CMC Materials, Inc. (CCMP) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Cabot Microelectronics earnings conference call. (OPERATOR INSTRUCTIONS)

I will now like to turn the call over to Amy Ford, Director of Investor Relations. Please proceed.

Good morning, this is Amy Ford, Director of Investor Relations for Cabot Microelectronics Corporation. With me today are Bill Noglows, Chairman and CEO; and Bill Johnson, Chief Financial Officer. This morning we reported results for our second quarter of fiscal 2007 which ended the March 31. A copy of our press release is available in the investor relations of our website, www.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 first quarter of fiscal 2007, ended December 31, 2006, and Form 10-K for the fiscal year-ended September 30, 2006. We assume no obligation to update any of this forward-looking information. I will now turn the call over to Bill Noglows.

Thanks, Amy. Good morning everyone and thanks for joining us. This morning, we announced financial results for our second quarter of fiscal 2007 that we believe reflect a continuation of the soft industry environment that we began experiencing last September. Consistent with what many other semiconductor industry participants are reporting this quarter. I will begin this morning by sharing our thoughts on the current market environment, and then talk about my continued confidence in the strategic direction of our company.

We believe today's results reflect tough industry conditions and overshadow some of the important initiatives on which we executed during the quarter that we believe will drive shareholder value in the long term. Bill Johnson will follow with a more detailed summary of our financial performance.

You will recall that during our first fiscal quarter, we experienced a revenue reduction that we attributed primarily to a decrease in the production of semiconductor devices by a number of our customers, particularly among the foundries in an effort to correct excess inventory of semiconductor devices. Since demand for our products is primarily driven by wafer starts and since foundries represent a very important part of our business, this general industry downturn adversely impacted sales of our slurry products.

During our second fiscal quarter, this trend continued as the inventory correction has persisted. Certain industry experts have commented that semiconductor inventory levels have significantly decreased from their peak in the September quarter. However, it is uncertain how much excess inventory remains and how strong end use demand will be going into the second half of year. Bill will comment later on our order patterns during the quarter and what we are seeing during the first four weeks of April.

Consistent with what we stated last quarter, we do not believe that the slowdown in our revenues is representative of any material change in our business or market position. Recent data released from world semiconductor trade statistics or WSTS, indicated this year's January to February decline in the IC market was the largest January-to-February decline in 30 years. In addition, IC Insights and Gartner have both recently reduced their semiconductor industry revenue forecast for 2007 based on year-to-date results. Despite these industry conditions, we remain confident that our strategy supporting our three key initiatives, technology leadership, operations excellence, and connecting with customers, remains critical to maintaining our leadership position.

Even in this soft market environment, in our view, we are among the most aggressive in the industry at investing in people, products, and technology to stay ahead of the curve and partnering with our customers to enable future expanding relationships. We believe our solid cash flow and strong balance sheet have consistently allowed us to successfully weather semiconductor industry downturns and to continue to drive our strategies which we believe makes us an attractive long-term investment in the technology sector.

Our ability to invest through industry cycles should provide shareholders with confidence that our continued execution in technology leadership will enable our product pipeline to remain productive and robust in the coming years. As you all know, long development and commercialization cycles are common in this industry so investing early and continuously is necessary to secure wins two to five years down the road. As part of our technology leadership initiative, we seek to enter into long-term strategic codevelopment arrangements with a number of leading edge technology customers.

A supplier to the semiconductor industry has to demonstrate credibility, advanced technical knowledge, and flexibility to be invited into these arrangements and we are invited time and time again. We believe that our strong business model makes us unique in our capability to manage multiple joint development projects at the same time with leading edge semiconductor manufacturers over a broad range of applications. A successful new CMP slurry developed through one of these joint development programs is only as good as our ability to produce it consistently and reliably over the life of the product. Over the last three years we have made significant improvements in our entire supply chain by driving out variability in our products, processes, and raw materials that we have implemented our operations excellence initiative. Our continued successful execution of this very important initiative has resulted in material savings achieved through productivity gains, and many accolades from our customers. This initiative will continue to be a major focus as we move forward and expand our business around the world.

As part of our connecting with customers initiative, we have completed several infrastructure and customer-support projects in the Asia-Pacific region. We believe that these initiatives have meaningfully increased our responsiveness and service to our customers in this very important area. For example, we have new technology centers in Japan, Taiwan, and Singapore which provide our customers better and more rapid technical support and service. Our response time has improved because we are now working in the same time zones and speaking the same languages as many of our customers. Our belief that we are successfully executing on these strategic initiatives is reinforced by the performance ratings that we are receiving from our customers. Supplier scorecards are a formal means by which customers give us systematic feedback on our performance in various areas such as technology, quality, supply assurance, cost targets, availability, and responsiveness goals. Over the past three years, our average scorecard rating has increased in aggregate by over 20% which we believe is evidence that we are executing and improving on our technology leadership, operations excellence, and connecting with customer strategic initiatives. All areas that are typically evaluated on these scorecards.

