital contributions they make to Advanced Energy and to our customers everyday. Our first quarter performance is a true reflection of their hard work and winning spirit, and effective ability in getting results. I would now like to turn the call over to Mike to review the financials with you.

Thanks Doug and good afternoon, everyone. I will review the results of the first quarter and then provide guidance for the second quarter of 2005. Revenue for the first quarter of 2005 was 86.1 million, a 2.6% decrease compared to fourth quarter 2004 revenue of 88.4 million. Year-over-year, revenue decreased 17.6% compared to first quarter of 2004 revenue of 104.5 million.

We improved gross margin ahead of plan to 33.8% for the first quarter, compared to 16.5% of sales for the fourth quarter of 2004. If we exclude the fourth quarter charges, gross margin on a non-GAAP basis was 26.7%. The first quarter margin is a 710 basis point sequential improvement on lower sales, primarily due to the cost improvements we have made and favorable product mix. Gross margin in the first quarter of 2004 was 36.8%, on 17.6% higher sales.

As Doug mentioned, the first quarter marked our return to net profitability also ahead of plan. Net income for the first quarter of 2005 was 734,000 or 2 cents per diluted share, compared to the fourth quarter 2004 net loss of 23 million or 70 cents per share and the first quarter 2004 net income of 6.9 million or 21 cents per diluted share. The higher than expected net income reflects the acceleration of the Fort Collins manufacturing realignment, as the facility transitions from volume manufacturing and new product introduction and advanced manufacturing.

Over the past several quarters, we have maintained dual manufacturing operations in Fort Collins and Shenzhen, essentially a double mortgage to meet customer needs while completing product qualifications from the new Shenzhen facility. We estimate this double mortgage reduced our gross margin between 200 and 300 basis points. We believe additional cost savings will be achieved, as the transition of Tier I and localized agent suppliers' progresses throughout this year. We estimate that we will see an additional 400 to 500 basis point improvement to gross margin, once the target of 75% of materials send is transitioned overseas and the remaining duplicate costs are eliminated.

Looking at end market sales, semiconductor capital equipment represented 53% of total first quarter 2005 sales or 46.1 million, up 8% compared to 42.7 million in the fourth quarter of 2004. The increase is primarily attributable to the momentum in 300-millimeter-related products. In the first quarter of 2004, sales to semiconductor capital equipment customers represented 66% of total sales or 69 million. Applied Materials, our largest semiconductor capital equipment customer represented 24% of total first quarter 2005 sales or 20.8 million, up 20% in dollar terms from fourth quarter 2004 sales of 17.3 million.

In the first quarter of 2004, Applied was 28% of total sales or 29.4 million. Flat panel display sales represented 21% of total first quarter 2005 revenue or 17.8 million. This represents a sequential decrease of 8% in dollar terms compared to our record 19.3 million of total sales for the flat panel industry in the fourth quarter of 2004. ALVAC, our largest flat panel display customer represent 8% of total sales in the quarter. Flat panel display represented 10% of total sales in the first quarter of 2004, a year-over-year increase of 68% in dollar terms. We expect softness in near term demand onto to the latter part of the year, as the transition to Gen 7 and Gen 8 gains traction.

The data storage industry was 5% of total first quarter 2005 sales of 4.2 million, which represents a decrease in dollar terms of 16% when compared to fourth quarter 2004 sales of 5 million. The decrease is due in part to seasonal weakness. This market represented 8% of total sales or 8.6 million in the fourth quarter of 2004. Advanced product applications represented 21% of first quarter 2005 revenue or 18.1 million, a 15% sequential decrease in dollar terms compared to the fourth quarter 2004 amount of 21.5 million. Advanced product applications represented 16% of total sales or 16.3 million in the first quarter of 2004.

In addition to architectural glass, this division includes a variety of applications such as our ICORE power supply for the high-end computing market. Also included our industrial coatings, laser and medical applications. Global Support represented 12 million or 14% of total first quarter sales and an increase of 17% in dollar terms compared to 10.3 million or 12% of total fourth quarter 2004 sales. Global Support was 9.3 million or 9% of sales in the first quarter of 2004. Global Support revenue has been increasing due to expanded service offerings as well as upgrades and refurbishments.

Looking at sales by geographic region, United States sales represented 52% of total first quarter 2005 sales, an increase of 10% in dollar terms compared to 46% of total fourth quarter 2004 sales and a decrease of 24% in dollar terms compared to 57% of total sales in the first quarter of 2004. Sales in Europe represented 10% of total first quarter sales, a decrease of 22% in dollar terms compared to 13% of total sales in the fourth quarter and 15% of total sales in the year ago period.

