CMC Materials, Inc. (CCMP) 2006 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Cabot Microelectronics fourth quarter 2006 conference call. [OPERATOR INSTRUCTIONS] At this time I will now turn the presentation over to Barbara Ven Horst, Director of Investor Relations. Please proceed, ma'am.

Thanks, and good morning, everyone. And welcome to our conference call. Joining me today are Bill Noglows, Chairman and CEO; and Bill Johnson, Chief Financial Officer. This morning we reported results for our fourth quarter of fiscal 2006 which ended September 30. A copy of our press release is available in the Investor Relations section of our website, cabotcmp.com, or by calling our Investor Relations office at 630-499-2600. Today's conference call is being recorded and will be archived for four weeks on our website. The script of this morning's formal comments will also be available there. Please remember that our discussions today may 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 report filed on Form 10-Q for the third quarter of fiscal 2006, which ended June 30, 2006, and Form 10-K, for the fiscal year ended September 30, 2005. We assume no obligation to update any of this forward-looking information. And I will now turn the call over to Bill Noglows.

Thanks, Barbara. Good morning and thank you for joining us today. This morning I will quickly highlight some of our accomplishments of the year just completed. These achievements are all part of our long-term growth plan which has two parts. Build on our global leadership in chemical/mechanical planarization for the semiconductor industry and develop opportunities to leverage our strength in surface modification and materials into other areas adjacent to our core CMP business.

Our efforts have been guided in the past few years by our three key strategic initiatives. Technology leadership, connecting with customers, and operations excellence. These initiatives will continue to be our compass in 2007. Cabot Microelectronics has been the technology leader since the beginning of the CMP industry and we work hard to maintain that position. During this past year we continued to refine our products and technology development processes and to enhance the vitality of our new product pipeline. At CMP this cross functional effort involving sales, marking, R&D and operations has resulted in the introduction of eight new products in fiscal 2005 and 10 new product in the year just finished, and we expect to introduce a similar number in fiscal 2007.

That's new products are not merely beaker-scale experimental samples. These are robust offerings with dedicated supply chains and manufacturing capability. This is true of our new pad offering which has been fully qualified on our installed manufacturing equipment with a dedicated supply chain to back it up. These product have been well received by our customers and are currently generating revenue for Cabot Microelectronics.

As part of our connecting with customers initiative, we completed several infrastructure and customer support projects in the Asia Pacific region and believe that these initiatives will greatly enhance our ability to grow in this critically important region. The first of these projects was the opening of our Asia Pacific technology center in Geino, Japan in November of 2005. We are now conducting product demos in the center's labs and clean room allowing customers to witness firsthand our product and scientific capabilities while working side by side with our scientists and engineers. In April we began selling directly to customers in Taiwan rather than through a distributor. We also opened our Taiwan technical service center which provides our customers better and more rapid technical support and service.

Singapore and the surrounding region is home to many participants in the data storage business. In fiscal 2006, we moved our data storage, manufacturing, R&D and business leadership there, bringing our expertise closer to our customers. Our customers benefit because our location is much more convenient for them and thus we are able to be more responsive. We also expect to benefit from lower shipping and logistics costs.

Along with all our other achievements in the Asia Pacific region I am particularly proud of the people we have assembled there to manage and lead our business. Their dedication to our company and passion for our business are outstanding and I have very high expectations for the success as we grow with our Asia Pacific customers. Our third strategic initiative is operations excellence, and this year we continue to improve our productivity within our manufacturing, logistics, and supply chain operation. We achieved logistics, and supply chain operation. We achieved a 3% improvement in yield, raw material utilization, and labor efficiency, driven by huer volumes and variation reduction initiatives across the supply chain. This was below our internal goal but it it reflects some higher costs associated with our data storage move to Singapore, a slower than anticipated pad ramp, and a dielectric slurry quality issue that we reported earlier in the year.

On balance we are not comfortable with the year's level of improvement but we know we can do much more. Our initiatives incorporate Six Sigma which is a discipline we have employed for the past three years. Our results this year are built on the 9% productivity improvement we achieved in fiscal 2005 and we have set aggressive targets for fiscal 2007.

An added benefit of our efforts to improve productivity and drive out variability is that our customer's ratings of our company have gone up. Our customers periodically conduct a formal and systematic evaluation of our processes, performance, and quality, and they share these results with us. We also know that they consider those evaluations when making purchasing decisions. We see many of these scores steadily increase and a number of customers have recognized us for substantial improvement in service and quality performance. The goal of reducing variability and increasing productivity is now part of the fabric of Cabot Microelectronics and is factored into everything we do.

I'm particularly excited with the progress we made with our pad business in 2006. We have established manufacturing capacity in the United States and we'll be adding capability in Taiwan. Our U.S. pad plant is located in a retrofitted building we previously used for slurry manufacturing. By converting this existing building that we already owned, we created production capability at an extremely low cost. We believe the opportunity to use our existing assets and the continuous process pad manufacturing technology that we utilize should give us a significant cost advantage over existing technologies. We think our pad can offer longer life, lower defectivity and less erosion and customer evaluations have supported this. We have made commercial sales to two customers for use at three different fabs and we are working with a number of other customers who are evaluating and qualifying our pad.

Last, but not least, we are pleased with our progress on our engineered surface finishes initiative. Our two acquisitions in fiscal 2006 brought this initiative to life. Our first acquisition, surface finishes, specializes in precision machining techniques at the sub nanometer level. This acquisition is providing valuable access to a host of demanding high-performance polishing applications where we believe our knowledge of materials and perfecting surfaces can create value.

