Advanced Energy Industries Inc (AEIS) 2005 Q2 法說會逐字稿

Good afternoon. My name is Kashika(ph) and I will be your conference facilitator. At this time I would like to welcome everyone to the Advanced Energy second quarter 2005 financial results call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question and answer period. If you would like to ask a question during this time simply press star then the number 1 on the telephone key pad. If you would like to withdraw your question press star and then the number 2 on your telephone key pad.

Thank you. Miss Kawakami, you may begin your conference.

Thank you. Good afternoon everyone and thank you for joining us today. Doug Schatz, Chairman, President and Chief Executive Officer, and Michael El-Hillow, Executive Vice President and Chief Financial Officer will be today's speakers and will provide an overview of the results before they open the call to your questions.

By now you should have received the press released, though we issued approximately an hour ago. If you still do need a copy, please contact us at 970-221-4670, or you can view the release on our website at advanced-energy .com. Before we get started today I'd like to remind you that for -- except for any historical information contained herein the matters discussed in this call concern 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 syncrocality(ph) of the semiconductor, semiconductor capital equipment and flat panel display industries and the timing of orders received from our customers. Other risks are described in our forms 10-K, 10-Q and other reports that are filed with the SEC. In addition, we see no obligation to update the information that we provide to you during today's call.

I will now turn the call over to Doug Schatz.

Thank you, Cathy. Good afternoon everyone and thank you for joining us. Our second quarter results demonstrated continued, strong financial performance that reinforce the achievement in some important milestones.

First I'll review some of the key financial highlights for the quarter. Gross margins continued to improve driven primarily by structural improvements. Specifically, we had close to 3% to gross margins quarter over quarter to take them to 36.7% on revenues of 87.4million. These revenues were slightly up from sales of 86.1 million in the first quarter of 2005. This improvement of our operating model is due to two things, completion of the transition phase of our China strategy, and the beginning of the harvest of the benefits of the strategy itself. The new model generated an operating income increase of approximately 60% sequentially on these sales. This operational focus also extends into inventory and cash management. We made further progress on converting our inventories to cash and to improvement of our inventory terms. Inventories were down from 73.2 million to 59 million. A 14.2 million sequential decrease. This increases our inventory turns from 3.2 to 3.6.

Our business model improvement was also driven by focused execution, that in turn resulted in an accelerated restructuring of all of our operations. We made these changes while strengthening customer relationships, driving market share gains and delivering new products and technologies that adjust the larger opportunities we see in our market places. We believe that many of the most critical aspects of our business benefit from our extended China strategy, which now includes much more than low cost manufacturing. The benefits come from localized sourcing, a larger service footprint, the global product launch to Shenzen, stream line logistics, proximity to a stronger customer base, and of course flexibility. The manufacturing transition itself is in its final stages with only a few planned products remaining to be transferred by the end of this year. Currently 75% of our power product and nearly 90% of our mass flow control manufacturing is shipping from our Shenzen China location. A significant milestone that we have been working toward since we began this initiative three years ago.

Our Shenzen operation provides us with a highly differentiated competitive position that enables us to better serve our global customer base with our high quality and innovative products. The facility receives the highest of marks and praise from our customer, who have called it a model for other companies in our industry when expanding their manufacturing presence to Asia. They specifically comment about the sites commitment to quality that comes through during technical audits. A major customer recently said that the operations focus on quality is unparalleled. Quality in Six Sigma culture have become a corner stone for our plans of the future of our company. We now added operational excellence in a powerful Asian presence to our existing leadership in both products and technologies.

We continue to extend our lead in our serve markets. We've had several recent and major design wins that should further increase our market share in flat panel and semi. We can seek gains in flat panel as it moves through generation 6 and now 8 and beyond. At semiconductor processing moves to copper, (locate dial electrics)ph, larger wafer sizes and smaller line widths. In flat panel specifically, our summit DC platform continues to expand on its successes. First winning in generation 6 and 7 applications and now securing the lead in generation 8. This next generation panel size is expected to begin production in 2006. These panels will be used for 45 and 50 inch LCD TV's.

The summit product is central to how our customers can scale the larger panel sizes with confidence in gaining yield improvement while getting the best reliability available in the industry. The LSI estimates that the flat panel display equipment industry is poised to grow an 11% compound annual growth rate through 2009 and Advanced Energy continues to expand its already leading market position.