Asia pacific represented 37% of sales, down 11% in dollar terms, compared to 41% of total sales in the prior quarter and up 8% in dollar terms compared to 28% of total sales in the year ago period. We ended the first quarter of 2005 with a total backlog of 45.7 million compared to the fourth quarter backlog of 33.9 million. R&D spending was 11 million or 12.8% of sales during the quarter. We continue to drive a more focused approach to our R&D investments, pursuing those opportunities that meet business goals and leverage core competencies. We expect R&D to remain at approximately 11 million in the second quarter of 2005. R&D was 12.7 million, or 14.4% of sales in the fourth quarter of 2004, and 13.4 million or 12.8% of sales in the first quarter of 2004.

SG&A was 12.9 million in the first quarter of 2005 or 15% of sales compared to 16.2 million in the fourth quarter of 2004 or 18.4% of sales. This compares to 13.8 million or 13.2% of sales in the first quarter of 2004. The amortization of intangible assets was 497,000 in the first quarter 2005, 538,000 in the fourth quarter of 2004 and 1.2 million in the first quarter of 2004. We had charges of 1.3 million principally related to headcount reductions in the associated severance and termination benefits. We anticipate additional charges in the second quarter of approximately 1 million, as we continue to realign our worldwide manufacturing infrastructure.

Non-operating expense was 2.1 million. Our effective tax rate was approximately 40% and our earnings per share were 2 cents. Headcount at the end of the first quarter was 1,503 people compared with a headcount of 1,651 at the end of the fourth quarter of 2004. We continue to focus on strengthening the balance sheets. We grew cash and short-term investments by 13.4 million during the first quarter of 2005 and ended the quarter with cash, cash equivalents and short-term investments of 121.4 million. We expect this total position to increase to approximately 125 million by the end of the second quarter.

Trade accounts receivable was 63.8 million for the first quarter of 2005, compared to 66.6 million at the end of Q4. We were able to hold DSOs cost in the 67 days compared to the fourth quarter of 2004. We lowered inventory by 7 million during the quarter. First quarter inventory was 66.2 million compared to 73.2 million in the fourth quarter of 2004. Inventory turns of 3.2 turns in the first quarter, 3.2 turns in the fourth quarter, and 3.8 turns in the first quarter of 2004. Total days inventory was 114 days, the same as the fourth quarter of 2004, compared to 95 days in the first quarter of 2004.

Our capital expenditures in the first quarter of 2005 were 2.9 million compared to 1.5 million in the fourth quarter of 2004 and 3.8 million in the first quarter of 2004. We expect CapEx in the range of 2.5 to 3 million in the second quarter, as we continue to invest in our manufacturing operation, IT infrastructure and approximately 10 to 12 million for the year. Depreciation was 3.3 million in the first quarter, which is the same as the fourth quarter of 2004, and compared to 3.2 million in the year ago period.

To summarize, our second quarter guidance, we believe that sales will be flat up 4% to 86 million to 90 million. Gross margin will be in the range of 33.75% to 34.25%, as continued operational improvements will be offset somewhat by more normal product mix, the impact of annual wage increases that went into effect March 1 and variable compensation accruals. R&D will be approximately 11 million and SG&A will be approximately 13.5 million. The sequential increase is due to salary increases and variable compensation in the SG&A area. Amortization will be approximately $500,000. And operating income will be in the range of 3.5 million to 4.5 million, including charges of approximately 1 million, as we essentially compete our operational transitions. Non-operating expenses will be 2.25 million, and our earnings per share will be in the range of 3 to 5 cents with an effective tax rate of 40% and outstanding shares of approximately 33.250 million.

Cash, cash equivalents, and short-term investments should be approximately 125 million and inventory in the $60 million range. While we believe that we will continue to generate free cash flow with our restructuring plan, we are actively reviewing our financing alternatives at the current time.

To give you a perspective on the financing situation, we currently have 195 million in long-term debt. Approximately, 188 million is related to two convertible debt offerings that come due in the second half of 2006. Of that amount, 122 million converts at the share price of about $30 a share, and 68 million converts at about $50 per share.

After any refinancing, we would like to have a positive net cash position of at least $40 million. Combined with our $25 million working capital line of credit, we would have the flexibility we need to operate the business. Under those parameters and given our current cash situation, we would raise approximately $100 million.

An equity offering with a $10 stock price would increase our share count by 10 million shares. A convertible debt offering with a 30% premium above the $10 share price would require approximately 7.7 million shares on conversion.

So taking into account the 5.4 million shares that are covered by our current convertible and which we would pay off, our fully diluted shares, ignoring shares related to stock options and other stock-based compensation would increase an additional 2.5 million to 4.5 million shares, to a maximum amount of approximately 42.5 million. From an EPS leverage standpoint, this is in line with or better than our peer companies.

Of course, if market conditions change and we generate more cash internally, the amount we raise in a funding transaction may change. We have a $250 million universal shelf registration, that provides us with the ability to offer public debt, equity or a combination of the two. We can also access the private funding market.