Our second acquisition was QED Technologies. We are confident about its future potential as a revenue generator and as a gateway to the high precision optics industry. Precision polishing and the optics industry is transitioning from artisan-based manual process to more automated, predictable, and reliable manufacturing techniques. We believe QED is leading this transition with its MRF and SSI technologies. QED generated $5 million in revenue in the September quarter. We are delighted with that result. However, remember that QED sells equipment and services, so their revenue may fluctuate quite a bit quarter to quarter. Finally, and perhaps most important to this audience, our achievements this year allowed us to set quarterly and annual records in slurry volumes sold and revenues. Bill Johnson will discuss our results in more detail in a minute.

I'm proud of what the Cabot Microelectronics team has achieved this past year and I am excited about what lies ahead. My confidence stems in part from the way our customers are reaching out to to us partner in developing semiconductor technology, several nodes into the future. Going forward, as I have discussed on previous conference calls, this technology is demanding more sophisticated designs and materials than ever before. As outlined at the International Conference on Planarization and CMP Technology held earlier this month in California device designs with smaller feature sizes are introducing more new materials and processes into next-generation chips. To put this in perspective, consider that the move from the 130 to 90-nanometer technology introduced three or four new materials. In the transition from 90 to 65 nanometers, up to a dozen new materials are being introduced. And in the future transition from 65 to 45 nanometers, some believe up to 30 new materials may need to be introduced. This proliferation of materials means the end to -- of one-size-fits-all CMP slurry. We have been discussing and incorporating this important emerging customization into our growth and product development plans for over two years now.

As the material combinations and designs become more complex, IC manufacturers are paying even closer attention to the CMP process, a process some describe as more art than science. They want greater understanding and expertise in CMP at a time when some in the industry are cutting back on resources. Chip makers are now turning to suppliers to fill this need. Suppliers who understand these materials, design, and process complexity. All this bodes very well for Cabot Microelectronics. We are widely recognized as having the most sophisticated research facilities and the most talented research staff in the CMP industry. We believe that CMP is not art. We deal in predictive science aimed at rapidly and efficiently meeting customers' technical and production needs.

To the best of our knowledge none of our competitors operates on a comprehensive level as we do at all nodes, in all CMP slurry application areas and on a global basis, nor do any of them have the depth and breadth of resources dedicated solely to CMP technology. The CMP process is getting harder and more demanding and we like that. It requires what we do best.

Over the last couple of years, we have made a determined effort to be far more open and willing to share knowledge and expertise with our customers. To listen carefully to their needs and requirements and to tailor our responses to meet those needs. I believe this approach and our customers' recognition of our unique skills and capabilities are paying dividends in improved relationships and joint development opportunities. Partnering with customers creates trust and strengthens the desire to continue working together. As technology advances we're finding chip makers are selecting suppliers much earlier in the development process and we plan to be the supplier they choose. We go into the 2007 fiscal year with the confidence and determination that results from success. We believe we had a great year in fiscal 2006 and that fiscal 2007 will build on that success. And with that I'll ask Bill Johnson to review our business results in more detail, then we'll turn the call over to questions. Bill?

Thanks, Bill. Good morning, everyone. Our revenue for the fourth quarter of fiscal 2006 was $87 million, which set another quarterly record for our company. Revenue was up by 2.4% versus the prior quarter and up by 17.8% versus the same quarter a year ago. Revenue for the full fiscal year was $320.8 million, 18.6% higher than in fiscal 2005.

Drilling down into the quarterly revenue numbers, sales of copper slurries, which represented 19.3% of our total revenue this quarter fell 5% sequentially. However, they were up 11.9% higher than the same quarter last year. Tungsten slurry sales achieved another quarterly record and contributed 38% of total revenue this quarter. Tungsten slurry revenue increased 3.4% sequentially and 22.8% year-over-year. Dielectric slurries provided 30.7% of total revenue this quarter with sales down 9.1% sequentially and up 2.6% compared with the year-ago quarter. Data storage products represented 5.6% of our quarterly revenue. This revenue was down 4.9% sequentially and down 7.8% year-over-year.

Finally, our new QED business which we acquired early in the September quarter generated 5.9% of our total sales. This was one of QED's strongest sales quarters in its history. You should note that this is our first quarter with QED revenue, so the percentage revenue split by application area this quarter may not be comparable to prior quarters.

On a geographic basis sales in Europe, Japan, and the U.S. grew sequentially mainly driven by QED revenue and sales in other geographies declined sequentially. Our average selling price for slurry products increased by 1.6% compared with the June quarter. This increase was driven by a higher priced product mix, partially offset by selected price reductions. Gross profit this quarter represented 44.4% of revenue, which is consistent with the updated outlook we issued on October 12. This was down by 3.2 percentage points from 47.6% last quarter and down from 46.9% in the year-ago quarter. Three unique accounting items caused most of this decrease as we addressed in our October 12, press release.

First, we wrote off assets in conjunction with establishing polishing pad manufacturing capability through the building conversion that Bill mentioned and this is a nonrecurring item. The second factor was amortization expense associated with intangible assets we acquired through our QED Technologies transaction and the portfolio of CMP technology patents we bought from IBM. This will be an ongoing cost over the next couple of years. The third item was the write-up to market value of acquired QED inventories according to purchase accounting rules. This increased the cost of goods sold on those acquired inventories that we sold during the quarter. This impact will continue as we sell the remainder of that acquired inventory. The combined effect of the three factors reduced gross profit this quarter by approximately 3 percentage points. Other factors impacting gross profit this quarter were higher costs in certain areas including lower yields on our manufacturing operations, partially offset by a higher valued product mix.