As an added note, the learning of the Company that was required to project our lead in flat panel displays from gen-7 to gen-8 is now being incorporated in the new designs for large area glass coating. This is an example of the unique power of AE to take advantage of the expansion of plasma manufacturing applications across a broad range of different applications. We have added another strong position in flat panel display with our mass controlled products. And we anticipate that we will continue to increase our share of this space with the newly introduced mass flow products. Specifically, pull through from a major end user who already uses AE DC products is contributing to our gains in the flat panel display market. This is similar to the positive end user buy-in we've already gained in the semiconductor market.

At the Semi-Con West Trade Show in San Francisco two weeks ago, we launched our new pressure and sensitive mass flow controller, the PI-980. This product is based on the multi gas, multi range capabilities within our latest era transformer digital MFC product line. The transformer line features our neural step technology, which provides a fast response time and a very flexible operating range. These factors increase process yields and simultaneous decrease MFC inventories. This advanced control allows the further addition of the pressure sensor on the PI-980 which removes one of the barriers to improved accuracy and repeatability which has plagued the semi industry for the past two decades. This product also reduces the cost of the gas stick by integrating the pressure transducer directly into the MFC. The PI-980 is expected to commence volume shipments in late 2005 from Shenzen and is currently receiving positive customer feedback at evaluation sites.

When we acquired Aera in 2002 we said it was a respected leading flow company known for reliability and support that was needed to reinvigorate its R&D programs to keep the leading edge. The multi gas, multi range line, and specifically the PI-980, signifies a return to technology innovation in the flow product line. And we expect our market share to trend up in 2005 and 2006 based on this new technology and the strong reputation of the Aera brand. The PI-980 is also a great example of our global team capabilities. It was jointly designed between our Hachioji Japan and Fort Collins Colorado based engineering teams, and then launched directly in early production into Shenzen in China and is being actively marketed to customers via our San Jose, California product managers and sales team.

Our significantly improving financial performance supports this expanding portfolio of highly differentiated and innovative products that allows our customers to move beyond today's processing challenges. We continue to increase share even where we are already the established leader, such as in the semiconductor market with our DC power systems. Looking ahead we will out pace our total serve market growth rate by capitalizing on our recent design wins and finding new ways to integrate our core technologies in a new plasma-based and high value power applications. Plasma manufacturing and high value power delivery is quickly evolving in the more mainstream and high growth areas that range from meat packaging to medical to solar cell manufacturing. We are focusing on opportunity that's have the potential for high growth and high profits as we continue to expand our boundaries and long-term potential.

I'd like to now turn the call over to Mike to review the financials and give you more details on our financing plans.

Thank you, Doug, and good afternoon, everyone. Revenue for the second quarter of 2005 was 87.4 million. A 1.4% increase compared to first quarter 2005 revenue over 86.1 million and the 88.4 million for the 4th quarter of 2004. We improved gross margin of 36.7% for the second quarter compared to 33.8% of sales for the first quarter and 26.7% adjusted for special items for the 4th quarter of 2004. The 10 percentage point improvement in our margin over the last two quarters in an essentially flat sales environment is principally due to realizing more benefits from our move to Asian-based manufacturing and sourcing while essentially eliminating a double mortgage that we have spoken about previously. Product mix and improved logistics costs have also contributed to the improvements.

Looking at end market sales, semiconductor capital equipment represented 52% of total second quarter 2005 sales or 45.4 million, down 1.4% compared to 46.1 million in the first quarter of 2005. In the second quarter of 2005, we, as other companies in the industry, experienced softness in demand from semiconductor EOM's based on the timing of equipment orders driven by the end users. We expect this softness may continue in the third quarter and is reflected in the lower end of our sales guidance you will hear later.

Second quarter 2005, 300-millimeter sales represented approximately 74% of total power product sales to semiconductor EOM's, and this number continues to track in line with our major customers. Applied Materials, our largest semiconductor capital equipment customer, represented 23% of total second quarter 2005 sales or 19.8 million, down 4.7% in dollar terms from first quarter 2005 sales of 20.8 million. Flat panel display sales represented 21% of total second quarter 2005 revenue or 18.3 million. This represents a sequential increase of 3% in dollar terms, compared to 17.8 million of total sales to the flat panel industry in the first quarter of 2005.