In terms of timing, we would prefer to take some type of action, before the debt becomes current later in 2005; although it is heavily dependent on market conditions. We are comfortable that we will be able to address the situation with one or more of the vehicles available to us.

Doug and I will, now, be happy to answer questions. So, operator, please open the line for questions. Thank you.

[Operator Instructions]. We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Jim Covello from Goldman Sachs.

Hi. Good afternoon, guys. Thanks so much. Congratulations on the good execution here on the turnaround. A couple of quick questions. Around the revenue guidance, you say, you're taking a conservative approach, which I understand. But your customers have guided that -- you have couple of customers -- big customers that have guided -- so far have guided shipments down, and you are guiding revenue up. So can you help me think about that a little bit? Is that maybe some flat panel that's better off or how do you think about that?

Well, hi, Jim. It's a combination of things. The one thing that we've noticed is, in the past several quarters, we've been a little bit out of pace with what our customers have announced. And so we see a demand right now, that has been consistent and strong in some areas of our business and independent of some of these signals we've been getting from out of the press. We've been seeing a pretty strong demand with quite a bit of confidence within the normal range of visibility that we have. So we can't account for what's being communicated from our customers outward, but we see pretty strong indications of support over at least the visible part of the next quarter.

Okay. That's helpful. Thank you. And then my second question would be...

Doug.

In terms of the -- it sounds like there is going to be continued earnings leverage opportunities in the model from here. Revenues are up a little bit. The EPS guidance is kind of flattish on an operating basis. Can you help me think about that?

Well, first of all, Jim, let me add something to the first question.

Sure.

We've talked about this over the last several years. Our continued investment in R&D, as we continue to position ourselves in 300-millimeter. We are seeing strength in 300-millimeter. So even though our customers may be going sideways, they are moving more and more to 300-millimeter and the designs wins that we've talked about over the past several years are continued to contribute to, so what you see is maybe a difference in the overall market demand. Michael?

Really, Jim, there is one other piece -- there is actually two other pieces in there too. One of them is that even though we don't break out the detail, we feel that we have gone through almost a V-shaped curve in our flow control business. And although we announced that market share went down, we've been seeing a lot of indications that we've been picking up market share with our transformer products, and some of our newer introductions.

The other thing is the part of our business that's associated with global service and support has gone up, and that's a good long-range adder to the whole business capabilities, as we've leveraged the flow control business and relationships and long-term relationships with the customers to support the best. So we're getting -- in other words, we are getting more than just product sales from existing power products.

And so the answer to your second question, Jim. As we said in the presentation, our first-quarter results were ahead of our plan. The people did just a tremendous job accelerating the transition. And so what appears to be a flattening of, if you will, the improvement curve, that essentially what we've done is we have decelerated that improvement curve. And one of things we talked about is that a lot of the improvement that we expect, going forward, is the continued transition in the tier-1 suppliers. So what you saw in the first quarter was an acceleration of reducing a double mortgage. The continued improvement to tier-1 suppliers is on schedule and moving up at the same slope, as we had expected earlier in the year. And the other thing, as we pointed out in the presentation is, we had impact -- a positive impact of product mix in the first quarter. So we expect the product mix to go back to what has been a historical mix. And so we'll continue to cut operational cost, but much of that happened in the first rather than the second quarter. We continue to do some material costs, but that will be slightly offset by product mix. But from the standpoint of an operating model and operating leverage, the things that we've talked about on recent analyst meetings about driving to $70 million breakeven by the fourth quarter is still intact. What we've done is we've accelerated some of that movement.

Thank you so much and congratulations, again.

Thank you.

Your next question comes from the line of Stuart Muter of RBC Capital Markets.

Thank you. Good afternoon and let me add my congratulations on the excellent operational turnaround. A couple of questions -- first for Doug. You guys mentioned the increased product or service offering and global support. Maybe, could you talk a few minutes about, you know, what products and services you are offering there?

Thank you, Stuart. We don't want to get too detailed, but one of the pieces of thinking about Aera was that they were renowned as having this phenomenal service capability, particularly in Asia, and that we believe that with cross-selling and the strength we have with the OEMs that we could make this synergistic. So with flow control products, you have an ongoing relationships with fabs, as they change calibrations, as they change gasses, as they move equipment around in the fab. And so the relationship is you're really part of their airflow, if you will, the operating structure. And we've been able to find some ways where we can offer different kinds of solutions with power as well where we can upgrade products, we can provide performance improvements, and we can provide different ways of looking at service. And that's being well received.

Okay. Is it fair to say that you have a goal to increase the percentage of service revenue long-term?

I think it's better to say that we have a goal of increasing service revenue.

Okay. Thanks, Doug. And a question for Mike on the gross margin improvement and the 400 to 500 basis points potential. You know, how should we look at modeling that, going forward?

