CMC Materials, Inc. (CCMP) 2004 Q2 法說會逐字稿

Good morning. At this time I would like to welcome everyone to the Cabot Microelectronics 2004 second quarter earnings release conference call.

(OPERATOR INSTRUCTIONS)

At this time I would like to turn the call over to Mr. David Lee, Director of Investor Relations for Cabot Microelectronics Corporation. Mr. Lee, you may begin, sir.

Thank you. Good morning. With me today are Bill Noglows, Chairman and CEO and Bill Johnson, Chief Financial Officer, to host this earnings conference call for the second quarter of fiscal 2004, which ended March 31st.

This morning we reported results for our second quarter of fiscal 2004. A copy of our press release is available in the investor relation's section of our web site at www.cabotcmp.com or by calling our investor relations office at 630-499-2600. Today's conference call is being recorded and access will be available for two weeks via telephone play back.

The play back numbers are 800-642-1687 in the U.S. or 706-645-9291 internationally. And you will need access code 4711975. Play back will also be available via web cast for the next two weeks in the investor relation's section of our web site along with a script of this morning's formal comments.

I would like to remind you that our conversations today might include forward-looking statements that involve a number of risks, uncertainties and other factors that could cause actual results to differ materially from these forward-looking statements. These risk factors are discussed in our SEC filings, including our reports filed on form 10-K for the fiscal year ended September 30th, 2003 and form 10-Q for the first quarter of fiscal 2004-ended December 31st2003.

We assume no obligation to update any of this forward-looking information. I will now turn the call over to Bill Johnson, who will review our financial performance. Bill Noglows will then provide a business review. Our formal comments will take about 25 minutes, after which we will take your questions.

Thanks, Dave. Good morning. As we reported this morning, total revenue for our second fiscal quarter was $73.5 million, down 3.6% from the $76.3 million we reported for the prior quarter. But up 18.2% versus the same quarter of last year.

Sales volumes were up slightly from the prior quarter, but our average selling price decreased sequentially by 5.3% causing the sequential revenue reduction. Roughly half of the ASP decrease was due to a lower valued product mix and approximately half was due to selective price reductions. In the March quarters of both 2002 and 2003 we experienced comparable sequential price reductions. We have found pricing pressure to be particularly concentrated around the beginning of a new calendar year. All major product areas experienced modest sequential revenue reductions this quarter. Revenue from our copper slurries decreased by 2.6%. The vast majority of commercial copper slurry volume used by the IC industry this quarter appears to have been for the 130-nanometer technology. Since 90 nanometer technology is only now becoming commercial. We believe the semiconductor industry has been running 130 nanometer copper technology at essentially full capacity and little, if any, new capacity has become operational in the last several quarters.

As such, sales of our copper slurries appear to have generally been constrained by the limits of our customers' 130 nanometer copper production capacity. Revenue from copper slurries represented 21.6% of our total revenue for the quarter, up just slightly from the 21.3% we reported last quarter. Revenue from tungsten and oxides, CMP slurries taken together was down 4.3% and data storage slurry revenue decreased by 5.2%.

On a graphical basis, our sales in to South Korea, Southeast Asia and China increased sequentially this quarter. Notably, our revenues in South Korea grew by 11.2%. All other geographic regions showed sequential revenue reductions.

Gross profit for the quarter was $36.1 million, down by 3% versus the prior quarters $37.3 million and up 18.9% from $30.4 million in the year ago quarter. This represented a gross profit margin of 49.2% of revenue this quarter, compared to 48.8% of revenue that we reported last quarter, and 48.9% in the year ago quarter. This quarter gross profit benefited from higher yields in our manufacturing process and lower product costs than last quarter, but was adversely affected by the average selling price reduction and lower valued product mix that I mentioned earlier.

Operating expenses, which include research and development, selling, marketing and general and administrative costs were $21.3 million this quarter, which are $1.6 million higher than last quarter and $4.5 million higher than the comparable quarter last year.

The primary causes for the sequential increase were roughly $500,000 in separation cost for two departing executives that we previously disclosed, along with annual wage and salary increases that will effective January 1, higher depreciation expense and a modest increase in research and development expense.

Operating income for the quarter was $14.8 million, down by 15.6% from 17.5 in the prior quarter but up by 9.1% from $13.6 million in the same quarter a year ago.

Operating income represented 20.1% of revenue this quarter, which was down from the 25.8% of revenue that we reported last quarter on higher sales, and 21.8% in the year ago quarter. As with the last quarter, our effective income tax rate was 34%, and this is also our expectation for the full fiscal year. Net income for the quarter was $9.7 million, down by 16.2% from the $11.6 million last quarter, and up 7.3% from $9.1 million in the same quarter last year.

The weighted average number of shares outstanding on a diluted basis was 24.9 million this quarter. Diluted earnings per share for the quarter was 39 cents, this is down from the 46 cents per share we reported last quarter, but up from 37 cents in the year ago quarter.

Turning to cash and balance sheet-related items, working capital increased by $2.6 million or 6.4% this quarter, due primarily to a reduction in taxes payable, based on the timing of a tax payment. Days of sales outstanding and accounts receivable decreased from 50 to 46 days, and inventory increased marginally. Capital spending for the quarter was $1.1 million as we made modest investments in our research and development and manufacturing areas.