Now I will turn to operating expense, which includes research and development and technical, selling and marketing, and general and administrative costs. Operating expenses of $28.2 million increased by $1.6 million sequentially and were $4.2 million higher than in the same quarter last year. This is also consistent with our October 12, update. The sequential increase was mainly due to the addition of operating expenses of the QED business, a one-time write-off required under purchase accounting related to in-process research and development activities at QED, and a one-time write-off of research and development assets in conjunction with the building retrofit. These increases were partially offset by lower cost of materials used in our research and development activities and lower professional fees, including costs to enforce the Company's intellectual property portfolio. The year-over-year increase in operating expenses was primarily due to share-based compensation expense.

As you know we began expensing stock options in the current fiscal year as required by accounting rules. Pretax share-based compensation expense was $2.8 million this quarter, of which $2.6 million was classified in operating expenses. Higher staffing costs, including costs to support our initiatives in the Asia Pacific region, also contributed to the year-over-year increase. Net income for the quarter was $8.2 million, down 16.6% from $9.8 million last quarter. However, the combined effect of the asset write-off and purchase accounting reduced net income for the quarter by approximately $3 million. Net income this quarter was only 1.1% lower than the $8.3 million we reported in the same quarter last year, despite these accounting items, along with $1.9 million in after-tax share-based compensation expense this quarter. Net income for the full fiscal year was $32.9 million, which exceeds fiscal 2005 net income of $32.5 million even with the share-based compensation expense and the accounting items I just described.

Weighted average number of shares outstanding on a diluted basis this quarter was 24.1 million shares. This was down from the prior quarter due to $8 million of share repurchases in our fourth fiscal quarter. Diluted earnings per share were $0.34 this quarter which includes an adverse impact of approximately $0.12 from the asset write-off and purchase accounting and approximately $0.08 of share-based compensation expense. Earnings per share were $0.06 lower than in the previous quarter and equal to EPS reported for the year-ago quarter. Earnings per share for the full fiscal year were $1.36, compared with $1.32 for the previous fiscal year despite the effects of the asset write-off, purchase accounting, and approximately $0.28 of share-based compensation expense this year. So on a comparable basis we achieved significant EPS growth year-over-year.

Turning now to cash and balance sheet related items, capital additions for the quarter were $2.7 million, and this included investments to establish pad manufacturing capacity. Depreciation and amortization expense was $6.2 million for the quarter. This includes approximately $0.6 million of incremental expense due to the QED and Patent Portfolio acquisitions. We ended the quarter with $165.9 million in cash and short-term investments which was $3.6 million lower than last quarter. Our cash balance reflects the $19 million we paid for the QED acquisition and $8 million of share repurchases.

I'll conclude my remarks with a few comments on our outlook for the future. We have frequently characterized our business as unit based. Overall demand for our products is driven by wafer starts at subquarter micron technologies. But variables such as production of logic versus memory devices, 200 versus 300-millimeter wafers, customer integration schemes, share gains and losses and pricing changes all affect how that demand translates into revenue. Taking all these factors into account our long-term goal is to grow our revenue by 15% per year. This includes our core CMP slurry and pad business and areas adjacent to our core, such as our two recent acquisitions. I would point out that timing of both industry cycles and acquisitions by us will affect actual growth. As you may know we have limited visibility on near-term revenue and it can vary significantly quarter to quarter. So as in the past we will not provide quarterly revenue guidance.

Our full-year guidance for gross profit is 46 to 48% of revenue. This guidance reflects modest CMP slurry price erosion, continued productivity improvements from Six Sigma, benefits of commercialization of new CMP products and contributions from the QED business. Previously our gross profit guidance was on a quarterly basis. However, since fluctuations in our product mix can move our gross profit for a given quarter by a couple of percentage points, our guidance range was relatively wide, 4 percentage points. Our new range is narrower but it applies to the full fiscal year only. Quarter to quarter we may see gross profit above or below this range. In fiscal 2007 we expect operating expenses of 27 to $30 million per quarter, trending modestly upward within this range through the year. This reflects a run rate in our core CMP business similar to fiscal 2006 plus incremental cost of the QED business.

Our full-year tax rate should be between 32 and 33%. Capital spending should be around $17 million, which represents our steady state run rate. Beyond this, we are exploring options for providing CMP slurry manufacturing capability in Taiwan to better serve our important customers there. Depending upon how we fulfill this initiative our capital spending for the year could potentially double. Depreciation and amortization for the fiscal year should be approximately $25 million.

Finally, commenting on recent sales and order activity within our CMP business, during our fiscal fourth quarter sales were strong in July and August, then dropped about 10% in September. Against those benchmarks, sales orders we have received to date in October that we expect to ship by month end imply October will be somewhat stronger than September, but not as strong as July and August.

Signals we are seeing in the public statements of several important semiconductor players suggest the December quarter as a whole may be lighter for parts of the industry than the September quarter was. And we may be seeing some of in this our October orders. However, as we always caution, four weeks of orders out of the quarter represent only a limited window on full quarter results. Now I'll turn the call back to Barbara.

Thanks, Bill. We're ready to take questions.

[OPERATOR INSTRUCTIONS] And your first question comes from the line of Suresh Balaraman with ThinkEquity.

Good morning, Suresh.

Regarding your gross margin guidance at the 47% median, plus or minus 100 basis point, should we infer that this is a qualitative change from your 48% median? And I understand there's amortization co efficient that comes in.