Well, most of it is going to come, going forward from improvement with our suppliers. I think the best way of looking at it is we said that, by the end of 2005, we expect to be at the $70 million breakeven and we've talked about having a margin at that level -- gross margin of about 33.4%, and obviously zero operating income. The goal we set internally is that we used an incremental model. And from an instrumental growth margin basis, we would like to be able to put a minimum of 50 cents of every $1 in the gross margin line and 40 cents of every $1 in the operating margin line. And so I can't talk about the interim quarters, but the executive team and management team of Advanced Energy is committed to hitting that lower -- that $70 million breakeven goal by the fourth quarter. Also with that, that incremental gross and operating model -- margin model.

Okay. If I could take one follow-up on that? Mike, is it fairly linear, the transition to the local sourcing in Asia on your building materials or is it, kind of, more backend-loaded?

I think it's fairly linear, but the thing that we're also addressing is while our team did a tremendous job reducing inventory in the first quarter, we still have to roll out the higher priced older inventory. But the real key that we also look at is few share points to it. So we look at the building materials on a go-forward basis, and we expect to see those lower costs. How we burn up the older inventory depends upon product demand and also -- on a product specific basis and also on macroeconomic demand. So I think it should be fairly linear, but not straight-line per se.

Okay.

And it should continue beyond the 2005-2006 boundary.

Right. Okay. Thanks a lot, guys.

You're welcome, Stuart.

Your next question comes from the line of Steven Pelayo of Fulcrum Global Partners.

Great. Congratulations, guys. Just so I make sure I've got my math right here. You guys reported EPS of 2 cents, but I guess you've excluded the charge. I see it was actually 4 cents. I also want to make sure -- first, do I have that right, and secondly, is the gross margin that you just printed. I know you guys had some inventory write-off. Did that benefit from any recapture though?

There was nothing. We have ventured out in the fourth quarter with no recapture in the first quarter. And if any recapture, Steve, we would disclose.

Okay.

And your math is right. It was 2 cents.

Okay. But 4 cents excluding that charge? Right.

4 cents excluding the charge.

Okay. We're breakeven really today or...

Well, we're probably in the high 70s.

And a couple of just quick ones here. It looks like your bookings are up, I don't know, 25% or so quarter over quarter. I know it's really more of a turn's business. But is this foreshadowing the inventory rebuild at your major OEM customers or something?

No. I mean we went into that over the last several days, Steven. I mean some of it has to do with new introductions with the summit and the DC part we talked about. But I think that the base case is we were shut down for the last two weeks of 2004. And while we were shipping products, we're not going to lose to reduce our backlog. And we had our order department open. Our customers tended to know that we were going to be gone for those two weeks. And so, you know, we saw some orders go into the first couple of weeks of January. So I wouldn't read too much into it.

Okay. And then, just to clarify again, what was your guidance again on the tax rate?

About 40%.

And, you know...

40%.

Okay. Where do you stand in the wealth position, now? That surprised me. I thought we have been sticking at just, kind of, $0.5 million run rate for taxes.

Well, it's an interesting question. The fact is that, you know, of course, like all companies in the industry, we took a full valuation allowance against the deferred tax asset, principally because of losses in the United States. Well, we've taken in the first quarter, because you do a taxing based upon the whole year. We've looked at it, we'll look at sustainability on generating profits in the United States over the next couple of quarters. And if we are comfortable that is going to be in place, then we'll do -- we'll restore the deferred tax asset valuation. And that's where it stands. But, you know, for one quarter, it does not a trend make. We want to see a couple of more quarters of sustained profitability in the United States.

Okay. And one last clarifying question. The diluted share count again that you talked about -- I went into that math again. If you guys retire the existing debt and do convertibles or do equity, it would range from -- what was it again -- and additional 2.5 million shares to M&A?

2.5 to 4.5 million shares.

Okay. Okay. That's a little better than I thought. I guess I forgot to pay off the other ones.

Yes.

Excellent. Thank you, guys.

You're welcome, Steve.

Your next question comes from the line of Jay Deahna of JP Morgan.

Thanks. I think a couple of questions. First of all, Mike, can you reiterate your gross margin guidance range for the second quarter please?

33.75 to 34.25.

Okay. The second question is in terms of the product mix from 1Q to 2Q, can you kind of qualitatively or quantitatively explain how that changes? Is it more power versus flow or a different mix of power? What are you referring to?

It's probably just a different mix of power. It may be a different mix of markets where products are sold in and where we have a variability in prices around the world. We also have variability in end user versus OEM. One of the things that as Doug pointed and I pointed out, we had a significant increase in our service revenue quarter over quarter. The business continues to grow, but you never exactly know where that's going to take off. One of the things that I've found in the time I've been in this industry is that companies usually delay service, and the fourth quarter of the year when people are getting towards the typical end of their fiscal year, they will even put on service not just CapEx. So not to take away from the great first quarter we had in global support, but we just wanted to see a couple of quarters of sustainability there.

