CMC Materials, Inc. (CCMP) 2013 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to your Cabot Microelectronics fourth quarter and full fiscal year 2013 earnings conference call hosted by Trisha Tuntland, Manager, Investor Relations. My name is [Bupendra]. I'll be your event manager today. (Operator Instructions). Now I would like to hand the conference over to Trisha. Please go ahead.

Good morning. With me today are Bill Noglows, Chairman and CEO and Bill Johnson, Executive Vice President and CFO. This morning reporting results for our fourth quarter and full fiscal year 2013, which ended September 30th. A copy of our earnings release is available on the Investor Relations section of our website, www.cabotcmp.com or by calling our officers at 1-630-499-2600.

A web cast of today's conference call and the script of this morning's formal comments will also be available on our website. 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-K for the fiscal year ended September 30, 2012. We assume no obligation to update any of this forward-looking information. I will now turn the call over to Bill Noglows.

Thanks, Trisha. Good morning, everyone, and thanks for joining us. This morning we announce strong financial results for our fourth quarter and full fiscal year 2013. During the quarter, we achieve record revenue of $116.3 million. Our gross profit margin of 50.9% of revenue and diluted earnings per share of $0.70,an increase of 43% compared to the same quarter last year.

For full fiscal 2013 we reported revenue of $433.1 million,reflecting stronger demand for our products in the second half of the fiscal year after soft industry demand during the first half. Gross profit margin of 49%, which is the highest annual level since fiscal 2010 and earnings per share of $2.16, approximately 23% higher than last year.

Bill Johnson will provide more detail on our financial results later in the call. Let me start this morning by recapping certain industry trends which we believe began to impact our CMP consumables business during fiscal 2012 continuing through fiscal 2013, and may continue into fiscal 2014.

As the industry continues to consolidate fewer and larger semiconductor companies are accounting for a greater portion of the capital spending in the industry. We think that more capital spent by fewer companies has resulted in more [irrational] capacity expansion, and this has reduced the cyclicality of the industry when compared to historic trends.

At the same time, the semiconductor industry is now being driven more by consumer products such as smart phones and tablets versus demand for personal computers and enterprise IT spending. Consumers are now driving industry demand trends and this has introduced more seasonal shifts in demand around the back to school and holiday seasons.

Finally the industry's multi year trend of declining PC demand, being slightly more than offset by greater growth in mobile devices, has resulted in relatively soft overall semiconductor industry growth. The overall effect of all these trends has resulted in a slower growth rate for the semiconductor industry as a whole, whichis less cyclical than in the past with greater seasonal swings in demand.

For calendar year 2013 world semiconductor trade statistics estimate semiconductor industry revenue growth at approximately 2% and predicts 5% growth in calendar year 2014. We have seen the impact of these trends in our CMP consumables business, which has generally tracked overall semiconductor industry growth in the past.

Turning now to Company-related matters, during fiscal 2013 we continue to execute our strategies related to technology, customer collaboration and supply chain management. I would like to highlight some of our key accomplishments during the fiscal year. Let me start by talking about a heightened focus in our company from a technology standpoint. Historically we have developed new CMP consumables products on a relatively broad basis in pursuit of fulfilling our mission for being the CMP solutions provider to the overall industry.

However, in light of slowing industry growth and continued and increasing consolidation of our customer base, we are now focusing our research and development activity much more heavily on innovating game-changing technology for leading edge applications for technology-leading customers. In the recent past we have spent approximately 14% of our revenue on research and development activities.

We believe that by focusing on advanced technologies with technology-leading companies we can drive greater innovation and create more compelling new CMP solutions for our customers that will assure our continued success as technology continues to advance. The recent growth and revenues from our CMP solutions for polishing aluminum and advanced dielectrics are specific examples of our ability to innovate to meet our customers' challenging product performance requirements for leading edge applications.

Additionally, throughout the year, we continue to further develop our pad business. This year our first generation D100 and second generation D200 pad products were adopted for a number of applications, including advanced node technologies. However, we were disappointed that we were not able to grow our pad revenue in fiscal 2013 from the record revenue level of fiscal 2012 due to the slow pace of new business wins, continued competitive pricing pressure as well as customer efficiency gains in their use of our pad technology.

In fiscal 2013 we sold more pads than during the previous fiscal year, however, due to competitive pricing pressure our revenue did not increase. In addition, as we discussed last quarter, some of our pad customers appear to be extending the life of our D100 pads. While this increased efficiency had an adverse effect on our pad revenue, we believe it builds loyalty in these customers and reinforces our value proposition of longer pad life, which can drive further adoption of our technology.

We continue to view our pad business as an attractive growth opportunity and look to re-establish revenue growth in fiscal 2014. From a customer standpoint we believe the supplier excellent rewards we earned during the fiscal year exemplify our ongoing commitment to collaborating with our customers and consistently delivering innovative, high performing and high quality products and services.

During a second fiscal quarter, we were honored to have earned Intel's most prestigious award for suppliers, the Supplier Continuous Quality Improvement, or SCQI award, and Texas Instrument's Supplier Excellence Award. More recently we were delighted to have received Microchip Technologies' Outstanding Supplier Performance Award. These awards recognize our product quality and reliability and our service to our customers and we are honored to be recognized as an elite supplier within our customers' broader supply chains.