Depreciation and amortization expense was $4.4 million for the quarter. We have reduced our full-year forecast for capital spending from $22 million to $17 million due to slower than expected spending on clean room equipment. Our full-year forecast for depreciation expense is now $18 million. We ended the quarter with $140.3 million in cash, $12.9 million higher than last quarter.

Total capital lease obligations were $8.4 million and we have no long-term debt outstanding. I will now turn the call over to Bill Noglows for a business update.

Thank you Bill. Good morning everyone. I would like to begin by sharing some observations on the CMP industry and our company.

We see three trends in the industry that I want to clearly address, which seem to have created a great deal of speculation in the market; first of these relates to competition. Rapid incorporation of CMP technology, generally high growth of the CMP industry, combined with visible long-term success and high profitability has attracted many competitors. This combined with customer desires to gain purchasing leverage and lower cost of ownership has led to much greater competitive activity. This is a natural evolution that is common in most successful business arenas and we expect it will continue.

Given the nature of markets and desires of our customers, it is only natural that competitors will enter and obtain a portion of the overall business.

In many competitive situations we face, competitors will focus solely on one technology node for a single application at one specific customer, dedicating their bulk of resources to this particular opportunity. In some cases our customers assist these competitors seeking multiple sourcing and greater purchasing leverage.

In almost all competitive situations we have seen, competitors offer the promise of a highly discounted price to get a place at the table. It is of course our objective to deliver the best solutions to our customers such that we continue to be the leader in CMP slurries.

We have made and will continue to make changes to our approach and strategy to retain existing business and earn new business in this very dynamic market. In terms of pricing, we have always priced our products based on the value that we believe we provide to our customers.

As we have discussed, we make selective price reductions when conditions warrant. However, we expect to be the premium value slurry provider in our industry.

The second trend relates to technology. CMP technology is both maturing and advancing, and technological advantages in some application areas are becoming more narrow and of shorter life cycle. At the leading edge and beyond, the technology is far more complicated and far more advanced CMP solutions are required.

In many cases, this increase technical challenge leading to a fragmentation of technical solutions and customization by customer, tool set and process integration approach. This customer-customized approach has created challenges for the industry and for Cabot Microelectronics. It is becoming more difficult to develop one single CMP slurry solution that will meet the technical needs of all technology-leading customers and as a result, this can lead to different choices by customers of various suppliers and CMP solutions.

We believe this dynamic of fragmenting technology, which is relatively new, creates a significant opportunity for our company given our capabilities, size and global infrastructure relative to many of our competitors.

In contrast to competitors that are generally focusing on limited technology nodes, applications and customers, we have the capabilities and capacity in our technology and support organizations to enable us to serve the broader market with efficiency and economies of scale.

The third industry trend deals with product supply. As CMP has technology matured, semiconductor manufacturers processes have become highly sensitive to CMP slurries and slurry performance. And customers now demand absolute consistency in slurry products, gallon-to-gallon, drum-to-drum and lot-to-lot across thousands of gallons.

Beyond product consistency, product quality requirements have also increased dramatically as I see feature sizes have continued to shrink.

Product purity requirements are now in many cases measured at the parts per billion levels, and we are finding that product quality and consistency have become as important to our customers as ultimate product performance. This means the CMP supplier must now meet customer requirements for absolute product consistency and ever-increasing product quality while lowering the cost of ownership.

To this end we continue to build on and invest in one of our core strengths; a superior ability to supply and support our value adding products to customers on a global basis, through our substantial international manufacturing network, our robust supply chain and our strong quality infrastructure.

These three trends characterize what we consider to be a challenging industry environment. They are affecting our margins due to combination of pricing pressure both from competitors trying to gain a foothold and from our customers' desire to reduce the cost of ownership of CMP consumables, along with increasing costs to support higher product quality and advanced technology.

Now let's move to our strategy for addressing these trends and maintaining leadership within this challenging environment. Pursuit of three fundamentals: Technology, Operations excellence and Customer support and service. First technology.

As CMP technology matures, advances and fragments, we believe we have greater capabilities and scale within our technology organization than our competitors. This means we can segment our technical resources to provide very specific technology and customer focus and nimbly deploy teams to effectively and cost effectively develop more customized solutions in partnership with our customers. We will continue to focus on technology and on innovation and product performance.

But in addition, we are focusing more on research and development, on innovating to reduce the cost of ownership of our products, to respond to customer needs for lower cost solutions.

We will continue to manage technology innovation with financial discipline and manage our portfolio development projects to provide an attractive return on our technology investments.

Second operations excellence. The industry trend toward greater product quality and consistency demands ever increasing manufacturing capabilities from us, as well as requiring similar increasing capabilities in our suppliers and we believe we are up to this challenge.

We are unique among CMP slurry providers by having an established record of successfully delivering tens of millions of gallons of slurry to our customers on time and on spec.

We have a sophisticated quality process in our manufacturing operations and accompanying equally sophisticated supplier quality process.

We continue to implement more advanced process control systems and processes to manage the production of our products, to within ever-tighter tolerances and ever-higher quality levels.