You know, I think, Jay that you can look at it -- I don't know the exact number, but I think we've seen overtime with a range of products that we have and, as Mike says, the range of applications and markets that we can see a plus or minus roughly 2, 2.5% shift around gross margins on a constant if you use normalized revenues. So there's that amount of noise in the system, depending on unique product demand in a unique marketplace. We feel it's a normal thing, but it's normal on the favorable side right now, and that's part of the reason for describing that in the gross margin explanation.

Okay. And then one last one, Doug. This one is a little more philosophical in long-term looking. If you look at your customers, like Novellus and Applied, for example, there becoming increasingly competitive against each other. So, for example, Novellus getting more competitive in PPD is kind of -- I don't know if "collapsed" is the right word, but put a lot of pressure on Applied Margin Structure in PPD compared to where it used to be. Does your customers see you lowering your cost structure by getting your operations mature in China? To what extent, are they going to turn around and hey, "Hey, you know, we got more pressure on our pricing side of things, and we need some more concessions from you." You know, are they going to take away your gains or how do you prevent that from happening?

Well, I think, we prevent it by basically having products with the unique enough value where you really say you can't go there. We've got really constructive discussions going on, on what we can do with our cost-cutting roadmaps or, let's say, cost roadmaps based on restricted technology sets and very focused product developments. And I think that's a constructively way to approach it with a customer that can stand behind their commitment where we can really develop a product beneath those needs. I mean, historically, what we've done, Jay, is that we have customized products around the strategy of unique and individual customer needs. And, so even though we might have a platform that we service the whole industry with, there is wildly different philosophies, if you will, of what should actually be delivered to a specific customer.

I think there is always going to be pressure from the OEM's to drop prices, but we've been demonstrating that we can't have a high degree of technological development and innovation and do it cheap. So we can definitely have different business models, but we can't mix the two together. And I think everybody -- maybe, everybody might understand, but also people are beginning to accept that if you want low cost, you don't get that higher performance. You certainly don't get the leading edge of performance. And if that becomes the competitive issue out in the marketplace of who -- whether someone's got an extremely low cost product or whether they've got a product that brings extremely low cost of ownership because of performance advantages, I think we're going to go for the performance advantages because we're still in a technology-centered industry. So, that's kind of the philosophical way of addressing your question, I guess.

Would you say that the situation today is similar to where it was four or five or six years ago from this perspective or its different in someway?

Its really different. I think that what we felt five or years ago was mostly talk about having to lower prices. And everybody would push back because everybody was developing so many different technologies and products. Now it's clear that our customers are focusing their requirements into a much smaller set. They want that for an efficient delivery and cost, but we also have got to test how interested they really were in either having a superior product from, I would say a competitor that couldn't deliver that kind of capability were also restricted set. And they go back to what they need. Eventually, they find out in the marketplace what they need and like we wind up with some kind of a dialogue that gets us to something we can deliver to. But five years ago, it was a completely different universe. I think that all of the OEM's are very positive now they that have seen us and they have seen our facilities in China. They are very positive that we are being efficient and our inefficiency is not being translated into something they have to pay for. So I think we're in a unique position that way. But it's a strong dialogue, but it's -- we understand where the bottom of the lake is and we are not going to go there.

Okay. Terrific. Thanks guys.

The next question comes from line of Robert Maire of Needham.

And by the way, let me add to congratulations on very nice turnaround. In terms of the new facilities in China, is the ratio of fixed cost variable cost similar to what you had in the US production facilities or has that changed? You can give us a sense as to your ability to increase volume without increasing fixed cost or decreased volume and what's that structure look like in China?

Robert, it's a variable cost much lower, but the fixed cost are somewhat lower, but not significantly lower. If you talk about fixed cost, you get bricks and mortar, you have got machinery whether it's manufacturing machinery or IT support. I mean, those are all about the same but the ability to flex up and down from a variable standpoint is quite a bit less in China than in the United States. There's another benefit that you can get which is you can afford to have an efficient amount of capacity that we couldn't afford to have during some of these cycles in Fort Collins. So the cost of training isn't high when there's recovery. So you get some benefit in the flexing and average is down because of the average. So I think all in all, Robert you get a better model.

Okay. So flexibility you are seeing but, is that the cost basis over all aside from being 500 basis points lower just, you get other efficiencies that in terms of flexibility?

Yes, longer terms, you start picking up all kinds of other things. Because you have got a supply chain that's local, that's designed around flexing. You wind up with the cost of inbound freight and eventually outbound freight continuously going down as the customer concentration becomes the -- the customers, the end users becomes the customers that you ship to because of changes that the OEM's are putting in place. So long-term, you wind up with a lot of advantages from being there that show up both in flexible cost, variable cost and an absolute cost.