The change to full-year gross margin I think was in recognition that there's such volatility in our business that it makes it difficult to forecast on a quarterly basis. If you look at our historical results, you've seen that volatility both in revenue and in gross margin. If you look over the last seven years, on a quarterly basis, I think we've had 16 quarters where we've had sequential revenue increases and 11 quarters where we've had sequential revenue decreases. So that would demonstrate quite a bit of volatility in quarterly revenue, and I think we've concluded that we can't pick that. And that translates through gross margin. So in the past we've given gross margin guidance within a pretty wide range to account for fluctuations we could see and have seen quarter to quarter, mainly due to product mix, and we feel like over a full year, those fluctuations will tend to dampen out, and so we're more comfortable in tightening the gross margin guidance range within a narrower range, 2 percentage points, 46 to 48%, and this represents -- is consistent with our past performance. I think if you look at our last six or seven quarters, we've operated within that range.

Also when you look at the December quarter, PNC guided for a weaker December but when you look at the DRAM guys, and you may have seen that in your -- you have seen that in the tungsten sales, they seem to be having -- they are going full blast for the -- they have been going full blast and they continue to be strong and can you give us some qualitative color on how the different segments are sitting for December?

I think, Suresh, this is Bill Noglows, in Bill's comments he discussed some of the public statements that have been made by some of our customers, particularly in Taiwan, the foundries, the IC people are seeing that's a little softening. What we hear and what we think is that we're not looking at a massive correction like the industry has seen in the past, but a small inventory correction in the IC side of the business. I would say we're delighted with what we see the strength of the memory business, both NAND flash and DRAM, but remember that, as you know, in the memory side of the business there are far fewer CMP passes than there are in the logic side of the business so the gearing is less than might be if we were more bullish on ICs than memory.

Just a final question. Do you have any meaningful [Inaudible - highly accented language] of copper to the memory customers yet? Copper slurries to the memory customers.

We of course, have been in development work with several of the leading memory manufacturers on not only copper but some other materials for what is being called PRAM memory, or phase shift memory. We are -- to this point have not seen significant sales to memory producers in copper but we expect to see some copper sales emerging from our development work in memory, Suresh.

Thank you, guys.

Thank you, Suresh. Next question, please.

Your next question comes from the line of Chris Blansett with JP Morgan.

Thanks for taking my call. A question on the guidance now that you have QED in the mix. How should we look at the guidance? Because traditionally it's been consumables based and since QED already is about 6% of revenue that's a real big swing factor in where you end up. I'm trying to get a better idea of how to model your next quarter's revenue based on the fact that -- I don't know if you can give a range for what you expect QED's revenues can swing back and forth what kind of growth rate we should be looking at that, something like that.

Chris this is Bill Johnson. Let me answer that by giving some historical perspective. In the 12 months prior to our acquisition of QED they recorded about $12 million of revenue, and now we've owned them for about a quarter. If you look back the same 12 months from the current date, they recorded about $15 million of revenue. Most of their sales, around 70% of their sales is capital equipment. So like any capital equipment company they're going to have some volatile sales quarter to quarter. So as Bill mentioned we're delighted with the $5 million of revenue they reported in the first -- in the fourth fiscal quarter. We would not have an expectation that that would be sort of a run rate. It's going to be lumpy, and I'd point you to the historical results as sort of a guide.

We acquired the Company for a couple of things. As a growth vehicle, and also as a means to translate our technology, CMP technology into other demanding polishing applications. So our expectation over time is that will be a growth vehicle for us, but I think looking back at the historical numbers would be probably your best data point.

How should we compare QED's specific growth on a year-over-year basis versus what you guys are projecting for the Company overall?

Well, it's a different growth driver. In the case of our CMP business it's driven by wafer starts and those are things you can look at in, at least on a historical basis, or a trailing basis. In QED's case they're really introducing new technology and the growth -- a lot of the growth could come from penetrating the whole different market. They have focused in the past on the highest precision applications and sold to large companies. There's a second tier in the market that would represent the hundreds of smaller optical shops in each of kind of three important geographies. The Americas, Europe, and Asia. And selling these automated machines into these applications where right now the polishing is being done by artisans, skills opticians, and crafts people, so it's really penetrating a whole new market.

Now, to the extent you could be very successful at that there could be a high growth rate on that but it's an untapped market as yet and we'd be creating a new market so it's something you'd probably have to be a little cautious about.

All right. I guess looking at some details, what was your -- what kind of tax benefits did you have for the write-offs?

Well, there would be the ordinary -- nothing unusual. These were just write-offs of assets associated with the pad manufacturing capacity buildout, and the other was the in-process R&D associated with QED that's required under purchase accounting rules. So no unusual tax treatment of those. Just an ordinary tax deduction.

Maybe you'll take this off-line after the call. I was just trying to get some pro forma numbers to try to understand how that affected the earnings. Then lastly, your SG&A costs were down on a pro forma basis, or at least they appear to be quarter over quarter. Any reason why? You're running at 13.5% it looks like, percent of revenues on a pro forma basis. Does that sound about right?

Yes, think about, Chris, think about our operating expenses more in terms of dollars and not so much percentage of revenue, because our revenue is pretty volatile. Our operating expenses tend to be more people oriented and pretty fixed but we did call out two things. We had some higher expenses during the full fiscal year on an ongoing basis in professional fees and two sources of that. One is audit related, and the other is in professional fees related to enforcing our intellectual property, and we have talked during the year about some success we have had in that area. And that was one area where we saw a reduction in cost in our fourth fiscal quarter. The second area is, an important cost element for us is our wafers and laboratory supplies and our research and development activities, and if you watch our historical results quarter by quarter those can move by $0.5 million to $1 million per quarter, and this is a quarter that they moved down.

Chris, I think Bill mentioned a small point there that I think is important, we don't think of SG&A and R&D expense in terms of percentage of sale. We think about the total spend, and our process is to always look for ways to be more efficient in how we spend those dollars and we do our best to try to hold them flat as well as we can and utilize some of the processes that we've talked about on prior calls to drive efficiency and productivity into how we do our work.