Flat panel display represented 12% of total sales in the second quarter of 2004, a year over year increase of 41.4% in dollar terms. The quarter over quarter increases primarily related to gen-5 demand. We expect sales in this market to increase modestly in Q3 as generation 6 and 7 equipment inventory is absorbed and as end users begin to invest in generation 8 facilities. Over the last year, we have had a substantial increase in our sales to the flat panel industry driven by our summit direct current product which we introduced in late 2004 and which continues to be well received in the market place.

The data storage industry was 6% of total second quarter 2005 sales or 5 million which represents an increase in dollar terms of 19.4% when compared to first quarter 2005 sales of 4.2 million. Although the magnetic disc market has been weak, the revenue increases due to sales to hard drive equipment providers driven by handheld consumer applications such as portable MP3 players. Advanced product applications represented 21% of second quarter 2005 revenue or 18.7%, a 3.1% sequential increase in dollar terms compared to the first quarter 2005 amount of 18.1 million. In addition to architectural glass, this division includes a variety of applications such as our eye core power supply for the high end computing market. Also included are industrial coating, laser and medical applications.

At 52% of our revenue, the semiconductor industry is an important market for us. However, we are significantly less dependent than other sub tier suppliers in this market as we continue to make progress on the flat panel display, industrial coatings, and data storage markets. For the third quarter in a row, our flat panel display and advanced product application sales each accounted for over 20% of revenues. Global support represented 11.7 million or 13% of total second quarter sales, a decrease of 3% in dollar terms compared to 12million or 14% of total first quarter 2005 sales. We have several growth initiatives under way within our services group such as annual service contracts, new educational programs and fixed rate repair agreements. Global support has grown steadily over the past few years and we believe we can capture additional revenue opportunities through these new offerings.

Looking at sales by geographic region, United States sales represented 53% of total second quarter 2005 sales, an increase of 3.4% in dollar terms compared to 52% of total first quarter 2005 sales. Sales in Europe represented 10% of total second quarter sales, a decrease of 4.6% in dollar terms compared to 10% of total sales in the first quarter. Asia Pacific represented 37% of sales up 1.3% in dollar terms compared to 37% of total sales in the prior quarter. We ended the second quarter of 2005 with a total backlog of 32.8 million compared to the first quarter backlog of 45.7.

R&D spending was 11 million or 12.6% of sales during the quarter flat and dollar terms sequentially. We are continuing to control costs in R&D as part of our focus on select growth opportunities. We expect R&D to remain at approximately 11 million in the third quarter of 2005. While R&D spend has remained essentially flat over the last few quarters, we have been able to increase our product development velocity by redirecting engineers who were previously working on the essentially completed China transition.

SG&A was 14 million in the second quarter of 2005 or 16% of sales compared to 12.9 in the first quarter of 2005 or 15% of sales The sequential increase is related, in part, to increased legal and consulting fees, costs incurred due to Sarbanes Oxley Section 404 compliance and variable compensation. We expect to reduce SG&A to approximately 13.5 million for the third quarter of 2005. Amortization and intangible assets was 518,000 in the second quarter, 547,000 in the first quarter of 2005. We expect amortization to be approximately 500,000 in the third quarter of 2005.

The second quarter results also include 1.1 million of restructuring charges primarily related to an impairment of facility related assets and employee severance and termination costs. Employee severance and termination costs total 1.3 million in the first quarter of 2005. In the second half of 2005, we expect restructuring charges of approximately $500,000 as we complete the final changes of our worldwide restructuring. As Doug mentioned, operating income increased approximately 60% sequentially and was 5.5 million or 6.2% of sales for the quarter compared with 3.4 million in the first quarter of 2005 or 3.9% of sales. Nonoperating expense was 719, 000 in the quarter compared with 2.1 million in the first quarter. The sequential decrease is due to a $1. million gain on the sale of certain marketable securities and higher interest income.