Further, we continue to help our suppliers embrace these same requirements so that their inputs to our process are at the same level of consistency and quality, as our customers require of our products.

We have the largest global manufacturing network of CMP slurries in the industry, with five manufacturing facilities on three continents, which afford us access to efficiencies and economies of scale that we believe our competitors do not have.

We also have opportunities to improve our manufacturing cost structure, to improving our manufacturing yields as our quality processes progress further.

Third, customer service and support. Customer requirements vary by application and technology node. Our existing products and mature technologies, our customers need attentive and responsive commercial and technical service and support.

For leading edge commercial technologies they require responsive support and process integration and for their commercial ramp.

For future technologies, customers require close interaction and research and development to develop new, more customized and specialized CMP solutions.

In order to be more responsive to various customer needs, we realigned the company from a traditional functional organizational structure to a global business team structure. We now have global business teams operating in each major CMP application area. These teams are led by global business managers charged with overall responsibility for the performance of the respective businesses. This business team structure provides a single point of accountability and contact with respect to business performance and customer relationships.

We believe this structure will enable us to be more responsive and agile in meeting ever the-evolving customer and business needs.

Also under the customer service and support umbrella and on a geographic basis we deployed additional executive and senior management talent and attention for the Asia Pacific region, where we already have a strong presence and continues to be a key growth area for our business.

Although we had previously discussed plans to add clean room facilities in the Asia Pacific region in order to be more responsive to customers, we are continuing to develop our strategy to support and grow our business in Asia, and are still formulating the appropriate combination and type of facilities and people we will need to continue our leadership in this very important growing area of our business.

Now I would like to comment briefly on a few key business areas, beginning with our slurry products for copper. As Bill mentioned, we see the vast majority of slurry used for polishing copper today still at the 130 nanometer node.

While we do not comment on specific customers, we believe that we are the leading copper CMP slurry provider to five of the six technology-leading semiconductor manufacturers for 130 nanometer copper technologies. This is not changed since our discussion with you last quarter. 90-nanometer technology still emerging and we believe there are only three technology leading semiconductor manufacturers producing 90 nanometer devices on a commercial basis.

Although volumes are expected to become more considerable over time. Of the five semiconductor companies that we view as the most advanced in 90-nanometer technology development for copper, we have been selected by two of these, two others have initially selected two different slurry providers, and one semiconductor manufacturer is still evaluating suppliers.

We believe our position in 90 nanometer copper technology has also not changed since our discussions last quarter 130 and 90 nanometer technologies, we are working with a number of companies on copper slurry products for 65 nanometer technology and are in early development on products for 45 nanometer technology. We continue to believe that we are well positioned to maintain leadership in copper CMP slurries.

CMP slurries for polishing copper interconnection and logic devices attract a great deal of attention given the considerable growth opportunity. However, Tungsten and oxide slurries for memory applications represent a sizable portion of our business, along with their use in logic devices with aluminum wiring. We see a continuing bright future for Tungsten and oxide slurries.

In Tungsten, we continue to hold a very strong position although we are beginning to see more competition in this area. We are confident in our technology leadership and our intellectual property position in Tungsten slurry products, and we are currently pursuing opportunities to convert some traditional home Brewers to our slurry.

Beyond existing products we have two innovative product in development for applications at the 90, 65 and 45 nanometer nodes that we believe will offer improvements in defectively, planarity and corrosion.

Now let me turn to our slurries for dielectric applications slurries compete in the more mature area of the CMP industry.

Oxide slurries are the most price sensitive products. In the oxide area where we are innovating in product development to specifically address not only product performance, but also the cost of ownership of our products, within dielectrics, direct shallow trend isolation is a much newer technology area.

We are qualified with two customers with our new STI product for 90-nanometer application and are in evaluations with a number of others. In our data storage business we continue to support the leading players in both hard disk drives and magnetic heads. Data storage continues to represent a very promising extension of our core IC CMP technology.

In polishing pads, we have been participating both as evaluated reseller of pads, supplied by a third party, as well as through the development of pads of our own technology.

As evaluated reseller, we have had commercial sales to a number of customers. However, I would say that we have been disappointed in the slow rate of adoption of our products despite performance advantages that we believe our products offer.

Further, prices in the pad arena have become increasingly competitive, such that we are; we now have some concern with the contribution that the value-added reseller model may provide the company. We continue to develop pads with our own technology and early results indicate that our products offer differentiated performance and overall lower cost of ownership.

Now I would like to offer a few concluding remarks before we open up the call tore your questions. You are aware that we do not provide guidance on revenue, but as we look at orders for our products during the first three weeks of April, we see business activity roughly on par with the same period in each month of the March quarter.

However, I would caution that the first three weeks of sales out of a quarter represent only a limited window on quarterly results. Previously we had provided guidance on gross margin in the range of 50% of revenue, plus or minus 2%.

Given the margin pressure we face from the three industries trends I discussed earlier, we are modifying our guidance going forward to a gross margin of 48% of revenue, plus or minus 2%. Having said that, as I emphasize this morning, we will continue to innovate in technology and execute as the industry's premium value slurry provider.