How should we look at, I guess, just to quantify the extraneous stuff like the legal fees and so on, how much of a decline did you see quarter over quarter just so we can get an idea how much that was really impacting you previously on a quarterly basis?

Well, the larger factor was the professional fees, smaller factor was the research facilities. They're large enough that we mention them but I don't have specific numbers to provide.

So going forward out in the next year if I kind of ballpark things at about a $12 million level you think that's a good assumption? Increasing gradually throughout the year?

$12 million for?

SG&A.

Oh, yes, I think in terms of the total. I think our average run rate through the year, fiscal '06, other than the unusual items at the end of the year, was around $25.5 million, and so as we said in the script, consider that sort of a run rate, and then add QED on top of that, and that gets to you this 27 to $30 million per quarter rate.

Okay. Sounds good. Then one last thing. Did you have a -- what was your pro forma tax rate? We can take this off-line if you want.

I think it was 32.8% but I can't recall exactly.

Thanks a lot, guys, appreciate it.

Just to add one cautious, the professional fees I want to just use an example, professional fees associated with intellectual property, we are a technology company, we are very rigorous about how we defend and protect our technology and when we perceive or believe people are infringing on that technology we go after them with everything we have, and so if and as we see those instances you could expect those fees to go up through the year.

So right now are there any ongoing legal--?

None of significance but there's always kind of a low level activity that goes on within the Company to stay on top of who is doing what and where.

I'll come back around.

Thanks, Chris. Next question please.

Your next question comes from the line of Steve O'Rourke with Deutsche Bank.

Good morning. A couple questions. I know you talked a little bit about this, but can you be a bit more specific about where you saw the softening in September, and when you look at the incremental strength that you're seeing now in October, is this coming from the same place or different?

I guess it was -- I think it was mainly -- the softness we saw in September, a couple of sources. One, it was primarily Asia, I think, and it was more foundry oriented. And it's not clear yet where the strength -- additional strength was coming in October. Part of it could be just attributed to some order pattern variation. If you look year-over-year, for example, ILD, dielectric was actually down year-over-year, or either up very just modestly. And there's something we've seen in our ILD business that quite a bit of volatility in customer order patterns. It's hard to explain but we would see, for instance very strong orders in a particular quarter or a particular month, and then they would soften with a particular customer for a couple of months, then they would spike up again. I think that explains some of the dielectric behavior.

Our tungsten business was particularly strong this quarter and we think that's due to strong -- or high capacity utilization at sort of some of the not leading edge technology nodes, but sort of the 130, 180, 250, and also probably some market share gain in that product line. But like someone mentioned earlier, it seems like the weakness was on the foundries with logic and advanced applications and with some real strength in -- continuing strength in memory.

Okay. On the pad front, I think you mentioned that you're getting revenue from pads now. Is this a quarter early? How will gross margins in pads in the future compare to company averages? And how will you kind of gauge revenue from the pad business in '07?

Steve this is Bill Noglows. I think I said in my comments that we are -- we haven't moved as quickly as we would have liked to, to commercialization with more customers with our pad technology. It's very difficult for us to be able to set targets when qualifications are totally customer dependent. Or not completely totally customer dependent, but they're based on when the industry is running flat-out, our customers have little tool time and little engineering time to support a pad qualification, which is a long and expensive qualification. We've been disappointed at our success at penetrating more accounts. However, that success is dampered by our success in CMP sales because the industry is running flat out and that isn't such a bad thing.

As I think we've talked on previous calls our technology to manufacture pads is continuous process technology. Which implies that we have -- we have a base load of fixed costs that we have to kind of break over and break through to begin to generate margins to the bottom line. That break-even point is at a very low number of pads. And we believe our capital costs and our investment in our pad manufacturing technology are significantly lower than the incumbent technologies that are available today. So I think as we ramp, and we get into more and more customers, I think in our prepared comments today we said we were in at two customers at three different fabs, and we're working with a number of others. We would expect the gross margins to start out below our company average, but assuming we can penetrate a significant number of accounts quickly, we would hope to rapidly get up to and above our current company's gross margin level.

And, Bill Noglows, just one other question. You have mentioned on a couple few calls now that with slurry customization that is many more materials and processes, there should be a differentiator and it should help Cabot. It seems like in the transition to sub 100 nanometer technology this has actually attracted competitors. When do you think it starts to weed out competitors?

I think that's happening now. There's some discussion, we've talked about the fragmentation of our technology. We haven't talked about fragmentation of the industry. We have talked about fragmentation of the technology. And why we think we're well positioned to take advantage of that. I think many people that look at the CMP space, they see this -- what looks like a growth -- wonderful growth market with large margins, and easy to penetrate, and I think that's a bit of a misconception, and what we see happening is if you attempt to penetrate CMP slurry technology, and even if you were to win one node at one customer, it's very difficult to make money in that environment, and the challenge is, you used to be able to take that win and transfer it, or superimpose it on all the other people that were at the same node with the same technology, and you cannot do that any more. The materials are different, the integration schemes are different, and the subtleties in the design are such that the CMP solution has to be somewhat unique by customer, by node, by application which I think makes it very difficult for let's say a smaller competitor of Cabot Microelectronics to penetrate.

We have the luxury or the advantage of, because of our scope and our scale and our breadth, we tend to work with everyone at every node, at every application so we have experiences and technical knowledge about each material and the interactions of those materials and how they might perform in different integration schemes, and that lends to what we do best and why we think that we're uniquely positioned to take advantage of this fragmenting technology. And I think that's happening now, and some of my comments I think I expressed my pleasure in the fact that many of the leading edge customers are coming to us now and we've actively involved in 45-nanometer, 65-nanometer, and even beyond 45-nanometer technology on joint development programs for new products, some of which we may not be commercialized until 2011. But that's what we do, and that's what our customers value us for.