Remember, our relationships with our customers are long lasting. As we continue to build their trust and confidence in our company, we would hope to have more opportunities to expand our relationship with them going forward. One specific recent example was our winning of Intel's preferred quality supplier or PQS award for 2006 based on improvements that we have made across all areas of its supplier scorecard. Out of approximately 1500 suppliers, 44 companies were granted this award, and we were the only CMP consumable supplier chosen to receive the PQS award for 2006. In all of our years of working with Intel, this is the first year that we received this prestigious award. We are very proud of this accomplishment and I am delighted with all the hard work and dedication that the team at Cabot Microelectronics put forward in our effort to continue to build upon our relationship with this very important customer.

I'll close my comments with an update on our CMP polishing pads business, which is an important future growth initiative for us within our core CMP consumables business. Last quarter, we discussed our ongoing sales of our Epic D100 pad to two customers and in February we announced that one of those customers is Freescale. As our pad is qualified and incorporated by early adopters of our technology, and our value proposition is being realized, we believe that this enhanced value will be the driving force for more rapid adoption by others. We continue to believe that this is an important revenue stream in the years to come for Cabot Microelectronics.

During the second quarter, we experienced increased customer pull for our polishing pads and we are currently selling pads to 4 customers and have over 20 customers testing, evaluating, and qualifying our pad. Test results continue to reveal significantly longer pad life and lower cost of ownership. Additionally, our new pad manufacturing facility in the United States went into full commercial service this quarter. With this plant now up and running, customers evaluating our pads are able to directly sample from this automated high volume manufacturing line, rather than from a pilot line. We believe that this is an important step in speeding up the pad qualification and commercialization process at our customers' sites.

We also opened a fully capable satellite pad finishing facility in Hsinchu, Taiwan this quarter. In the finishing process grooves are cut into the pad surface and the final pad is cleaned and packaged for shipment. This grooving process can be highly customized based on customers specific application, integration scheme, and tool set. By opening this facility close to a number of key pad consumers in the region, we believe we can be more responsive to these regional customers' needs by offering customized -- customization capability with very fast turn arounds.

As we have discussed in previous calls, the pad qualification process has taken longer than we would have liked or expected. It is a difficult qualification that requires several long marathons of testing utilizing large quantities of wafers and CMP tool time. The current industry slowdown has helped the process by providing additional tool and engineering time to do the qualification work at many of our customers' fabs. We are hopeful that things will begin to move more quickly and we will start to generate material revenues to cover the fixed costs associated with our investment in pad manufacturing, testing and support that we are currently bearing as part of our gross profit margin.

Despite the challenging industry conditions, we remain committed to staying the course and executing on our proven strategic initiatives. We believe that our business is well-positioned to both weather market downturns and accelerate forward during better times. And with that, I'll turn the call over to Bill Johnson. Bill.

Thanks, Bill and good morning everyone. Our revenue for the second quarter of fiscal 2007 was $77 million, which was down by 5.9% from the prior quarter. As Bill mentioned, our revenue this quarter was affected by continued softness in the industry that we first saw last September. We believe that the sequential revenue reduction we experienced this quarter was primarily due to a continuation of these industry conditions and does not represent any material change in our market position or business.

Revenue in our second quarter was up by 14.2% from the same quarter a year ago. You may recall that in the year-ago quarter we transitioned to selling directly to customers in Taiwan, rather than through a distributor. This adversely affected revenue in our second fiscal quarter last year, making year-over-year comparisons more difficult. Also, last year's second quarter results did not include revenue from the QED business that we acquired last July.

Drilling down into the quarterly revenue numbers, sales of copper slurries represented 18.3% of our total revenue and decreased 4.3% sequentially. Tungsten slurries contributed 39.1% of total quarterly revenue with revenue down 3.7% sequentially. Dielectric slurries provided 30.8% of our revenue this quarter with sales down 10.2% sequentially. Data storage products represented 6.5% of our quarterly revenue and this revenue was up 10.6% sequentially. Finally, revenue from our ESF business which includes the QED business, generated 5.2% of our total sales and our ESF revenue was down 16.4% sequentially.

On a geographics basis, sales in Korea grew sequentially while sales in all other geographies declined. Our average selling price for slurry products increased by 0.6% compared with the December quarter, due primarily to a higher priced product mix. The average selling price was 4.9% higher than in the same quarter a year ago, mainly as a result of a higher-priced product mix and higher selling prices. As a percentage of revenue, gross profit was 43.9% this quarter, which was 4.2 percentage points lower than the 48.1% of revenue we reported in the prior quarter, and 2.9 percentage points lower than 46.8% in the year-ago quarter.

Gross profit this quarter was adversely affected by lower utilization of manufacturing capacity based on the lower level of sales as well as lower yields in our production operations, and higher fixed manufacturing costs. These effects were partially offset by the benefits of a higher valued product mix. Gross profit for the first half of the fiscal year was 46% of revenue, which is consistent with our full-year guidance range of 46 to 48% of revenue. We continue to expect gross profit margin for the full year to be between 46 and 48%; however, given performance in the first half of the year, it is likely that it will fall at the low end of this range. Remember, that this is full-year guidance, and given the variability of our gross profit, it may fall above or below the guidance range in specific quarters as it has demonstrated in the last two quarters.