Net income for the quarter was 5.9 million or $0.18 per share. Income from continuing operations was 3.3 million or $0.10 per diluted share. Our effective tax rate was 30.2% on continuing operations. However, if we adjust the results for the marketable security gain, our effective tax rate was approximately 40%, similar to the first quarter, and diluted earnings per share was 7 cents. This compares to net income of 734,000 or $0.02 per diluted share in the first quarter of 2005.

Income from discontinued operations was 2.6 million or $0.08 per diluted share resulting from the sale of our EMCO industrial product (indiscernible) line. EMCO developed unique technology that was well entrenched in defense and industrial applications with strong potential for semiconductor applications. Some of this technology has been applied to our existing (inaudible) control align wherever applicable. However, because the larger EMCO market opportunity remained in our none core markets we chose this other remaining product line. Doug discussed our renewed focus on leveraging core expertise for high growth, high profit opportunities centered on our core expertise. And the EMCO opportunity was ultimately outside of that core focus.

Both the marketable security gain and the income on the discontinued operations was significant, discreet U.S.-based transactions and can be offset by our U.S. net operating loss carry forwards resulting in no related tax expense. This accounts for our overall effective tax rate of approximately 20% for the quarter. We have approximately $65 million of U.S.-based net operating loss carry forwards that we can utilize as we generate U.S.-based income in the future.

Head count at the end of the second quarter was 1,521 people compared with 1,503 at the end of the first quarter of 2005. We continue to focus on strengthening the balance sheet. We increased cash, cash equivalence and short-term investments by 16.4 million during the second quarter and ended the quarter with 137.8 million. Year to date we have increased cash, cash equivalence and short-term investment by approximately $30 million. Trade accounts receivables was 61.5 million for the second quarter compared to 63.8 million at the end of the first quarter of 2005. DSOs increased to 64 days -- decreased to 64 days in the second quarter compared to 67 days in the first quarter.

We lowered inventory by 7.2 million during the quarter. Second quarter inventory was 59 million compared to 66.2 million in the first quarter. Inventory turns of 3.6 in the second quarter of 2005 compared to 3.2 turns in the first quarter. Total days inventory was 101 days in the quarter, down from 114 days in the previous quarter. As Doug said, year to date we have reduced inventory by approximately $14.2 million.

Our capital expenditures in the second quarter of 2005 were 2.3 million compared to 2.9 million in the first quarter. We expect CapEX to increase to approximately 3.5 million in the third quarter, essentially for system enhancements and be approximately 10 to 12 million for the year. Depreciation was 3.1 million in the second quarter compared to 3.3 million in the first quarter.

To summarize our third quarter guidance, we believe that sales will be down 2 to 7% to 81 million to 86 million. The upper end of which would be essentially flat with the second quarter if we adjust for the sale of EMCO. Gross margin will be flat to up slightly and in the range of 36.6% to 37.5%. As we continue to benefit from the realignment of our manufacturing supply chain in the Asian region and improvements in logistics costs. R&D will be approximately 11 million and SG&A will be approximately 13.5 million. Amortization will be approximately 500,000. Our operating income will be in the range of 4.5 million to 6.5 million.

As we have discussed the last year, our goal by the end of 2005 was to have a 70 million-dollar quarterly sales break even operating model and to provide a minimum of 40% incremental operating margin above that sales level. Based on our third quarter guidance, we have achieved our break even operating goal as we enter the third quarter. Nonoperating expenses will be approximately 1.75 million to 2 million. Our earnings per share will be in the range of $0.05 to $0.09 with an effective tax rate of 40% and outstanding shares of approximately 33,250,000. Cash, cash equivalence and short-term investments are expected to grow to approximately 142 million, and inventory levels are expected to decrease to the $55 million level.

Given the accelerated improvement in our operating model and expected continued improvement as exhibited by our third quarter guidance, the Board of Directors has authorized management to retain an investment banking firm to advise the Company on raising approximately $100 million if market conditions are favorable. We have a $250 million universal shelf registration that allows us to issue equity, convertible debt or a combination thereof. The Company would use the funds and its cash on hand to redeem its approximately 188 million of convertible subordinated debt that is due on the second half of 2006.