Fair enough. Thank you.

Thank you, Steve. Next question, please.

Your next question comes from the line of Dmitry Silversteyn with Longbow Research.

Good morning. A couple of questions. First of all just for -- I guess to clarify my thinking on accounting here, was there a special reason why amortization charges were part of cost of goods sold rather than part of operating expenses?

Yes. It's Bill Johnson. If you recall, last -- during our third fiscal quarter conference call, we guided toward those amortization expenses to be in operating expense. In the past, amortization expense had been nonmaterial to us, and we had included as an individual line item. But what we're seeing is the SEC has indicated some guidance and a strong preference for attaching amortization expense to the part of the income statement that it supports. And so in the case of the QED acquisition and the acquisition of the IBM patent portfolio, amortization of the intangible assets, we determined was more in line with cost of goods sold as opposed to operating expenses, and our accountants, our auditors agreed with that. So it's really based on some SEC guidance that we're seeing.

Okay. Now, IBM patent amortization is going to go on for a couple of years until you write off basically the acquisition price. How long will the amortization of QED intellectual property last?

It's probably longer lived, but it's quite a bit smaller. The IBM -- the total amortization expense was about $600,000, and about $0.5 million was related to IBM. So the QED will continue longer. I don't know offhand what the life is, but it's much less material.

Okay. Fair enough. You have outlined the one-time impact of special items and gross margin, or gross profit. You have given us a list of one-time items in the operating expense but what was the magnitude of that in dollar terms of those items?

In total the--?

Of just the operating expense.

Okay. It was $1.8 million.

$1.8 million.

Which was the write-off of in-process R&D at 1.1 million, and the asset write-off related to R&D activities of 0.7.

Got it. It looks like if you add up the percentages of revenues that you've given us for the businesses that the pads generated somewhere in the neighborhood of $400,000 or so. Am I doing my math right there?

Not quite. There's an element in part of our insured surface finishes initiative, it's called Surface Finishes Company, that was the first acquisition that we made. That and some internal organically developed ESF activities would also be a part of that, and pads would as well. The pad revenue is in there, but it doesn't rise to the level that you're talking about, and we're still very, very early in pads, as Bill mentioned.

I understand. In the past, you have used 5% of revenue kind of as a cut-off point for reporting a segment separately, or at least giving us an idea of what the growth rates and the revenues were. Would it be the same case with the pads, we'll have to wait for revenues of pads business to make up about 5% of your total revenues before you start breaking it out for us?

I don't know if we've ever set that precedent, Dmitry, but I think we'd be quite happy and excited to begin to talk about pad revenue as soon as we record it. I'd come back and just remind everyone that what I said earlier was those qualifications are moving slower than we would like, however, our activity here in Aurora, Illinois is almost fully complete with manufacturing capacity. We're in the process of adding an additional 10,000 pad per month finishing capacity in our Taiwan technical service center, and I'm delighted to tell that you this week our pad team is in [Sinchu] conducting a symposium on our pad technology and some training on our pads with over 100 of our customers' employees from six different companies in Taiwan. Although we're very excited about our activities and execution on our plan we're less than happy with how fast we have got it to commercial ramp and we're doing all we can to make that happen.

Then last question if I may. The inventory write-off for QED you said you used up some of the inventory this quarter, you continue to use that up. Any idea how long it will take you to work through that inventory?

There's probably another 1.5 million or so, maybe a little more of margin impact associated with that write-off, and we'll recognize it over the time that it takes to sell that inventory. So spreading that out over a year is probably reasonable.

Okay. So you're carrying -- this business requires you to carry that much inventory?

Well, it's a different business. These are pretty customized pieces of equipment, so the decision is do you maintain machine inventory versus build it to order, and sometimes the lead times on these could get long. So I think QED has managed sort of halfway in the middle. They maintain some inventory of more common components and then try to make to order the -- or assemble to order the final machine. But it's a different inventory type business than what the CMP slurry business clearly where we have very little finished goods inventory.

So about 1.5 million over a year's time is the impact that you're talking about to work this off.

That would be appropriate to use for your model.

Great. Thank you very much.

Thanks. Next question, please.

Your next question comes from the line of John Roberts with Buckingham. Please proceed.

Hi, John.

John?

Hello?

Go to the next question.

Hello, John?

Yes, this is John Roberts.

You're on, John.

Yes. The unusual charge in the quarter, the $0.12 that you call out in the third page there, that's 2.9 million after-tax. What's the pretax number that goes with the 2.9 million after-tax?

About 4.5 million.

What are the additional items in that 4.5 million besides the 1.8 million that you called out?

There's 1.8 million of the asset write-off related to the pad manufacturing capability building conversion, and that's in -- and then there's two elements of purchase accounting. One is related to QED. There's a write-off of $1.1 million of in-process research and development activities for not yet commercial research activities under purchase accounting rules, there was, also under purchase accounting there was the inventory write-up on QED, had an impact of $0.9 million, and then there's amortization of intangibles and between the IBM patent amortization and QED amortization there's another 600,000 or so. All those total 4.5 million.

Isn't that last one a continuing expense? Going to go on?

Yes, it will. The IBM amortization and the QED amortization will continue. The inventory write-off, as we just explained to the previous caller will be with us probably over the next year. That's probably a good assumption. Everything else is one-time.

Okay. Then on the volatility in QED, this quarter you said was sort of an above trend quarter for them. Over the past 12 months, what's the lowest three-month period that they have had? What's the range that they've experienced?

It can go pretty low. You could have a dry spell of several months, and that wouldn't be unusual.