Okay.

As you are modeling the world Robert, but the fact is once we get this thing fully in place and we see some volume increases in the industries that we serve, we keep looking at the incremental margin now you think about modeling. Yes that variable cost was down substantially but part of that variable cost it allows us to return to the shareholders.

And one last question related to that. In terms of the overlap with production in the US, how long will that last until we can get rid of the sort of double expenses and you anticipate any write offs at the end of the year to close out any US facilities or US facilities-related issues?

But the write offs would be minor and they are envisioned in the million dollar that we talked about during the presentation. And we expect that this is going to be essentially complete in the early summer.

Okay. Great. Thank you. Congrats again.

Thanks Robert.

Your next question from the line of Ali Irani of CIBC World Markets.

Yes. Good afternoon gentlemen and congratulations again for getting back on track. I'm hoping you could clarify two things for me. One in terms of the fixed cost reduction, the head count drop. It seems that you pulled in some of the efforts previously expected in the second quarter to Q1. We've seen the step-function gain. I'm wondering though, since most of those efforts were focused on between mid 2Q and 3Q, whether there's another step function gain coming after the second quarter and your third quarter fixed costs. And that's my first question and I'll come back with a second one. Thank you.

I would say, Ali that the step-function will not be as great, but it's still there. What you saw in the entire empire presentation, we applied everything we've been learning over the last year or so and put all together at once just a tremendous effort by the manufacturing and obviously supply chain part of the business. The other part we're looking at closely is how do we ramp-up China. Doug's point that we can pay for more efficiency thing, for say as one thing but we're will be looking at head count. We are going to take full advantage of China to make sure that given the low cost of operations there, we don't solve efficiency problems by putting more people on the floor. And the people in day in and day out are trying to fix that, in fact our person in charge of manufacturing is I think, it's currently in China and goes there every two weeks. So I wouldn't think a whole lot about a step function coming up. There will be improvement. The 400 to 500 basis points we're talking about is going to be a bit more gradual as we get through the rest of the year.

Michael, given that you pulled in the curve here a little bit, why should we not expect that 70 million break even could be achieved earlier in the third quarter?

There is a potential to get it achieved, but what it comes down to Ali is inventory turns burn off and getting more suppliers qualified. We have a great supply chain management team, but there is only so much our customers can do. We can try to push this along as fast as we can and our suppliers are meeting our needs to most extent. We start to go back to our customers so it's possible Ali, but only time will tell.

Okay.

But and Ali, I think there is the underlying piece is we can be pretty aggressive and specific about the things that we can control 100% or even 80%. We just want to make sure that we can, we are not overstating anything. And we can meet our execution commitments on this. And some of the issues as Mike said are built on a working relationship in agreement with their customers. And some of it is just the capability of suppliers if step into play. But it's going really well, but we aren't going to over commit.

Okay. The second part of my question relates to your second quarter guidance. And I'm just trying to understand the parts of the business that are moving higher sequentially. Obviously, we know some of the guidance from the larger OEM, some of your larger OEM customers. And at the same time, we've seen some activity pick up again in the flat panel business. The Japanese equipment bookings were up 15% sequentially in the first quarter. Could you give us some clarifications to those parts of your business in the second quarter in Japan? You have a strong footprint and then in flat panels, should we expect sequential recovery in your volume in 2Q?

In flat panel, Ali but what we see today, we do not expect to see an up tick in flat panel in the second quarter. I know that there is some talk in the market today, but as of today, we don't expect it. By the same token, we talked about slow downs flat panels for a while. Right now, looking, we talked about backlog, looking at our backlog, we would say no. That doesn't mean the order is not going to come in. Strength quarter-over-quarter, it comes down to our position in 300-millimeter semiconductor. I believe that is what's driving it. And we take a close look, obviously, at what our customers are talking about. I think all too often, people try to get too precise in that calculation and try to tie it together. Even, Doug said earlier there appeared to be some mismatch, but the bottom-line is, even though our customers are maybe saying that they are going to ship as maybe down a little bit, we continue to drive the successes in 300 millimeter. Flat panel seems to be flat and down a bit, data storage as this is a small part of the business. We're not exactly sure.

The advanced part of the applications, especially architectural glass, there has been a bit of a slow down there, but that could pick-up ever so slightly. You see energy price is coming down in the $50 range. And that's another thing when we talk about Tier 1 suppliers, I mean, there is some cost going through the food chain trying to absorb higher energy cost. But at the end of the day, the up-tick or what appears to be our positive trend versus the industry is further penetration with 300 millimeter.

And just trying to get one more clarification on this. Would it be a premature to assume that as we go to 65 nanometer platforms are being delivered in the next couple of quarters, that the value of the power supply system in the 300-millimeter platforms is actually gaining share over other components? Have you done any studies of that?