Now I'll turn to operating expenses which include research, development, and technical, selling and marketing, and general and administrative costs. Operating expenses were $28.9 million, which is within our guidance range of 27 to $30 million per quarter. This quarter's expenses were $1.7 million higher than the $27.1 million we reported last quarter. Factors affecting operating expenses were higher professional fees, including cost to enforce our intellectual property portfolio, higher cost of laboratory materials for our research and development activities, and higher compensation-related costs typical of our second fiscal quarter. This quarter's operating expenses were $4.2 million higher than the $24.6 million in the same quarter last year. The year-over-year increase in operating expenses was primarily due to costs of the acquired QED business, higher professional fees, and higher costs of laboratory materials. We expect operating expenses to continue to fall within the range of 27 to $30 million per quarter this fiscal year.

Net income for the quarter was $4.5 million, down from $9.1 million last quarter, and down from $5.4 million in the same quarter a year ago. The weighted average number of shares outstanding on a diluted basis this quarter was 23.7 million, this was down from the prior quarter, due to $4 million of share repurchases in our second fiscal quarter. Diluted earnings per share were $0.19 this quarter, down from $0.38 last quarter and down from $0.22 in the year-ago quarter.

Turning now to cash and balance sheet-related items, capital additions for the quarter were $1.8 million, depreciation and amortization expense was $6.1 million, and share-based compensation expense was $3.3 million for the quarter. We ended the quarter with $163.6 million in cash and short-term investments, which was $3.2 million higher than last quarter. Cash flow reflects a $5.5 million increase in working capital, mainly due to the timing of income tax payments. Our cash balance also reflects the $4 million of share repurchases I mentioned earlier. We are pleased with our continued strong cash flow as this allows for the continued investment in our three strategic initiatives in the CMP consumables business, as well as the pursuit of growth opportunities in our ESF business.

I'll conclude my remarks with a few comments on our outlook for the future. Earlier in the year, we described our long-term goal to grow revenue by 15% per year, including revenue from our core CMP slurry and pad products, demand for which is driven by wafer starts, and from our ESF business, which has been driven primarily by acquisition activity. We had qualified this 15% revenue growth goal as being subject to timing of semiconductor industry cycles that affect our core CMP business, and timing of acquisitions in our ESF business. Given the downturn we have seen in demand for our CMP products in the first half of fiscal 2007, we no longer expect to achieve this goal this year.

We are eagerly awaiting an upturn in demand for our products which would be an indication of an end to the soft industry environment that has impacted our financial results in the last two quarters. Looking at our revenues in each of the three months of the second fiscal quarter, we saw modest increase in CMP revenue in the month of March, relative to January and February. This appears consistent with the upturn in monthly revenue that was publicly reported for March by a couple of large Taiwan foundries, after six successive months of reporting decreasing revenues. Since the Asian foundries represent a significant part of our business, we are hopeful that the upturn reported by the foundries in Taiwan may be an indication of an end to the industry inventory correction.

As we observe orders received to date in April, that we expect to ship by the end of the month, we see April results trending slightly higher than March. However, I would caution, as I always do, that several weeks of orders out of a quarter represent only a limited window on full-quarter results. Now I'll turn the call back to Amy as we prepare to take your questions.

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

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Suresh Balaraman with ThinkEquity. Please proceed.

Thanks. When we look at the margins, the drop was pretty surprising and you guys have had pretty steep declines in the last five years or so, but margins have never dropped by so many, by hundreds of basis points. So is it yields declined (Inaudible - audio difficulties) gross margins declining, can you go into the break -- I mean, can you give us some more insight on what was the bigger issue in terms of such a huge drop and what is going to change in the next quarter that you're so confident of the 46 to 48% in overall annual gross margins?

Thanks, Suresh this Bill Johnson. I'd be happy to provide a bit more color on the variance sequential change in the gross profit margin. Our gross profit margin decreased from 48.1% in Q1 to 43.9% in the second quarter, so a delta of 4.2 percentage points. We believe that the biggest single factor in that decrease was about capacity utilization. But you have to consider that we report cost of goods sold during the quarter which may differ from the cost of actually producing those products during the quarter. And this has been a complexity we haven't talked with you about in the past. Let me give you an example.

In the December quarter we reported gross profit of 48.1% which was quite high. But some of the product that we sold in the December quarter was produced in the September quarter, the previous quarter, when our production levels were quite high and plant utilization was also high. And so those were produced at a low-cost per unit.

The March quarter did not benefit from this because the product we sold in the March quarter was produced during a period of lower production levels for us, and lower manufacturing capacity utilization. So these were produced at a higher unit cost. So when they flow through cost of goods sold, they came through at a higher unit cost and that depressed our gross profit margin. Capacity utilization, we think, accounted for about half of that 4.2% reduction quarter to quarter. Now, there were a couple of other items that impacted gross profit. One of these was, and you mentioned this yield in our manufacturing operations. For us, yield is the amount of salable first quality product that comes out of our manufacturing facility relative to the inputs that go in. And we've seen some fluctuation of this in the past and we did see somewhat higher off-quality material or lower yields in our operation this quarter but nothing extraordinary and we've seen this kind of fluctuation in the past.