Like almost a zero?

Well, you could go through a period of time and not sell machines. I don't know quarter to quarter what exactly their history has been, but it is a capital equipment business, and so I think you should expect some volatility.

Okay. And then lastly, the 1.6% price improvement was attributed to mix. It's 100% mix? There was no material price changes within any of the product lines?

We said there was -- the biggest factor was product mix. There was some -- a limited effect of some selected price reduction.

But they sound like they're very modest.

Modest relative to the product mix effect.

Great. Thank you.

John, quickly, Bill mentioned earlier QED about 70% of QED is equipment sales, the other 30% is service and consumables and contract research. So there is a floor on how low it can go, assuming they would sell no tools in a quarter they'd still have that 30% of services and consumable sales.

So it might be 30% times 5 million or maybe, -- 1.5 million?

I think 5 is a record quarter, and although I'd be delighted if we recorded several more quarters at $5 million, I'm not sure I'm willing to expect that right now.

Okay. Thank you.

Thanks, Steve. Next question, please. John, I'm sorry. Next question, please.

Your next question comes from the line of Colin McArdle with Needham.

Good morning and thank you for taking my question. It's actually a similar question to the SG&A question from earlier but referring to R&D. It increased about 80 basis points in the quarter as a percentage of revenue. Is it fair to think about that more as absolute dollars than percentage of revenue as well? Is 13 million a number that looks to be fairly consistent, given the number of new products, I think you quantified 10 coming to market in '07?

Yes, Colin, the -- I think about -- what we have guided is operating expense in total, and the expectation is that we're going to hold operating expenses at a similar run rate in '07 than we saw in '06. And really that would include R&D, selling, admin, but we're thinking in terms of more of the total. And the range you ought to expect is $27 million to $30 million per quarter, but operating within that range but trending up modestly during the year. But the expectation is that we're going to get more productive in what we're spending and so the expectation of any increase is more aligned with the QED acquisition than any significant kind of ramp-up in spending.

Okay. So 10 new products to market this year. Should we think about R&D budgets being consistent with historical -- that doesn't create an additional R&D spending challenge?

I think, Colin, if you look at what we got done in the year we just finished, we added the Asia Pacific technology center in Japan, our Taiwan technical service center in Sinchu, our data storage, laboratory, business, leadership, and manufacturing capability in Singapore, and we did that all in an environment of what I think was pretty disciplined cost management. I think -- we started out, I think several years ago talking about Six Sigma and design for Six Sig and I won't bore everyone with that on this call today but we are beginning to see the results of what we think is a very rigorous new product introduction process, that it's cross functional and involves a lot of different people in the Company.

The results of some -- some of the comments I made earlier today were about the robust nature of these new product offerings and how we get to them is an interesting process but it works very effectively and efficiently and we think we can continue to look for those kind of efficiency gains and productivity gains as we go into 2007. And just work smarter and better and use our money more efficiently than perhaps we had done in the past. That's how we're doing it it, and we are going to continue to try to do it that I way. Supporting -- I think your point is a good one. Supporting ten new products and the commercialization activity that goes on with our customers puts a huge demand and strain on our application engineers and field engineers that are out around the world that are in the fabs with our customers commercializing these new products and we will not -- we will not in any way constrain our ability to do that and we probably add some incremental costs along the way, but our overriding focus here is to try to do all we can to be as efficient as we can and hold our total spending as flat as we can.

Thank you. That's helpful. Then separately, you bought back I believe $8 million worth of shares in the quarter?

That's correct.

Could you just refresh me on what the full allocation by the Board is in terms of a buyback program?

We're operating on a $40 million buyback, and we have spent $16 million of it.

40 and 16 spent. Thanks very much.

Thanks, Colin. Next question, please.

And your next question comes from the line of Jay Harris with Goldsmith and Harris. Please proceed.

Hi, Jay.

Hi. How are you guys? Engineered surface materials, I'm sort of getting the impression from the call that it includes the surface finishes group that you have acquired QED and pads. Is that correct?

Jay this is Bill Noglows. No, we think of the pad opportunity and our pad initiative as part of the core CMP business. It's -- listen, we're leveraging directly our knowledge and expertise in the CMP process, and we believe that there is clear opportunities to begin to engineer, or coengineer, if you will, pads, slurries, solutions that are unique to specific applications and we see it as a key element of our core strategy within the CMP business or the semiconductor industry.

Well, ow much larger than QED is this engineered surface activity?

Well, let's be clear. Engineered surface finishes is our description of our activity to extend our technology, our technology, our materials knowledge and surface preparation into other applications outside of the semiconductor space. We call that engineered surface finishes.

Well, how large is that relative to -- relative to QED?

I think, Jay, I think what we're -- you and I are confusing two things. We bought a company called Surface Finishes, which is a small company, much smaller than QED, if that's what you're asking me.

No, no. Well, I understand that but I also thought that you had some product lines that were generating revenues even before surface finishes was considered. So I -- the thrust of this question basically is are we going to see an engineered surface segment emerge? If so, when are you going to talk about the whole segment, or are you just going to talk about QED portion of that segment?

Right now, Jay, the QED -- QED is by far the largest piece, or largest element of the ESF initiative. This surface finish is very, very small relative to the QED. If you add up all the percentages that I gave in terms of revenue split, you come up with 99.5%, and so there's another 0.5% out there that represents surface finishes and pads and other things like that. When this becomes sizable, then we'll start talking about it potentially as a segment but we're not there now.

Is that a three-year objective, or something closer in time?

ESF? As a segment. I think our ESF initiative is -- it's difficult for us to put a time horizon on it. As we have talked in the past we're looking at a number of different applications to extend our technology. Optics was the first and perhaps closest in application area where we committed and dedicated resources and some technologies to begin to explore opportunities for Cabot Microelectronics to bring value to that segment.