In parallel with our continued differentiation and value creation through technology, we believe we can capture efficiencies and economies of scale that I discussed during my earlier comments and we are renewing our focus on overall cost control within the company. We believe this approach can offset further margin pressure.

To close and summarize, let me say that in the face of a challenging industry environment we plan to continue to lead the CMP slurry industry by first, continuing to execute as the premium value slurry provider, innovating to differentiate ourselves through technology.

Second, leveraging our substantial existing global manufacturing and supply chain infrastructure, to achieve the product quality and consistency required by our customers, while capturing economies and efficiencies accessible through our significant scale. And third, continuing our focus on customers. I remain very excited and encouraged by the opportunities for this company. .

Operator, we will now open the call to questions.

At this time your first question is from Jay Harris of Goldsmith and Harris.

Good morning, Jay.

I missed the number on copper. What were your copper revenues in the March quarter?

We expressed it in terms of 21.6% of overall revenue.

So that's 15.9 million. And you said that was down sequentially?

No, that was a percentage of revenue, it represented an increase from 21.3% of total revenue in the prior quarter, but it was down sequentially by 2.6%.

All right. You had an arrangement with one of your customers on a multiple year obligation for them to buy at a fixed volume and a fixed price from you. Has that been continued?

Let me comment on that. The commercial arrangements we have with our customers are confidential and non-public and we have never really commented in any detail on our arrangements with customers. I would say that contracts with customers are not the norm in this business. Typically it's an arrangement of sort of mutual dependency but contracts are not the norm.

Well, I didn't mention the name of the customer because I was hoping you would comment on whether this is a portion of your business that's likely to continue or not.

Yes, but I think we understand -- we can't really talk about the specific circumstances I think you're getting that, because I think it deals with a specific customer. If you look at our copper revenues in total, we talked about it in the past that our copper revenues rise or fall with, you know, a small handful of key leading customers who are the technology-leading customers at a 130 nanometer.

In the past, we have talked about variations month to month with as business rises or falls at a particular customer given their order pattern or their consumption pattern or the like.

What I would say is that, you know, over the last several quarters our copper revenues have been relatively flat, some sequentially up or down basically we think that our copper sales have been constrained by industry capacity at 130 nanometers which we believe has been running at essentially full utilization with very little incremental capacity being added to now.

I think a number of our customers in the industry are investing additional capacity so we expect to see that capacity increase over the near term, but in the past several quarters we think we have been relatively constrained by the production capacity of the leading customers.

Jay Harris Just to finish this up, then I'll get back in queue, since last June your copper revenues are down and we have had a near record ramp in 130 nanometer wafers. What does this mean in terms of the prospects for your copper revenues going forward?

I would take some issue with the ramp at 130 nanometer. I think broadly there has been, since the June quarter, there probably has been 130 capacity added. What I would say in terms of 130 capacity for logic devices with copper interconnects, we feel like that capacity has been running near full utilization with very limited additional capacity added.

So copper slurry sales could not grow faster than the capacity that was added and we think that the capacity has been relatively flat in copper for logic devices.

So I think everything else being equal, should we assume that your copper revenues at these levels will be constant and possibly show some growth?

Well, we don't guide -- we haven't given guidance around revenue growth or growth numbers in particular. But I would simply say that our copper slurry sales have been constrained by capacity to an extent and so to the extent that there's additional capacity comes on stream and we continue our position as the leader of, leading supplier of copper slurry, it would follow that we would expect to participate in some of that growth.

Jay Bill Noglows. I want to take the opportunity to add to what Bill said. Although there's a tremendous amount of focus at 90 nanometer and 300 millimeter wafers and as we talked earlier we believe we're in it too and -- we're in at two, two have chosen others, a thirds is still in evaluation but there is still a tremendous amount of growth at the 130 nanometer feature size node as well as our customers are still investing significant capital in 200 millimeter wafer fabs at a 135 nanometer, at the 135 nanometer node.

So we paid careful attention to where the capacity comes on and our customers and their future expansions and we believe that we hit capacity in our first fiscal quarter and that we're waiting for more increments of capacity to come on at the 130-nanometer node.

What I'm worried about is the fact that 72% of fab equipment orders have been placed at the 300, for 300-millimeter wafer equipment. In my senses is that the momentum of demand in the marketplace is going to shift from 130 to-- from 130 to 90 and at some point I would love to have you fellows address that. This is not the right, you know, this is perhaps not the right forum. Thank you very much.

OK, thanks, Jay.

Your next question is from Ollie Irani of CIBC World Markets.

Good morning, Ollie.

Good morning. A couple questions for you. One, looking at your second quarter March overall revenues as well as your second quarter tentative view, given the first couple weeks in April, it seems that your overall business is tracking now more in line with the semiconductor industry in terms of volume versus pricing and the overall combination of the two, looking at the ten-year historical averages.

I'm trying to identify here going forward whether that means that we can hold this ratio or are the pricing pressures at this point, Bill, you have been around for four, five months in the company, are the pricing pressures stabilizing, are they getting worse?

Could we get in to a situation where your overall revenues would now start underperforming the semiconductor industry revenues? The second part of my question is with respect to the third customer at 90 nanometer, that's still in the pending evaluation and I think a lot of us are wondering what's taking this customer so long to make a decision that seems already past due. And is that good news for Cabot?