To give you an idea of the potential impact a transaction, at near term operating level may have, assume that we had completed a common stock deal at the end of the second quarter, raised $100 million at $10 per share and redeemed all of our convertible debt. The impact in our third quarter guidance strictly on a pro forma basis would be to eliminate approximately $2 million of interest expense, net of interest income and bond issuance costs, have 43,250,000 in shares outstanding and have end of quarter cash of approximately $50 million. This would result in an earnings per share range of $0.07 to $0.10 versus our actual guidance of $0.05 to $0.09. Therefore, the elimination of the net interest expense more than offsets the impact of the higher share count in the near term. Also a cash balance of 50 million, combined with our recently increased $40million working capital line of credit, should give us official liquidity to meet operating needs and fund future growth. We also expect to continue grow our cash position to profitable results.

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

[OPERATOR INSTRUCTIONS] We'll pause for a moment to compile the Q&A roster. Your first question comes from Avinash Kant with Adam Harkness.

Good afternoon, Doug and Mike. One clarification, the EPS guidance that you gave $0.05 to $0.09, does that include the extraordinary charges you are talking about, or excluding them?

The extraordinary charges, I'm sorry, related to? We didn't talk about extraordinary charges.

We talked about restructuring of 500k.

If it is restructuring charges, Avinash, absolutely, yes. But the 500, 000 is spread the remaining six months. We don't know the exact timing, but for your purposes you can use half of that.

Half of that?

Yes.

Okay. And of course, you did mention that your power product, 70% of them are being shipped from China right now and 90% of the MFC's, right?

75% of the product, power products.

75% of power? Okay. And That's exactly what your target was, so there's not going to be any changing to that one anymore, right?

We've got a few more products that we're shipping there because we found that we can manufacture more complex products than we had originally anticipated at this time.

So it could grow a little bit more from here?

Slightly, yes.

Perfect. That's all I wanted to find out. Thank you.

Thank you.

Your next question comes from David, Dave Egan with Lehman Brothers.

Hi, guys. Thank you for taking the call.

Hi, Dave.

Could you just talk a little bit about the flat panel display market and when you think that -- last quarter you said that you really didn't expect much growth for this quarter. You saw a little bit. When do you think that will really start to pick up for the gen-8 line?

Well, if we go back two quarters, I think we saw everything kind of collapsing. Last quarter we saw things starting to flatten out and this quarter we're looking ahead and saying that people are definitely making investments in gen-8 and they will be starting to take deliveries in Q3.

And Dave, also, from the standpoint of figuring out the market, it is as hard for us as it is hard for you. Some of the products we introduced a year ago continues to make wins in the flat panel market. I mean, it is just a -- it is a great product with a lot of flexibility allowing us to -- allowing our customers to have more flexibility with a larger panel sizes. I mean, That's what we're looking to to help us in the market, but trying to predict the market persae, it's really hard for us also.

Fantastic. In terms of the mass flow controllers, is that one of the areas where you're expecting to really gain market share and you think that you can grow revenues faster than your competitors?

Well just from the fact that we're going to pick up market share, our rate of increase will be faster than our competitors and yes, we definitely feel that we're going to pick up market share. You know, the basic foundation of Aera was service and a very, vary reliable product around a very capable technology. And then as technology started changing and require this multi gas, multi range, they hadn't made the investment there to be on-line with a product of the same quality as the rest of their products.

So we -- when we stepped in and then started one, covering that gap, and then putting this advanced technology that we had embedded in that, the control technology, when we put that in place so that now we can put in the pressure and sensitive technology, we really started to take similar advantage of our core competencies with flow as we have done before with our power products. So, we expect to see that being recognized in the market place.

Okay. And there are -- you feel that even though many of the designs have already been done that you are going to be able to get in as a second source primarily?

No. We're already the primary source in several applications. There is no one that's been determined as the standard with pressure and sensitive MFC's so we got there in time with an advanced and we think much better product. But then we have the advantage of being able to cross sell with our lead in the power products.

Great. Thank you very much.

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

Thanks a lot. Good afternoon and congratulations on some good operational numbers. A couple questions, first for Mike on gross margins. So with the divestiture of EMCO, is the flow through now about is it around 40%, is that what you said?

A minimal of 40%, correct, Stuart, yes.

Excellent. And in terms of SG&A, it looks a little bit higher than I thought for Q3. Are you still seeing some impact of Sarbanes Oxley?