We also experienced somewhat higher fixed manufacturing costs. Some of these will be ongoing and some were one-time events. For example, we -- Bill mentioned that we put into service our pad manufacturing facilities in the U.S. and in Taiwan, and we began to depreciate those facilities. So that was responsible for some modest increase in fixed manufacturing costs, but we also saw some higher labor costs that's kind of seasonal and a few one-time items that also impacted fixed manufacturing costs. So those were the three big factors that impacted gross profit in the second quarter versus the first. There's one other factor that I would mention that was apparent in both quarters, but it is pretty significant, and that's the impact on our gross profit margin of our pads, our efforts to develop the pads business where we are incurring costs, for an example, the manufacturing facilities we have in place ahead of revenues, and the costs associated with our pads business in the quarter, in a quarter of very, very small revenue, decreased our gross profit margin by about 1.5%. And that's not necessarily a difference from one quarter to the other, but it's a significant factor in the absolute number of our gross profit for the quarter. I'm sorry, go ahead.

So can we interpret your statement as saying that you're running slightly to the higher level because you're still maintaining the guidance for the rest of the year, can one say the March factory utilization of factory load is higher and I'm assuming that you will not have yield problems again and would there be a change in the pad issue as well as the cost of goods sold on the pads?

Well, we're within our full-year guidance range of 46 to 48%. We're indicating that we expect that we would be at the lower end of that range and the assumptions behind that would be that the hope that sometime during the remaining two fiscal quarters, we'd see some sort of an upturn, that the inventory correction that's caused the soft conditions in the first two quarters of our fiscal year would be relieved. There's some indication of that. Bill will probably talk more about that. But yes, there is an expectation that we would have less of the yield problem that we had this quarter, and some upturn in the margin.

And you also talked about the revenue targets for the year. You were hoping for 15% growth and you said it's no longer achievable. Is that data based, and I guess on that base purely reported so far, does it also include what you anticipate for the next few months?

I think I got that. The question was is our comment on the non-achievebility of the 15% growth target was that just based on sort of a current quarter or is it longer term than that. I'd just remind you, Suresh, that when we put out that growth goal it had in mind growth, continued growth in the CMP business, slurries and pads but also growth, organic and acquisition, in the ESF business. So to the first two fiscal quarters, we've had a very soft semiconductor environment, which has hurt the CMP business. And you're aware we have not announced any acquisitions in the ESF business subsequent to the QED acquisition that we did last July.

So in light of the cyclicality and the significant impact that acquisitions, the timing of acquisitions could have on that goal, we're saying that that 15% is not achievable for fiscal '07. In fact, we're really taking that goal off the table. We have growth objectives but the qualifications around industry cycles and timing of acquisitions are so profound that it seems like it doesn't make a lot of sense to put a goal out like that when it's so heavily qualified.

Okay, thank you.

Thank you, Suresh, next question, please.

Your next question comes from the line of [R.J. Sapru] with JPMorgan.

Good morning. A couple of questions. First, on the pickup that you alluded to briefly in the wafer starts, what kind of pickup do you anticipate in the second quarter of '07 right now, based on what you're seeing?

Well, I think as Bill said in his script, this is Bill Noglows, as Bill said in his script, March was the highest month of the three in the quarter and April looks, at least in the first four weeks, looks a lot like March. We're seeing a little pickup. We pay very careful attention to the foundries. And I think as Bill said in his script, after six consecutive or sequential months of revenue decreases, March saw a slight increase of about 5%, TSMC reported this morning that their Q1 was down 13.5% sequentially. However, they did talk about what they believe is an inventory correction is over and that they expect a stronger second half of the calendar year, which is good for everyone, including us. So we're optimistic for the second half of the year. But I'd say we're cautiously optimistic because there is some confusing or some contrary information out there from analysts and different customers.

So TSMC is guiding up second quarter back up to $75 billion Taiwan kind of level, so that's a pretty big jump from what they did in Q1. So are you not seeing that kind of outlook or where's the disconnect here?

Well, I think what we said was our March was stronger than January and February and April was looking a lot like March. So when the foundries announced that they saw a little pickup in March, that 5% pickup in March we were seeing sort of the same thing in March as well.

But I think there is -- if TSMC saw that kind of an uptick in the June quarter, we would expect that to have some impact on our business. One of the things that we've noticed, given the importance of the foundry business to our revenue, is a very strong historical correlation between our monthly revenue and the foundry's monthly revenue. There are two significant foundries in Taiwan that report revenue on a monthly basis. If you correlate our monthly revenue with those two companies' reported monthly revenues, over the past several years you see a very strong correlation. So there is some visibility or perhaps a window on intracompany results or revenue for us if you watch those monthly reports. So if TSMC does, in fact, report -- recognize that kind of sequential growth, then that should have a positive impact on our business. But we would have to see that, we're seeing a little bit of it perhaps in April but we'd have to see more of it.

Okay. Fair enough. And on the pads business, can you give us a little bit more color on what kind of revenue progression we should see through the rest of the year?