Ollie, I'll address the second question first. And then try to address the first question. We have seen that the ramp for 90 nanometer has been perhaps far more difficult than people expected, far more complicated node, and again, when we saw this at 130 nanometers and we continue to think that, you know, of the five leaders today, we think that only three are in commercial production.

But again, we know, we know of several that are struggling at the 90-nanometer ramp and I think that has resulted in the selection of the third undecided leading customer.

And we remain engaged with all five and we continue to work to make sure we are there and we are positioned to take that business if problems arise.

On the pricing side, we see some seasonality in the pricing pressure at the start of the fiscal year we tend to reengage with customers on agreements and we have seen it in prior '02, '03, first quarter of calendar '04 and we think we have seen that in this quarter as well.

I think the pricing pressure that we're seeing today is, I -- you're asking know describe, do I think it would get more intense or less intense. I think, my personal opinion, it is as intense as it will be, as competitors enter and some competitors exit, I think we're up against the normal competitive pressure that we would see in any market, you know, and the guidance we just offered is the guidance that we offer on gross margins.

Bill, trying to read a little bit through the guidance you provide and some of your comments, it seems at this point your strategy with respect to pricing is a lot more focused on seeing your raw cost and the company's efficiency, matching direct at least, pricing if not magnitude, is that correct? .

Ollie, I don't want to leave people with that message. I want to leave people with the message that we continue to believe that we have technical capabilities and capacity that make us unique in the industry and that we can continue to add value and bring value to our customers through innovation and technology advancement.

We haven't changed that focus in our business and we haven't changed that strategy in our business and that's in essence the root of what we do at Cabot Microelectronics. I think in my experience, there are always opportunities to drive costs out of business and find efficiencies and economies of scale and I think this company needs to be a little more focused on that side of the business and that side of the P. & L and I think I'm trying to lay out today a balanced approach to margin management on both sort of the top line and the bottom line and that's, -- but I don't want people to think we abandoned our technology leadership strategy in any way. We are still very committed to be the technical leaders in this industry.

Does it make sense at some point to start out sourcing some of your manufacturing?

That's something we continually look at and talk about and we will continue to look at out sourcing and better ways to optimize our supply chain are concerns about the quality requirements and our being able to manage the quality and consistency when going through a third party or an out sourced supplier. I can't articulate enough how demanding this industry is in terms of quality of supply, performance of products and the quality of our supply chain and that, to put that at risk through out sourcing is, it's a big question for our industry and our business in particular.

It's Bill Johnson l another part of your question had to do with the growth of our business relative to the industry. Let me provide a little bit of data around that. This quarter we had a sequential reduction, but that was on the heels of a 12.4, I think, percent sequential increase last quarter. We talked some about what we think is going on at copper and 130 nanometers, that we think has constrained some growth there.

But if you look at our Tungsten and oxide slurries, the last several quarters we have had 10%-plus growth in one quarter 14% sequential growth in a second quarter, and then sequential decrease this quarter. I think given the two strong preceding quarters which grew in excess of industry growth rates, I'm not surprised to have gone backwards a little bit in Tungsten and oxide.

But it cements like if you look at the broad business, the prior quarter was, you know, grew strongly and individual business areas, Tungsten and oxide in particular, we had some significant growth. So I think there's still plenty of growth opportunity. But quarter-to-quarter you can see a few ups and downs.

Thank you.

Your next question is from John Roberts of Buckingham Research.

Good morning, John.

I think, Bill, you said the first three weeks here in April are the same as the average in the first quarter, so that beg it is question as to whether the quarter itself sequentially improved or was flat. March versus April, you know, January, February, and March.

John, it's Bill Johnson. Yes, our comment was with respect to the first three weeks of the three months of the March quarter, tracking.

You're comparing the first three weeks of April with the first three weeks of January?

Well I am looking at, yes, January, February, March, the first three weeks of each of those months were roughly equal and roughly equal to what we're seeing in April. What I would say is we have seen a little bit of a different dynamic the last couple quarters.

For example, the December quarter, the month of December was stronger than the other two months. And in the March quarter, the March month sales were stronger than the first two months. But if you look at just the first three weeks, they're relatively equal across the first three months of that quarter.

Unless the fourth week of the month was substantially different, you didn't see any sequential pickup as the quarter progressed, then.

Well, I guess if the March, yes, the March month within the March quarter was strongest, and the first three weeks were equivalent to April, yes, we did see a pretty strong last week within March.

OK. Secondly, you sort of implied that the fifth 90 nanometer customers that's yet to select may be waiting because of these initial yield challenges, some of the other customers are experiencing, I guess that's good news for you if those yield challenges are where the competitor's 90 nanometer product is and it's bad for you, I guess, if the yield challenges are where your 90 nanometer is you comment at all in terms of whether your 90 nanometer customers and you haven't disclosed who they are, but whether or not they're having better yield experiences?