Well, always the power supply system is all part of it. I say that kind of -- it's like tongue and cheek. It's actually pretty accurate because the precision required and on also with the larger wafers, which is where the advanced technology is, the amount of power required. So you've got both, power and precision, the amount of control needed, and the risk of making a mistake in this process and wafer those way up. So the tendency is to move towards more and more exotic and higher and higher performance power in the application of the advanced critical dimensions inside of 300 millimeters.

If you have been gaining market share and the role of your supplies is growing, then it would be fair to say that the pricing has not been an issue for you.

Quite well, it's almost like pricing has turned into part of everybody's DNA. So you go through it and it's an aggressive part of every negotiations. The -- it's like that's a almost irrelevant after you get to the point of discussing what the needs are and whether or not you are capable of supplying the needs for a reasonable price. It's not like everybody is selling standard products and there is some stocking horses there.

To give you an idea, specific answer to your question, just go to 65 nanometers instead of a single power supply being used at a single frequency (ph) or more complex systems too. Now there is three and each one is running at a different frequency. And these things aren't just separate power supplies inside of a system they all interact in the plasma.

So the level of complexity and the level of understanding needed just to be able to deliver power that -- so that you don't get the different elements confused with each other or develop a reliability problem, it gets to be a huge issue. So the customers want the lowest price possible, but they also need the technology. And every customer that I've talked to when you start talking about what happens when we go to 30 nanometers. Does this get harder or do you use the same products? It's almost like their eyes cross.

You know it's a -- we see technology as being a core part of what we are doing in the future, but we just have to do it at a lower cost because we are getting so much pressure. I think what it is now it's just a matter of a certain number of players in the game and they are in the game. And you have to you got identified as having a certain capability of certain reach. And a certain group of competencies and people are not going to go very far outside of that. And there's not really outside of the current set, there is not really much of an alternative that you have. It doesn't give us what we have all like to see as pricing power, as anybody would care for, but you are able to justify the technology and the capabilities you bring to the relationship. So, price will always be a problem, but I don't think it's going to become one that would drive any of the players out of the business.

Thank you very much. The next question is from the line of Avinash Kant of Adam, Harkness.

Good afternoon Doug and Mike,

Yes.

I have a few questions actually. The first one, you talked about trying to grow your services business. What kind of margins can you get there? Gross and net margins both?

We wouldn't break that out separately.

Qualitatively would it be better than average?

I think I'd just place it in the same general category as the rest of our products.

Okay. And I believe you talk about some share loss in the flow side of the business. Now are you taking some initiative to gain that back or you have more momentum there?

Well, I think we've talked about that before. We bought a business that was the premiere supplier of reliable flow controllers and they leverage that with a world-class service organization. And every that is particularly in Asia, they were just viewed as a strong part of the customer business. They did not invest in R&D and it was justifiable for quite a while because there weren't many technical innovations that had come along on the market place to change that strategy. By the time we started looking that where they were technically, there was already several changes going on. And so the first thing that you saw from us that was part of the development was this transformer product that we introduced last year. That does an amazing job of refusing the complexity both with manufacturing and for all of the customers because it reduces the variation and increases the configurability of the mass flow controllers. So that was the first step and that's when I spoke to the -- its like we had to have that product in the market place to be able to compete. We were a little bit late getting started but we have made tremendous progress and I'd call it accelerating progress.

There is going to be another technological advance, which is called pressure and sensitive flow controllers. And frankly, two or three years from now, whoever has the leading market share will have done the best job of satisfying the customers with that technology. And we started a little bit late on that. But nowhere near as late as on the transformer product and we're doing nicely there. We expect to do very well here.

Okay. I think, you did say what was the tax rate? It's going to be 40% going forward?

That's correct, Avinash.

Okay. And one final question, of course I have to be asking that from where you sit right now over the last two or three months, how comfortable or I would say which way would you be leaning? Have you seen more positive side of the business going forward and for the rest of the year or you get more cautious incremental?

We are leaning up to 0% to 4% of second quarter. Avinash, that's as far as we are leaning. We won't go beyond the quarter.

Thank you.

Your next question comes from the line of Tim Summers of Stanford Financial Group.

Yes. Thank you. I guess, Mike you are not calling this a ramp, is that correct?

I'm not going there again, Tim. As you couple of years ago, although I was right, but I'm not going there again.

Mike, on the fourth quarter conference call, you had mentioned the revenue effect of FOB destination point shipping. And I'm wondering, if you had actually seen that impact first quarter revenue. And could you quantify it, and also is there a balance sheet impact as a result of that?

The effect is about 700,000. And it would show up as deferred revenue. Quite frankly, this was a question and I'm not sure, if we -- I don't think we included it, we may have it in receivables and also with deferred credit, we may have netted that. I'm not exactly sure, but the amount is about 700,000.