Sure. We can try. We continue to be optimistic about the success of our technology in our pad. In my prepared comments I mentioned that we have over 20 customers now that are either in the stage of testing, evaluating, or qualifying our pad. It's a longer process, the qualification process is longer than we had anticipated for a number of reasons, one of which is our technology is not necessarily drop-in technology. In fact, it's deliberately not drop-in technology for a number of different reasons. But it's close enough where it requires us to do a little bit of process development work with our customers and through our application engineers. So it's taken a bit more time than we expected. However, we continue to remain optimistic, given the amount of customer interest and pull that we're seeing. We have sales, currently have sales to four customers, not yet material, so we haven't broken it out yet and we will break it out as soon as it becomes material.

We would expect to see an increase in revenue through the second half of this year and into the first quarter of '08. But it's, again, it's dependent on the qualification process and how long things go. The current slowdown has helped us a bit, it's freed up some tool time and some engineering time at some of our customers' fabs and has allowed us to get in there and get our pad evaluated and qualified. So we go forward and again, we're optimistic about our long-term success.

Also, we have -- we've got capacity in place now that could enable us to achieve a double-digit market position, so we're ready to go. In fact, we established that production capacity in an existing facility at a relatively low capital cost. So we think we've got substantial capacity in place and ready to go and we established it with a low-costs position. So we think we're well-positioned for the future.

So that brings me to my next question. So you mentioned about like 1.5-point impact to gross margins based on the fixed capacity that you put in form pads?

Correct.

So then should we think of that as sort of a step down at least in the near term future until the pad revenues pick up?

Well, I think you'd expect that to persist. That with some pad revenue, that would turn to a breakeven and so that wouldn't -- that would be less of a drag and eventually should be a contributor to gross margin. But the 1.5% was the, kind of the pad burden on overall gross margin percentage for the quarter, with revenue, you would expect that to go to zero and then become positive over time.

I think would that be an '08 event?

We anticipate the gross margins for our pad business being in the same area equivalent to same gross margins that we currently record in our CMP slurry business. However, we have to overcome, there's a breakeven point and as Bill said, we believe it's a very low point but we have a breakeven point we need to get over where we cover the fixed costs with revenue. And we would -- I'm optimistic but I -- I'm cautious about putting out targets and time lines because the process is totally dependent on our customers and we can only do so much to drive it forward. I'm a bit hesitant to put out time frames and targets.

That's fair enough. So let me ask you a slightly different question, then. In terms of generational revenue opportunity going from 90 to 65 nanometer do you have any comments on what your opportunity is in that regard?

Well, we're active in all nodes. We're working on technology now at the 22-nanometer node. So we're active at all the nodes and we have been active at the 65-nanometer node for over three years now in terms of product development and process development. I don't think we've commented on our percent of revenue or expectations on how much we might record as our success in that node or future nodes, but our scale and our size allows us to work with all the leading-edge customers on all the advanced node technologies and that's what we do as Cabot Microelectronics. So we would expect a significant portion of the 65-nanometer CMP slurry business going forward. Thank you A.J., we'll take our next question please.

Your next question comes from the line of Amy Zhang with Goldman Sachs.

Good morning. I have a quick question. I was wondering how much you would, for your CMP slurry portfolio, how much would you characterize as advanced products and how much is more like a mature commoditized of products? And do you have any actionable plan to phase up some of those low margin commoditized products or now you feel pretty comfortable with your current portfolio positioning?

Well, I think we've characterized the applications that we serve as -- and I'll just walk through them, as the outside CMP business tends to be the most mature, it's been around the longest and it tends to be -- I don't like to use the commoditized word but tends to be the business that's the most competitive and has perhaps the lowest margins over the long term. Tungsten remains a -- I describe it as a high-value segment. We continue to introduce new innovative products in the tungsten segment and we think that's an important area going forward. Copper has been the latest area where I would describe as perhaps the most innovative and the most diverse in the number of solutions and complex challenges.

We recently had, I think you know, we recently had a price increase in the dielectric segment of our business and that price increase was put in place because we believe that over the years we have made several significant improvements in our oxide product line that we thought we needed to get paid for. We went out and implemented a price decrease last November. And we will continue to look for opportunities to do just that when we believe we're adding value and not getting paid for it. Did I answer your question, Amy?

Yes, I think that sounds great. And then another follow-up question, in terms of pricing actions, because underlying demand appeared to be pretty weak. Do you see more or additional customer resistance in terms of your pricing actions over the past few months?

Our pricing tends to not change very much month to month. So we try to operate on kind of long-term arrangements or understandings with customers. And we believe we're pricing our products to capture the benefit of all the technology that we bring. So because the industry would turn down like it has in the last couple of quarters, we don't see kind of short term greater or lesser pricing pressure during those kinds of periods. What we would see is kind of differing pricing dynamics in different applications. For example, Bill mentioned in dielectrics in the commodity kind of oriented business, prices are quite competitive and pricing is cost focussed. In copper, pricing is pretty competitive but more because of entrants or attempted entry by additional competitors. And then in Tungsten, pricing is competitive, but there are fewer competitors because we have such strong technology. So the pricing dynamic is more based on the competitive arena around the particular application rather than sort of short-term industry conditions.

Okay. Sound great. Thank you.

Thanks, Amy, we'll take our next caller, please.

Your next question comes from the line of Jay Harris from Goldsmith and Harris. Please proceed.