John, as you know, we don't talk about specific customers. I think as I said earlier, we think three out of the five leading-edge customers for 90 nanometer technology are in commercial production, which implies that two are not and that the two that are not, and other, are working to develop their process and deciding on which of their slurries, tools, pads and equipment they're going to use to manufacture 90 nanometer devices. I think that's more indicative of the process we see today than what you described.

OK. And third, even with the one-time separation costs, if you took that out, the operating expenses were up 24% from the year ago quarter and revenues up 18% or so. Normally business model works the other way around.

A little operating leverage from costs going up at a lower rate than sales. Are you surprised that's that high? Sort of an adjustment coming to the growth in the costs?

Well, if you look at, John, Bill Johnson, sorry. If you look back at the guidance we provided around operating costs, we pointed to the fourth quarter of fiscal 2003 as sort of a run rate for 2004 September quarter of '03, operating expenses were $20.5 million . If you strip out the $0.5 million in separation cost, we're roughly in line with that and also said to expect some modest growth, only modest growth in operating costs through the year.

So what we saw in the December quarter was sort of a downtick in operating costs, you recall that we talked about that and attributed a significant portion to the timing of some wafer supplies for our R&D activities, development activities to, the extent we had a return to a more normal level of wafer purchases and expenses in the March quarter then we had something of a recovery operating costs are really right in line with what our guidance was.

So we'll sort of have this inverted growth in cost versus revenues until we get back to the September quarter again?

That's right. You know, what we have said in the past is we pointed out that even through the industry downturn we continue to invest and grow our investment in R&D pretty significant limp what we have said recently is now we're moderating that growth and you're right, until we come on to the September quarter, the year on year growth rates will continue to be relatively high.

Your next question is from Suresh Balaraman of Think Equity.

Good morning. Can you give us some sense of how big 90 nanometer volumes are in the industry? I'm trying to get a perspective of a letter to 130 nanometer. Also as a follow-up, I remember the three years back a lot of the customers were evaluating competitors and they had, I thought they had even agreed on choosing a competing solution for 130 nanometers, somehow they switched back to you. Can you remind us as to what the reasons for switching back. And I have one more follow-up after that. Thank you.

It's Bill Johnson. First, in terms of size of the business at 90 nanometers versus 130, clearly we think that 90 are still in its infancy. As Bill Noglows mentioned, a lot of the headline news and attention is around 90 nanometer versus 130 and 300 versus 200 nanometer. But in terms of commercial volumes, we think it hardly hits the radar screen now.

Now, over time it's going to grow and it's going to be significant part of the business, but it's not large right now for our business or anyone's business, we don't think. The second question you had was with respect to 130 nanometer. Can you repeat that again?

Yes. I remember a lot of the customers were evaluating multiple suppliers and I mean three years back for 130-nanometer copper. And all of a sudden like out of the blue, everybody switched back to Cabot and I was wondering what the reasons were in those days. Can you remind us what it was?

I will give that a shot. I think the process is such that I think we explained this last quarter, you know, when the industry and when a customer in the industry approaches a next mode of technology, they invite many, many suppliers in to the process and do the qualification process as you well know. And then they select down to a number of one, two or three different suppliers at the node and they go in to pilot and eventually commercial ramp.

And along the way, the first criteria is always performance, product performance as measured by de-affectivity and yield and all the measures that you all are very aware of.

And then the secondary criteria, second qualifier is the ability to supply, as I said earlier, consistency and reliably and have a robust supply chain that can get the slurry to the customer when they need it, where they need it and it is what they want. I think at that node as I understand the history, Suresh, several competitors fell out of bed on one or two on those different angles and we were there to kind of pick it up and, you know, we're seeing this, I think we're seeing the same difficulty and challenges at 90 nanometer. I do predict the same behavior at the end of the day? I'm not going to do that, but that's what happened at 130 nanometer, Suresh.

Also on the same 130-nanometer issue, is there a risk of some other customer switching back? They are at high enough volumes and I understand they are switching cost. But that's, I mean harking back to what Jay Harris was talking about and can you just elaborate on that? But you also said that your market position at 130 nanometer has not changed since last quarter and can you anticipate it not changing for the next several quarters?

That is correct. I am not going to give forward guidance, Suresh, but I would tell you that the switching costs, as we understand it, the switching are very high. What compounds that effect is when the industry is running at capacity, they have little or no interest in either thinking about or considering re-qualifying another supplier, all right. They are in the mode of making, you know, sort of making hey while they can.

To come back to your earlier question, I think I described and in my talk today, I described some capabilities that we believe we have that bring to us the table with all of these customers in terms of our technology, the robustness of our supply chain and the technical and service support that we bring to these customers over the long-term, OK. And than our ability to serve these customers around the world with the same products, consistently and reliably is the strength that I think that keeps us at the table and bring us back to the table when things like what happened at 130 nanometer happened.

And regarding your margin guidance, I mean all along you have maintained your 50 percentage points, plus or minus 2, and now you're saying 48% and the question that most of us have, I think, is what makes you think that this guidance may hold for any reasonable length of time? Are we at a point that gross margin guidance will start declining on an ongoing basis?