Okay. I was under the impression that the revenue impact in the first quarter might be in the area of 3 to 4 million.

Oh, no, I think, we had said 1 million, the last call we said 1 million

Okay. Thank you, guys.

You're welcome.

Your next question comes from the line of Mark Fitzgerald of Banc of America.

Thank you. Mike. On the guidance that you gave for what's the leverages from the double mortgage here in the local content, the 200 to 300 basis points and 500 to 700. Is that what's left that can danger or is that what the total advantage is including, what's already been accomplished at this point?

Now that's what's left.

Okay. And is that based on your current run-rate at this point or is that the break-even?

It's based on the current run-rate in the mid-80s to high 80s, correct.

Okay.

But I will say also, Mark that tremendous part of that benefit is coming from the change in suppliers. So on a bill of material cost of operations, we expect to finish the year with that benefit in place and of course it's volume-sensitive. But we got to have those lower bills of materials in place and suppliers in place that can meet our lower cost needs.

Okay. And then can you tell us what the NOL is, that's off the balance sheet at this point?

We could absorb about 70 million of US based income. NOL is in the of the $25 million range.

Okay. And the other question, what's the explanation behind the inventory rate. Is this discontinued product line or so?

There was no inventory right after this. We had inventory level in the fourth quarter of about nine million down and in the first quarter the $7 million reduction inventory quarter-over-quarter was all sales.

Okay. And then can you give us an idea how big the mass flow controller business is, and relative to the overall revenue base here, and is it profitable at this point?

It is profitable. It's powers we've talked about all powers by way the largest part of our business, but the mass flow controller business is anywhere from say 15% to 20% of our business.

Okay. And just one last question. Can you give us any sort of guidance on what the option expense is going to look like for the balance of the year here?

We don't do options. We have an adopted 123, but if you look at our footnote based upon how we have been doing, we have been doing it for years. Our option expense are about $3 million a quarter. But unlike some other companies in this space, we have an accelerated divesting of options and we have looked at it. But we said that quite frankly and we were of the opinion that we did believe that this thing with options would be delayed slightly and we have been talking about options it since 1975. It was delayed and going forward, there's so many variables that can be going in there.

I think the best way of looking at it is that Mark, is that you look at our over hang. We have one of the smallest over hangs in the industry, in anywhere right around 13%, most of the high techniques are in the high teens some on low to mid-20s. And so at the end of the day, I mean, when the (ph) and finally drives us to completion and they give the flexibility on calculation. I would say that all the impact of auctions compared to the tier group and our space will be one of the lowest.

Okay. Thank you.

You're welcome, Mark.

Your next question comes from the line of Kevin Vassily from Susquehanna Financial Group.

Actually, my questions have been answered. Thank you.

Kevin, call any time. Thank you.

Your next question comes from the Ted Berg of Lehman Brothers.

Hi. Just a couple of clarification question a heard a couple different number that we expected gross margin improvement. And I thought I heard 400 to 500 basis points was the number that you stated. Is that correct?

That's correct.

Okay. And it would -- that be off the first quarters 33.8%? Is that what you're measuring of?

Yes. All things being equal if we finish the year about 85 million, 86 million whatever, we would expect the margin to be 400 to 500 basis points higher.

Okay. And then on the -- was your estimate of how much money that you want to raise, was it 100 million that you are looking at?

Correct.

Okay. Great. Thank you.

You're welcome.

Your next question comes from the line of Brett Hodess from Merrill Lynch.

Yes. Just a quick one. The 400 to 500 basis points cost reduction that you're going to get by going to some of the local low cost providers, I just wanted to be clear, are you saying you'll get that over the next few quarters to get down to the 700 -- the 70 million breakeven, or is that over a much longer period of time?

Yes. We expect as we go through the rest of the year that we will achieve that gradually, Brett.

Okay.

As Doug said earlier, I mean, that's just one stop along a destination through more robust product design -- redesign et cetera, a closer tie, and with our suppliers and we expect to continue to be able to drive that down in '05 -- end of '05 and '06 and beyond.

But that first time it will be by sort of at the end of the year?

Should it come in gradually as the year progress, correct.

Thank you.

The caveat we keep having is how we burn up inventory. But the ability to have the build material to that level will be gradually put in place through the rest of the year.

Got it. Thanks so much.

You're welcome, Brett. Thank you.

[Operator Instructions]

Okay. Thank you. Thanks for everybody attending our call. Our return to profitability. The first quarter results demonstrated the initial results of the positive and fundamental changes we've made to the operating model. We believe this performance is sustainable, and will improve as our initiatives move closer to completion later this year. We look forward to speaking to you during the second quarter. And thank you for your time today. Good-bye.

This concludes today's teleconference. You may now disconnect.