Good morning. I've got more of a philosophical question. Since 2004, gross margins are down roughly 5 percentage points. The operating expense levels have risen from about $20 million a quarter to $28 million a quarter. Is this a sustainable process? Do you expect at some point in the future to have a stream of proprietary higher gross margin products that will rebalance to where we had been earlier in the decade? I guess that's one way of expressing the question.

It's a great question, Jay, this is Bill Noglows. We are -- let me answer you with a philosophical answer, perhaps a more strategic answer. We are clearly focused on growth in the Company and we've articulated our strategy as two prong, that's grow in the core CMP consumables business which is both slurries and our new introduction of our CMP polishing pads which as I said earlier we're optimistic about, and then we also have a strategy to pursue growth through engineered surface finishes initiative and as you know we did two acquisitions last year which we're delighted with. Both of them are exceeding our expectations in terms of the quality of the people and the uniqueness of the technology as well as the performance of those businesses. We feel like we did those two acquisitions very successfully, and that we're anxious and hungry to do more. We have a team in place to help us identify those potential opportunities as well as the technical team in place to help us validate the applications where we think we can bring our technology to bear to create value. And we're doing all that within the financial structure you just sort of philosophically laid out in front of us. I think, the industry and the business is very different than it was in the time frame you described.

Back at the start of the decade, we were essentially the only CMP supplier when this business started and we enjoyed the -- we enjoyed that position and enjoyed the ability to generate the kind of margins and build the infrastructure that we have in place around the world today. There are clearly more competitors in the space today. And that's created the kind of dynamics that Bill discussed earlier on the gross margin side. But we continue to believe that in our core CMP slurry business that we have by far and away the leading ability to generate new and innovative advanced solutions as the technology becomes more complex and that's what we're doing, and we think complementing that with an entry into the pad space ultimately combining pad slurry solutions to bring incremental value to our customers, and then driving our ESF strategy is our path to growth for Cabot Microelectronics.

Well, but the -- the acquisition, the expansion into Japan and in Taiwan, I guess, are the major factors in your operating expense increases on a year-over-year basis. When do you think you'll start to get a payback on these higher operating expenses?

Well, the acquisitions both came with revenue to support the cost of the acquisitions. They're both driving revenue. The laboratories in Taiwan and Singapore and Japan let me just walk through them. The laboratory in Singapore is there to support largely our data storage business and the people there and the business that's there and the manufacturing facility that's there used to be here in Aurora, Illinois and we picked it up and moved it and eliminated the costs here in Aurora. So there's a case where we think net-net we have the same cost associated with that revenue that comes from the data storage segment.

The investments in Hsinchu and Geino, Japan are incremental to our R&D capabilities but we think they're necessary. These customers are moving very quickly and we need to be there side by side with them to move just as quickly. I think what's happened is what's evolving to Cabot Microelectronics is the laboratories and scientists in Aurora are now responsible and engaged in developing platform technologies and next generation enabling technologies that are then pushed out into the regions where our people in the regions are then chartered with tailoring, customizing, and modifying those solutions to meet the specific needs of our customers. That's the model that we're pursuing. And we would hope that along the way that we do what we've tried to do all along is to maintain our operating costs. I think our current guidance is between 27 and $30 million and we will hold to that and we will run the business as efficiently as we can.

All right. But in the meantime we've had a significant reduction over a three-year period in reported earnings per share reflecting the dynamics that were in my question.

There's one other issue at work, that was the $0.28 of share-based compensation that our business was burdened with in 2006.

So there's about $0.07 a share a quarter in these numbers that were not in the '04 numbers?

That's correct.

Okay. Thank you.

But admittedly, there has been more competitive activity and that's put pressure on margins but we're trying to work to reverse that.

All right.

Thank you, Jay, we'll take our next question, please.

Your next question comes from the line of Colin McArdle with Needham & Company. Please proceed.

Good and thanks for taking my questions.

Good morning, Colin.

Recently we've heard from several companies when they report, forecast that wafer stats could grow mid to high single digits for calendar year '07. I wondered if you would anticipate your revenue growing at the same rate as wafer starts, faster than or slower?

Well, we're driven by wafer starts, as you know, and we would clearly anticipate if the wafer starts pick up in the second half of the calendar year our revenues would pick up as they always have. So we're hopeful that some of these -- some of the indication we're seeing from some of our customers will clearly spill over on to Cabot Microelectronics. I think we're really, we're cautious based on what we can see and what we know. And we've seen this before where we see a big pickup in one month and then the next month it falls off again. So we're just being a little more cautious than maybe some others in the industry based on what we can see. Now, I'm not saying -- they may see more than we see but based on what we can see, we're being a little more cautious than maybe some others, Colin.

Okay. And if we were to look at let's say a peak and trough gross margin level over the last two or three-year period, would you be able to provide what capacity utilization rates would drive either end of the spectrum?