No, there is no impact there, but what we do know we have to do is given the improving financial results, we are accruing variable compensation. Earlier in the year, we don't give full year guidance, but given the spectacular job that our employees have done, we have to reward them sometime within the year or just after the year ends with variable compensation and that's accounting for the higher amount.

Fair enough. And now that you are well into the Shenzen move and you are really beyond the transition , have you guys had another look at your financial targets and have you updated those?

The financial targets still stay the same, having a break even of 70 million with incremental operating margin of 40%. That was the nearest term goal that Doug and the board established for management a year ago. We have always said that we will continue to push forward, and Doug has mentioned many times in the past that, we'll get there by the end of the year, but we'll keep looking at better ways to manufacture, better ways to source. We'll keep trying to drive.

We do say that we will provide a minimum of 40% incremental operating margin. Obviously we are above that from the $70 million base. In affect if 40% was our goal, we are below a $70 million break even. But we will continue to push. But being in Shenzen we wouldn't change that because that was always included in what the goal by the end of 2005.

Okay. That's very helpful. And once again, nice job.

Thanks.

Thank you, Stuart.

Your next question comes from Jim Covello with Goldman Sachs.

Hi there, this is Amanda for Jim. A couple questions. You mention in the past the double mortgage. I think you said on the call that it's mostly gone now. Should we expect anymore margin improvement coming from a reduction and any duplicate expenses going forward?

Amanda, there is some and that relates to be the $500,000 we talked about for future restructuring. But the vast majority of the double mortgage is now gone. In the second half of the year, we will complete the transition of products, mass flow control products from our location in Japan to China, but, if I had to give a range, we're probably 90% done with the double mortgage.

And, Amanda, I can put a little bit more color on that too. If you took exactly the same revenues with the -- with exactly the same product mix that we had today and you look at it 12 months from now, you would definitely see an improvement, assuming that we were obviously able to hold our ASP's. There is a continuous ability to improve on our margins on all of the existing products and there is a better chance of improving our margins from the introduction of new products that we're being much more rigorous around designing and we're targeting much more closely to exactly what the customers need.

Okay.

So, we see a pretty long runway ahead of us.

That's very helpful. Thank you. And the next question is, can you just walk me through again where that $0.03 after tax gain is that you included in that $0.10 EPS continuing operations number that you mentioned. Where that is on the P&L?

So, if you go to the press release, the line called other expense net.

Oh, it is included in there.

It is included in the 719,000 expense, is about a million dollar gain from the sale of the marketable security.

Okay. That's helpful. And the last question is the backlog it looks like it was down about 30% sequentially. Recognizing your business is mostly turns driven should we read anything into that? And what drove that?

I'll tell you, Amanda, when I got here a few years ago I took the backlog information out of the release -- out of the speech, but we kept getting the question. We've always said that returns business backlog's not indicative, but we put it back in. If you look over the last year our backlog has gone up and down, but actually the sales have been remaining fairly linear. It's timing of orders. Many times June companies getting ready for July shutdown, it has no bearing on where we think the quarter's going to go, and that's why we have given -- and you think about the upper end essentially flat revenue guidance.

I appreciate it. It thank you very much.

You're welcome, Amanda.

Your next question comes from (Thad Stroback with Quattro)ph Global.

Hi, guys. I just had one kind of book keeping question. What was interest expense for the quarter?

We typically don't break that out, but we bury it in net interest and other income. But, generally speaking, interest expense on our debt is about 2.7 to 2.8 million.

Just trying to get a free cash flow number. Just trying to rack that up. 2.7 just like last quarter?

Yes.

Thanks.

You're welcome.

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

Thank you. I think I had most of my questions answered. Just under transition, so you are going to be completely done at the end of the year and that includes the rest of the redundant capacity and I think you had already reached your goal of 50% sourcing in Asia. Is that true?

Yes. That's right, Alex. I'd almost look at the transaction as being done now. There's just some clean up, and if you look at it another way, with a continuous injection of new products in the Shenzen, we've got now a fixed manufacturing base here where we do the initial prototyping, stabilization. And it's the same way in other places in the world as well. But we'll just continue to get better and better benefits from localization in Asia and not necessarily China. And we continuously get better benefits on the logistics as we are not having to coordinate shipments to multiple facilities.

Will you do more design there in Asia as you go forward?