That's our guidance, the new guidance is 48, plus or minus 2. I think through a combination of the things that Bill talked about, one, maintaining our focus on technology and innovation and continuing to be the technology leader and to price our products for the value that they bring as opposed to, you know, trying to be the low price provider, which is not our strategy, that in conjunction with I think what we have to admit is a greater focus internally on cost management and accessing some of the economies of scale and efficiencies that we have by virtue of our size and scale of our manufacturing infrastructure, our quality infrastructure, our supplier management infrastructure that our competitors should not have access to, a combination of those two we think can prevent further margin erosion. But we have brought our guidance down by the 2 percentage points to reflect the kind of trends that Bill opened his talk with.

And is this a function of specific product lines or is it a function of your costs given the tighter tolerances or a function of pricing, just across the board?

Yes. You know, I think it's a combination of many things, Suresh. I think as I spoke earlier in my talk this morning, you know, pricing pressure, more competitors, you know, the ever-increasing cost to supply, cost to deliver and cost to provide quality, so we're getting squeezed on both sides. We believe we have opportunities on the cost side that perhaps we have not looked at before.

But we also believe we have opportunities on the ASP side, the selling price side to bring, continuing to bring additional value to the industry in the form of new products, innovative products and products that quite frankly help our customers lower their cost of ownership through increasing yields, lower defects, whatever that may be, Suresh.

Last question, any thoughts on what you will do with your cash? Seems to be mounting at the rate of 10 to $15 million a quarter, and I'll sign off with that question, thanks.

It's Bill Johnson again. If you look at our, the forecast we gave for capital spending for the rest of the quarter, you can see that we're expecting to spend some significant capital in the second half of the year.

Our forecast for CAPEX is $17 million for the year and we have only spent about $2.5 million in the first two quarters.

So we're going to, we will use some of that cash and additional cash that we'll generate through the rest of the year for CAPEX. If I step back and view this more broadly, you know, we brought our cash balance from around $10 million with the IPO to where we are now -- the IPO to where we are now. Low cash balances is a area of discomfort.

We like the flexibility and comfort that, a comfortable cash balance affords. I would say that in terms of our CAPEX for the rest of the year, the second half of the year, we are expanding capacity, production capacity within the $17 million I mentioned.

We have a project to expand capacity in Gano, our existing facility in Gano, will comprise both equipment and expansion of building space. But overall, we like the healthy cash balance, we think it gives some flexibility going forward to take advantage of some opportunities that could be closely related to our business in terms of acquiring access to technologies or interesting capabilities that could compliment our core business. So no other than the CAPEX, no specific plans for the cash now. But those are the kind of things we're thinking about.

Thanks.

Your next question is from Jeff Cianci of UBS Warburg.

Just trying to understand the margin on the operating level, if you could clean it up, you're down to about 21% and you gave gross margin guidance, you know, you've given expense guidance, you know, you've all but given the operating margin guidance. I mean is this a new level? We used to be shooting at mid-20s in good conditions for operating margin. Where we think now low 20s is the more normal condition?

I think operating margin as a percentage of revenue is going to be driven by our revenue going forward. What we're saying is that we'll hold operating costs relatively flat with the fourth quarter of September of '03. So with only modest growth, $20.5 million on a trend line with only modest sequential growth.

So to the extent that revenue grew, you would see an expanding operating margin as a percentage of revenue. If revenue stayed flat, it would stay, you know, on a percentage of sales, around where it is now. But I guess the point that we need to be clear on is that whereas in the past we increased our operating costs pretty substantially through the downturn, we're paying careful attention to moderating that growth going forward and so that should have some impact on operating margin going forward.

Sales and marketing shot up a lot here, but are you saying that's a new run rate, you don't expect more increase there?

I'm sorry, could you repeat that?

Sales and marketing that was where the biggest jump has been.

Yes.

Does it go flat from here?

Well, quarter to quarter the change in sales and marketing, that's really where the separation costs resided that I mentioned, the $0.5 million was in that area and that was, that accounts for a lot of the growth there.

Al right, fair enough. But then if I take this, these comments to '05, surely your operating expenses will grow in '05, I presume your comments about '04, I'm trying to get a feel for leverage R&D will jump, perhaps lower rate in sales, but SG & A.

I would rather not say anything more about operating costs in '05. You know, we're a mid-year '04, we will go through a budgeting process but I think in general, what you ought to expect is more moderate, more moderate growth in operating costs across the board, relative to what you saw through the downturn.

Again, maybe just a comment, maybe you don't like to provide guidance, but that practice really has not helped your stock.

Look back at EPS over the last three years, we have just been kind of bouncing around this sort of 40, low 40s level plus or minus and to the casual observer who I talk to, you know, seems that when fabs are running hard, you earn the money, when fabs are not running hard you earn the same money. Any conceptual response to that?

It's Bill Johnson. No, I'm not sure how to respond to that. I mean we came through an industry downturn and performed well through that at a time, as we continued to ramp up operating costs, we have maintained margins at a high level, we have now guided to a slightly lower margin, but we talked about moderating operating costs going forward.

So to the extent that there's some revenue lift with the recovery, then, and margin guidance holds and we hold operating costs, then the math would work such that you would see a higher EPS.

I appreciate that, thank you. Let me clarify. Some of us have seen a recovery. In other words, you're looking for recovery and really fabs are running much harder than they were when you were earning 47 cents, let's say, you know, granted some of this is margin erosion, but is that the whole story?