It's difficult to -- our business is influenced by capacity utilization but it's, I think, harder to measure than maybe in some other industries, such as large chemical operations. I've got experience in other industries where, for example, if you didn't have an 88% capacity utilization, you didn't make money. Our situation's not that. In fact, we try to maintain excess manufacturing capacity on purpose because such volatile swings in demand by customers have to be met. You can't not meet the needs of the customers. So that means having some flexibility in your capacity. Some surplus capacity at all times in order to respond to upturns. I don't think I could correlate gross margin to capacity utilization because it's not a figure, a metric that we track internally ourselves very closely.

Okay. And lastly, I know in fiscal year 2006 you introduced nine new products, I believe. And I was wondering if either you'd be willing to share what percentage of revenue they were derived in this quarter or whether you could project what this year they may contribute to revenue? Some type of metric.

It was 10, Colin. Just to get the numbers right. And we don't -- we track that number internally as a vitality index but we have not shared it or communicated it with the outside world.

Okay.

They tend not to -- it wouldn't be a large number because of the time it takes to develop new products, commercialize them, and then for customers to ramp. It's typically not like turning on a switch where we would go from a low volume to very high volume in a matter of a few months or quarters. It tends to take a longer period of time. But what we are gratified by is the new product introductions, 8 in 2005, 10 in 2006 and we're anticipating a similar number in 2007. And our expectation is, as we get more of these new products out they'll be adopted and the revenue will follow. But we don't have anything to share specifically on the vitality index right now.

Okay, thanks.

Thanks, Colin. We'll take our next caller, please.

Your next question comes from the line of Tim Summers with Stanford Financial Group, please proceed.

Hi, thanks for taking my question. Could you give us an idea of what your revenue split is between memory, foundry and logic?

Excuse me. I don't have numbers at my fingertips. We have characterized in the past that we have a very strong position among the foundries, that's a good thing because they tend to grow historically, they've grown sort of twice the rate of the industry. But they also tend to be more volatile. I think you see some of that volatility in our revenue. I'd say we have a very strong position in foundry. On the logic, the basis of our business in technology has been around advanced logic and mature logic so I think we have a strong position there. We're probably less strong in the memory area. That's kind of a newer area for us to focus on. So I'd guess I'd put the order of strongest in the foundry, strong in logic, and then not quite as strong in the memory. But I can't really quantify it better than that.

Okay. Sort of along those same lines, could you give us sort of at least qualitatively the dollar amount of slurry usage per square inch of memory devices versus just sort of a standard logic device? One way or the other?

Well, logic device is going to be more CMP-intensive, there are more wiring layers, more polish steps. On the memory side, there are more units but they tend to be smaller in terms of surface area and they have fewer polish steps but offhand, I can't give you a metric, just here right on the call.

I guess my point is, if you saw the foundry plus logic business begin to ramp going into the second quarter and through the second half of the year, your revenue might actually be some leverage of that rate of ramp?

Right, well based on -- right. Based on what the rank ordering I gave you of foundry, logic, memory, that's right, if the foundries and logic took off faster or more aggressively than memory, we would have some leverage to that.

Thanks, Bill.

Thank you.

Thanks, Tim. We'll take our next question, please.

Your next question comes from the line of Stephen O'Rourke from Deutsche Bank. Please proceed.

Thank you, good morning. Were the yield issues associated with new products?

I don't know if Bill and I have that breakdown in front of us. No. But I think they're not necessarily new products.

You followed us a long time, Steve, you know that periodically we'll have a blip up or down in yield in our operations. What's happened is with advancing technology, our customers' processes are so sensitive to any kind of minor change and any area of the process, and so periodically we've seen situations where we'll have yield issues for a quarter that we haven't seen before, and then they're solved and they go away. But I don't think it's anymore with new products versus established products.

Okay.

Part of ours process, Steve, is we continually try to improve the products. We've talked a lot about Six Sigma, I won't do that here, but part that process involves continually tightening our specifications as we improve the products. From time to time we get maybe a little overly aggressive with our own specifications, that can cause some of these problems but I don't think we have the specific answer to this one.

Okay. Did this margin quarter unfold as you expected or did the results kind of come as a surprise as you went through the quarter?

I think we ended the December quarter nervous and cautious and it just continued on. As we would have expected, it's probably not -- doesn't describe how we think about the quarter. We watch it very carefully and we're paying very close attention to what the foundries we are reporting on a monthly basis. And it unfolded the way it did.

Okay. And just one last question, data storage and ESF revenues, how do they compare to historic gross margins? I mean, are they above or below the average typically?

We haven't disclosed that. Our expectation, ESF, it's a new business for us, but our expectation would be that we would get into businesses where the technology that we bring and the surface performance would provide attractive margins so our expectation would be that would be an attractive margin business. Data storage has been a small business for us, but we've enjoyed that. That's a great complement to the CMP business for semiconductor applications. So it looks -- it's sort of what we're trying to accomplish with ESF and on a relatively small incremental efforts we've built a nice business there. So both of those are attractive in terms of margin, I think.

Thank you.

Thank you.

Thanks, Stephen, we'll take one more question.