One other question is, had you not acquired QED, what do you think your reported earnings per share would have been for the quarter?

When we made the acquisition of QED we indicated that we expected to be mildly dilutive in the first year or so, and so this is a first quarter and it included some unusual items, so it was dilutive in the first quarter. I don't have a particular number.

Well, if you took all of the R&D write-offs and the -- just took QED out of the quarter what would the quarter have looked like?

It would be a couple of cents, something like that, probably.

Thank you.

Thanks, Jay. Next question, please.

And your next question comes from the line of Chris Shaw with UBS. Please proceed.

Good morning. I was curious. You mentioned the lower manufacturing yields in the quarter. Just speak to why they were lower.

In conjunction with our ongoing CMP slurry business, there are a number of sources of yield loss. Some of it it is off quality production. If you make a slurry that you find that doesn't pass our quality requirements or it maybe doesn't meet the customer's needs, sometimes when you're qualifying a new material, a new product for a customer and high volume manufacturing, there's a number of lots that have to be produced and scrapped. They may be bought by the customer but maybe not. So it's a combination of things like that that represent yield loss in our manufacturing, and this quarter we saw that was sizable enough to call it out.

That doesn't really represent like the plant wasn't running right or the line wasn't running or something went wrong? It's just that kind of stuff you mentioned, right?

That's correct.

You mentioned before one of the Bill's, did how QED, 30% is the consumables and services and such. Over time, and I guess it it wouldn't be over the next year or, so but would you expect that percentage to grow, the amount of consumables, or you think it would stay pretty constant?

Well, we think there's opportunities to employ some of the CMP chemistries that we have developed at Cabot Microelectronics to the MRF tool and provide different abrasive systems and chemical systems to the QED technology to extend that technology into other polishing applications and different substrates and materials. I think there's a chance of that. I think -- Bill discussed QED a little bit. We think there's a number of business models that could be pursued with QED to grow both the machine side of the business as well as the consumable and service side of the business. I think it's a little too early for us to talk about those and make any predictions about where they might go but again, we're excited about the Company, we're excited about where they sit in the value chain of the precision optics industry, and we're excited about what we believe is the emerging transition from the artisan-based fabrication to the computer-aided fabrication that QED provides.

Okay. And then finally, you were talking about adding maybe to slurry capacity in Taiwan and you hadn't made a decision yet. Could you just talk about what the decision is, exactly what you'll be considering and maybe when it could happen?

Well, I think as you know, we have a very large manufacturing facility here in North America, and we have our largest, highest volume facility located in Geino, Japan outside of Nagoya. We see a strong need to put similar capability some where in Taiwan, mainland China area. Taiwan today is perhaps the, for our company, Taiwan represents our single largest market, and we are looking -- actively looking at different options to establish manufacturing capability there. And that goes from -- and I think our hesitation here is that goes from doing it on our own, going and buying land, building the building, or perhaps finding a partner or a toll manufacturer or going at it a different way that allows us to minimize some of our capital risk and get there faster with a local partner. So those are kind of the options that we're looking at and we haven't finalized our decision yet. When we do that we'll certainly let everyone know.

So you don't after facility there you could expand or grow on, you'd have to do a total greenfield kind of thing?

Well, what we have there is a large -- we call it a technical service center. It's in the science park, but it's a laboratory and laboratory support, we have a lot of metrology and equipment there as well as scientists and sales people and application engineers, but it's not a place where we would want to manufacture CMP slurries. It is a place where we will be installing our pad finishing operation, however, but it's not -- it doesn't have the scale or the infrastructure to support full-scale CMP slurry manufacturing.

I was wondering, because, you guys don't need a lot if I remember right, you don't need a lot of space for your production lines really, do you?

We don't need a lot of capital, but we tend to use a bit of space, relative to what? I mean relative to an oil refinery?

Good point. Thanks a lot.

Thanks, Chris. And we have time for one more question.

And your next question comes from the line of Tim Summers with Stanford Financial Group. Please proceed.

Hi, Tim.

Thanks for taking my question, guys. I actually had two. First of all, if the QED revenue was 5 million in the quarter does that suggest that slurry revenue was chose to 82 million?

Yes.

Yes.

Does that -- since you had a price increase, an ASP increase of 1.6% does that suggest that slurry volumes were down about 5% Q to Q?

Yes, that math probably works.

All right, good. And the second one, sort of a more global question, as you look at the major copper manufacturers at 65 nanometers, have all of them made, for the most part, their PORs on their slurry vendors, and where does that stand at 45 nanometers? Thanks.

Let me start with 45, then I'm going to ask Bill to comment on 65. I think 45-nanometer technology is -- we don't believe we'll see anyone in commercial ramp on 45-nanometer copper technology until late in the 2007 calendar year, if that. So most if not all of the work at 45 nanometer technology is what I would call precommercialization development work, and I don't believe that any of the customers have made a definitive choice on their process technology, let alone that CMP slurry technology. 65 is a different game, as I think everyone knows there's a couple of technology leaders in the world. And I am going to look to Bill to answer this question because he's a little closer to it than I am.

We think there are probably three semiconductor manufacturers that are in commercial production at 65 and others that are ramping or in evaluation, and that sort of thing. So there are a few that have made decisions, but we think that the field is still pretty open.

Okay. Great. Thank you.

Okay. Thank you all very much for your time this morning and your interest in Cabot Microelectronics. We look forward to the next opportunity to speak with you. Good-bye.

Thank you for your participation today's conference. Ladies and gentlemen, this concludes the presentation. You may all disconnect, and have a good day.