No, it's not. And some of it is top-line growth, which I think you have to breakdown in to the different product lines. With copper constrained by capacity, it's not grown over the last several quarters. But Tungsten and oxide have grown pretty significantly with the industry. Such to the extent that there's some new capacity that comes on in copper and we can enjoy some of that growth and continue the kind of growth we have had over the significant growth over the last two quarters, in Tungsten and oxide, then I would say that we are enjoying the recovery.

OK. Thanks a lot.

Operator, I think we have time for two more questions.

OK the next question is from Ted Bark of Lehman Brothers.

Good morning, Ted.

Hi, thank you, good morning. I was wondering if you could elaborate more on the pricing. Somebody asked earlier but I might have missed part of the answer. The pricing pressure, the experience, could you break it down by, you know, not necessarily quantitatively but qualitative how it is in copper and oxide and finally Tungsten? And actually, yes, just mainly those three areas.

My comments were broad in terms of overall pricing pressure. I think what I would, I'm not sure that the pressure is any more concentrated in one product versus another. I think it's really across the businesses.

And again, I think a lot of the pressure was related to the beginning of the calendar year. If I take the 5.3% ASP reduction and take about half of that, which I said was attributable to price reductions, that's 2.6 or 2.7%.

We had a very similar price reduction impact on ASP in the quarter, March quarter of 2003 and similar but smaller impact in 2002. So this sort of thing, has occurred the last couple years, around the first quarter of the calendar year and it really is sort of across products rather than isolated to any particular product area.

OK and than one other question on the cost side of things. Some companies, when want a component supplier to some of the major equipment manufacturers, another that reported yesterday, another consumable supplier talked about cost expedite delivery of product to their customers, because demand was ramping up and they were having trouble meeting demand. Have there been any issues at all as far as incurring higher costs because of supply chain issues or anything?

Not in the March quarter. I think we talked about that briefly in the December quarter, where our shipping and freight costs went up partially due to some expediting product, but that has not been part of our history in the March quarter.

I think that we also manage our supply chain such that we always have spare capacity and spare inventory in the chain as much as we can do that.

OK, thanks a lot.

Yes sir, your final question is from Jerry Flemming at WR Hambrecht.

Yes a couple of parts, for Bill Johnson first. Were there any 10% customers in the quarter? And if so, distributors or IDM's?

We'll report that in the Q, so I don't have that to disclose at this time. But you're aware that the last, in our last public disclosure the two 10% customers, 10%-plus customers were market tech, which is our distributor in Taiwan and China, and Intel. But I wouldn't be able to disclose that beyond that for this quarter right now.

OK. And as we look at slurry usage in the future, first of all, what's going on today in the market in terms of the amount of slurry per polishing step? And what happens if the industry starts converting to low-down force, CMP production tools?

I'll start to answer to that question and -- I think your first question was around slurry efficiency for DI or per wafer?

Per wafer.

I think as you know, as the industry moves from 200 to 300 millimeters, there are efficiency on the slurry side that go with the geometry and the number of DI per wafer.

Let me just go through, we continue to see some pretty compelling drivers, growth drivers in the industry in terms of further penetration at CMP technology at the submicron level, as more and more customers embrace CMP to move to smaller and smaller feature sizes we see that as a growth driver for more and more slurry.

As you know, more wiring layers and more topography, if you will, brings more polishing steps to the process. Finally, the introduction of new materials, which I think is your question about lower down force and some of this new dielectric materials that are being experimented and trial in the industry.

Let me answer that second question first. We are currently, and have been developing slurries for low down force on the CMP tool for I would say at least two years now and those slurries are being developed at the 1965 and conceptually at the 45 nanometer node.

As the industry moves in to those viable low-key dielectric technologies we hope to be ready with a CMP solution, a slurry solution industry has, through the downturn, worked very hard to optimize the amount of slurry per wafer/per DI in the CMP process because they had time on their tools and their equipment.

We think the bulk of that work, that yield improvement work for slurry usage has sort of run its course and that that kind of engineering, slurry reduction has gone as far as it can go. The next, you know, the next significant perhaps reduction in CMP slurry consumption is at the 300 millimeter wafer size and we're watching that very closely. Does that answer your question?

Yes, I'll talk to you a little bit more about it off-line and than the last question is, you've talked about the competitive evaluations going on and advanced copper technology. What about the next generation of D-Rams, competition in tungsten for the next node?

We're actually quite excited about the growth in flash and DRAM and it's promising future for our business in Tungsten and oxide.

That's a fairly significant part of our business today and we continue to invest in that area and do what we do in terms of getting very close to customers in the development phase of where we go. We have a very strong technology and intellectual property position in Tungsten slurries. And we continue to innovate around that position and around that technology to help our customers get to the next nodes and higher levels of performance.

But has a competitor had a recent major design win in Tungsten? A large DRAM house.

As you know, we can't talk about that and we won't talk about it.

OK. Thank you.

Bill Johnson Thank you, Jerry.

I want to thank you all for your interest in Cabot Microelectronics and we look forward to speaking to you again at our next call.