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

I always seem to close these proceedings every quarter. Good morning, everybody. A couple of questions. First of all I'd like to understand a little bit better what's going on in the gross margin. The drop there, I'm just having a difficult time explaining it, if you look at your historical levels of revenue, even if you exclude the 3 to $4 million from QED, the revenue growth that you posted in this quarter was not that dissimilar from what you did in 2005 when margins never dropped below 46%. And I understand that the pad business had a little bit to do with it which brings me to the next question because you've said even earlier on this call that you were expensing pads and pad plans all along. So why is there a step-up this quarter? And then finally, on the yield issue, is it resolved or is it dragging on into the next quarter?

Okay. It's Bill, let me start with the gross margin. And let me compare the Q2 gross margin at 43.9% with the same quarter last year at 46.8%. And so you could look at our revenue this quarter at $77 million which was $10 million higher than our revenue in the quarter a year ago, and yet our margin was lower. And so your question is why is that. And I went through an explanation in response to Suresh's question about trying to differentiate between cost of goods sold and cost of the goods produced. If you go back to the second quarter a year ago, where we had $67 million in sales, a low level of revenue, but a relatively high gross margin, we were producing in an environment there where there's very, very strong industry demand. So capacity utilization was quite high and our unit costs were quite low.

Compare that to this quarter where we had $10 million more in revenue, but we're manufacturing in an environment of a soft industry demand. And so we're spreading costs over fewer gallons produced, they are higher unit costs and so that had a pretty adverse impact on gross margin. And if I look at year-over-year, there's several percentage points of capacity utilization effect between this quarter and the year-ago quarter. So it has to do with the environment in which we're producing what we sell as well as the level of sales.

Has your ratio of fixed costs to variable costs changed materially from the, I don't know what it was several years ago when you talked about 75% variable, 25% fixed, and have you added some costs to your -- have you added some fixed costs where this type of consideration now becomes that visible on a gross profit line?

Yes, I think we have added some fixed costs. But I wouldn't say the cost structure has changed materially. We have -- we've talked for the last couple of years about our Six Sigma effort and we have beefed up our engineering ranks within our manufacturing area to pursue these kind of -- the productivity goals and we've gained that in terms of lower variable cost. But I think we have added some fixed manufacturing costs. I don't think it's materially changed the split of fixed versus variable costs but I think there is something there.

Okay. All right. Can you talk about the yield issue, whether or not it's been resolved and also just clarify for us what the extra pad expense was this quarter that wasn't there in the previous two, three-quarters when you were talking carrying the pad expense in your gross margin?

The yield issue, I don't want to mischaracterize, there isn't really a yield issue. Periodically you've seen fluctuations in our manufacturing yield. And this quarter we had a lower yield than the prior quarter but it wasn't dramatically lower. So there wasn't really any real issue, it's just kind of ongoing volatility and fluctuation you've seen in this business in the past.

Fair enough.

In terms of changes in pad costs from quarter-to-quarter, the depreciation of the new facilities would be incremental, but that's relatively modest. I don't think there was a big change quarter-to-quarter in the gross margin drag based on our pad efforts.

You're talking about a 1.5% impact so that's a pretty big drag.

Well, but it was a similar drag in the preceding quarter. Incrementally it's not much larger a drag in Q2 versus Q1.

Okay. So it wasn't 1.5% of the 4.2% delta between the March quarter and December quarter?

Sorry, I'm confusing two things. When I talked about 4.2%, that was a difference from quarter to quarter. And then separately, I'm saying in terms of absolute value, the 43.9% was reduced by about 1.5% due to cost of the pad business.

Got you. Okay, that's fine. Staying with the pads, I know you don't like talking about revenues until they become material. Let me ask the question a different way as I'm trying to kind of nail it down the time frame for this business turning profitable. You talk about having four customers currently that are receiving commercial orders. In that context, how far away are you from breakeven? Do you need 5 customers, 10 customers? Assuming they're on average of the size of the 4 that you have now.

Well, we have the capacity to manufacture and sell about 10,000 pads per month.

Right.

And that's a lot of customers. So I think -- I really can't quantify the number, I think we're going to need one or two big customers to get there, Dmitry.

Dmitry, if I take my adverse effect of pads, 1.5% times our $77 million of revenue, that's about $1.2 million of negative gross profit, extra costs that we would have to recover, it would be a contribution margin that would more than offset that drag per quarter.

So one or two large customers but of the customers that you have right now, four or five?

Four.

Four. All right fair enough. Can you give us an idea, if there was anything behind the sequential decline in QED revenues other than some cyclicality or lumpiness of this business that's typical in equipment business?

When we made the acquisition we made, I think we made it pretty clear that the sales patterns of QED are -- I think we used the word lumpy, Dmitry. We're seeing some of that lumpiness. In the last three-quarters that business is on a rate of, or has already recorded $13.5 million and prior to that they were on kind of a run rate of about $12 million, an annual run rate of $12 million. They're already ahead of what they've always seen prior to the acquisition. They're already ahead of it, only after three-quarters. So as I said earlier, we're really happy with that acquisition and the performance.

And then I take it that the higher-priced inventory is being worked off in an orderly fashion, and we're probably within a quarter or two of having that behind us?

I think there's about $1 million remaining of that out of initially 2 million or so. So it still probably stretches over the next several quarters.

Thank you, Dmitry.

All right, thank you.

Thank you 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 in today's conference. This concludes the presentation. You may now disconnect. Good day.