No. Nothing that we know of right now. There is also -- there's always an opportunity for localization of product modification. The more closely we work with the customers as we continue to expand those relationships, we'll do local customization and modification of our standard products. So that part we'll expand.

And mostly from here on out we now we've got to start focusing on top line growth for most of your profit gains as you go forward to get back to where you were.

As you can see, there is tremendous leverage there.

Right. And you're looking for service to be continually growing and improving?

Service will grow faster. From what we can see service is expected to grow faster than the semiconductor industry as a whole.

And flat panel, do you think that will be growing faster than semi?

Well, that's what DLSI says.

Okay. All right. Thanks very much.

You bet.

Your next question comes from Jay Deahna from J.P. Morgan.

Hi, guys. This is actually Chris for Jay. On the question the previous caller asked. You indicated that the transition to Asia based suppliers is also 50% done?

Yes, it's pretty close to that 50%.

And by the end of the year is that your goal to finish that portion of the move also?

I think we'll be expanding those relationships continuously.

As far as Shenzen, what kind of utilization do you have today of that facility and by the end of the year, do you have a target?

Utilization is probably half, but we could run multiple shifts. We have enough manufacturing and test equipment. We could keep putting product in the Shenzen and the access to labor is fairly easy and the training of their labor forces are fairly straight forward.

It is pretty enormous leverage.

So you have 50% utilization with a single shift today?

Yes.

Okay. I just want to clarify. And I guess, on the EMCO business, did you guys ever -- can you quantify what kind of revenue that was on a quarterly basis?

It was recently in the $1.5 million range.

Are any employees going with that business?

Just a few. We had outsourced most of the manufacturing, so around 10 or 12 employees.

Thank you very much.

You're welcome.

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

Hey, guys. Mike, was that 1.5 million a quarter or per year?

A quarter, Tim.

Okay. Were there any costs associated with that?

It is -- it was included in the gain of 2.6 million.

Let me rephrase that. If I looked at first quarter numbers versus second quarter.

Are you talking about costs going down?

Yes.

Not a whole lot, because we're outsourcing most of the business itself. The direct people costs were not substantial.

And, Mike, you mentioned that SG&A In the second quarter was impacted by higher legal expenses. What's that all about?

First of all, Sarbanes Oxley is in there somewhat. There are always issues we face around the world, there's customs issues, there's duties issues. One of the things we have done -- having done a spectacular job of taking our operation in many dimensions, (indiscernible), we're in new markets. So it is transitory legal expenses that we expect will slowly decline over the next two quarters.

So there are no laws -- there are no trials or legal issues?

Nothing new. Of course the action between us and MKS is still out, there but there is nothing new.

Okay. Great. Thank you.

You're welcome.

Your next question comes from Krish Sankar with Banc of America Securities.

Thank you. I just had a couple of questions. You guys said 50% of your sourcing to supplies in China is completed. Your target still stands (indiscernible) by the end of the year?

About that, yes.

We have gone after the high runners over the last six months to a year. I would say right now we're in a position where this is normal worldwide source and there is some additional I'll say legacy sourcing. But this is nothing more than keep going. So when people say go by the end of the year, to Doug's point, we're just going to keep pushing and pushing and pushing our suppliers and working with them. We are facing the same demands from our customers. So the whole supply chain has got a share in the situation and I think ultimately will share in the gain.

Okay. And what percentage of sales is (indiscernible)?

Well, it was below 10% now so we're not going to disclose it.

And also can you comment a little on the pricing in the DC power supply? How is it and how do you think it will trend going out the next couple quarters ?

I think in general we are going to see the pricing go up. A lot of the value of what we uniquely deliver is being realized. We spent 2 1/2, 3 years taking a pretty firm stance and taking something risks, and it has turned out that it is extremely costly for our customers to make a mistake and not have either reliability performance. It doesn't mean that we have a free day. But I think some of the pressure has been relieved. Some of the product mix is working in our favor forward new technologies. And we continue to look at ways to -- so the customer can both get the benefit of what we have going on in Asia and at the same time we can -- we can improve our financial performance. In general it's always a hard fight because everybody's trying to establish who gets the piece of the value, but I think a lot of the value, the unique value today (indiscernible) hasn't been recognized.

And just one last question and I think you mentioned this before, if you are banking on 70 million so what is the gross margin going to be, like 33 or 40%?

At the $70 million level?

Yes.

It'd be in the 33 to 34% range. Yes.

Okay. Thank you. Thank you very much.

You're welcome.

If you would like to ask a question, you may press star then the number 1 on your telephone key pad. You do have a follow-up question from Tim Summers with Stanford Financial Group.

Hi, did you guys have any shutdown days in the second quarter or do you foresee any in the second half?

We had no shutdown days in the second quarter, but we will more than likely shutdown -- we will shutdown during the holiday season at the end of the year, Tim. This has almost become within this industry a standard practice. So we have told our employees to expect to be shutdown at the end of the year. It has nothing to do with demand. It has more to do with the -- with that the industry essentially starts shutting down.

Okay. And are all customers taking volume production of all of your products now from China?

Yes.

Okay. Great. Thanks, Doug.

Okay.

Your next question comes from Steven Pelayo from Fulcrum.

Thanks. I guess I'm trying to understand. I remember your analyst day last year you talked about kind of the first half of the year being a little bit more the cost savings related to getting rid of the double mortgages. And the second half of the year really focus on material cost reductions. This year, your guidance going forward, you're suggesting gross margins can be flat on perhaps (inaudible) percent revenues. I guess, how much more on a cost savings can we expect, in margin improvement can we expect, if we were to assume that revenues are flat for the next three quarters or so, what else could we see from a margin improvement perspective?

First of all, Steve, we keep focusing on material cost savings. And trying to reduce logistics costs. So, to give apples to apples, we had talked about this, at about an $85 million rate similar to what our upper end guidance would be. (inaudible) We could probably be around 38 to 38 1/2%. So, you know, 50 to 100 basis points and we just talked about it at our upper end 86 million. Even though this isn't direct we talked about a 37 1/2% --

We would be -- this isn't -- this isn't forward looking except to tell you what our international goals would be. We would be pretty disappointed if we couldn't get above 40% gross margin.

What revenue level would we need to do that, Doug?

If we just stay flat, Steve. I think that was your question.

At about 85 million.

That's great. My next question I guess is relative to timing of any particular refinancing. What are we thinking on that these days ?

Well, we just said, I'm not sure if you heard the whole presentation, but the board has authorized management to retain an investment banking firm. So, if the market is favorable in the near term, then you could expect that we're going to drive down that road in the near term.

I thought one of the original constraints was the goal to try to do the free financing before the existing debt goes current. Is that still the target?

Given that the board has authorized to get a banking firm, I think you could say that's safe to say. Yes.

Excellent. That's all I had.

Thanks, Steve.

Thanks, Steve.

You do have a follow-up question have Avinash Kant from Adams Harkness.

Just wanted to find out, you bought an industrial environment at this point. I know your guidance (inaudible) is down 38% (inaudible). Do you have any idea of generally how the industrial looks like? Do you think December could be an up quarter from there or a down quarter or flattish?

Avinash we just have a policy we don't go beyond the current quarter.

We will not discuss beyond the current quarter.

In the body language of your customers, especially the OEM customers, does it look like it's gotten incrementally better over the last month or not?

What we've said is that we expect the softness to continue in Q3. So I guess the body language hasn't changed.

Thank you.

You're welcome.

There are no further questions.

Okay. Thank you. In closing, I'm very pleased with the progress we've made to re-align our worldwide operations and, of course, reengineer the whole business model. It's been the longest project, I think, the Company has ever taken on. And like most long ones, I think it's turned out very well, and as I said earlier, a lot of runway ahead.

This is also my last call, but I'm looking forward to working closely with Hans Betz over the next couple of months to complete our management transition. I'm extremely impressed with Hans. He is the right person, he's got a great focus, great background to take the Company through its next growth days. And now that the key strategic pieces are in place, I'm extremely confident that he's going to be able to pull that off with the incredible team that's here.

In my continuing role as Chairman, I look forward to focusing on the long-term strategic vision and the road map to help position the Company for even more profitable opportunities in the next generation of processing applications. In served markets and of course beyond the markets we already serve. To continue the success and leadership that the Company's demonstrated over 25 years well into the future. Thank you for your time today.