Furthermore our global business teams are focused on a range of formal and informal projects with our customers to address specific business opportunities with them for advanced technologies. Our pipeline of these opportunities remains healthy and we continue to partner with our customers around the world on product evaluations and qualifications.

Finally, from an operation standpoint, we continue to improve our productivity this year, which had a significant positive impact on our strong gross margin performance in fiscal 2013. Our emphasis on and expertise in quality systems and supply chain management has become increasingly critical as our customers' requirements for product quality and consistency continue to increase and product specifications for leading edge applications continue to tighten.

Continuous improvement in variation reduction in all aspects of our supply chain are the pillars of our global operation strategy. We believe our capabilities in supply chain management and quality systems are unmatched in the CMP industry and represented a competitive advantage for us as technology advances.

In addition this year we made significant progress in qualifying products from our research, development and manufacturing facility located in South Korea, which we opened in 2011. As planned, this facility has enhanced our capabilities in the region and has enabled better support for key customers. We were pleased with our ability to ramp this production for this facility in the second half of the year, which contributed to our strong profitability.

Now we provide a few comments in our outlook for the overall semiconductor industry for fiscal 2014. Certain industry analysts, and some of our strategic customers, are forecasting softness in demand in our fiscal year due to slowing of high-end smart phone growth in favor of higher growth of mid and lower end smart phones. Further, PC demand remains sluggish. Industry reports suggest that 2013 may be the bottom of the pc market with the 2014 forecast showing low single digit growth.

If this is true we would expect to see another fiscal year with softer demand conditions in the first half and stronger demand in the second half as we saw in fiscal years 2012 and 2013. To conclude my remarks today based on the sound execution of our long-term strategic initiatives and successful performance in fiscal 2013, we believe we are well positioned for continued success in 2014.

Our ability to provide innovative, high performing and high quality solutions for leading edge applications, in collaboration with our customers around the world, differentiates us from other CMP consumable suppliers. Looking ahead we remain focused on continuing to be a technology enabler and further strengthening our core CMP consumables business while delivering value to our customers and our shareholders. With that, I'll turn the call over to Bill Johnson.

Thanks, Bill. Revenue for our fourth quarter of fiscal 2013 was a record $116.3 million,which reflects continued strengthening and demand that we saw during the third fiscal quarter. Revenue is up by 5.1% from the same quarter last year and up 5.7% from the prior quarter. Total revenue for the full fiscal year was $433.1 million, whichrepresents a 1.3% increase from fiscal 2012.

Full year revenue results reflect stronger demand for our products in the second half of the fiscal year after soft industry conditions in the first half, and include a $5.9 million adverse impact associated with foreign exchange rate changes. Drilling down into revenue by business area, tungsten slurries contributed 34.2% of total quarterlyrevenue, with revenue down 2.2% from the same quarter a year ago and up 2.9% sequentially.

For the full year, tungsten slurry revenue decreased by 3.6%. As we've discussed in the past, our tungsten slurry products are used heavily in the production of DRAM chips and we believe that the decline in demand for PCs , with the associated reduction in DRAM demand, accounts for our lower tungsten revenue compared to the same quarter last year and full fiscal 2012. Dielectric slurries provided 28% of our revenue this quarter with sales up 3% from the same quarter a year ago and up 6.3% sequentially.

For the full year dielectric slurry revenue increased by 3.2%. Within dielectrics, revenue from our advanced dielectrics slurry business increased by approximately 18% for the full year and represents a record revenue level. (Inaudible) and slurries for polishing metals other than tungsten, including copper, aluminum and barrier, represented 18.3% of our total revenue and increased 23.7% from the same quarter last year and were up 5.5% sequentially.

For the full year our product revenue from slurries for polishing these metals increased by 13.7%,driven by particularly strong growth in our aluminum slurry business, revenue from which more than doubled compared to last year. We achieved record revenue levels for our aluminum slurry products for both the quarter and full fiscal year. Sales of polishing pads represented 7.5% of our total revenue forthe quarter and decreased 11.6% from the record revenue recorded in the same quarter last year and increased 2.7% sequentially.

For the full year, polishing pad revenue is down by 2.2% compared to our record revenue last year. Data storage products represented 4.2% of our quarterly revenue. This revenue is up 3.1% from the same quarter last year and down 6.5% sequentially. For the full year, revenue for data storage slurries was essentially even with the prior year.

Finally, revenue from our engineered surface finishes business, or ESF, generated 7.9% of our total quarterly sales. Our ESF revenue is up 38% from the same quarter last year,up 32.6% sequentially and down 3.5% for the full year. The largest part of our ESF business is QED and our QED business achieved record revenue for the quarter. Recall that most of our QED business is capital equipment related so revenue can fluctuate significantly quarter to quarter.

I would point out that our QED business enters fiscal 2014 with a very limited equipment order backlog. Our gross profit was particularly strong this quarter, representing 50.9% of revenue compared to 48.6% in the same quarter last year and 49.7% last quarter. Compared to the year ago quarter gross profit percentage increased primarily due to lower fixed manufacturing costs and benefits associated with a weaker Japanese yen versus the US dollar.

The increase in gross profit percentage versus the previous quarter was primarily due to lower variable manufacturing costs despite higher costs associated with the transition to a new raw material supply contract with an existing supplier that we discussed last quarter and higher sales volume partially offset by higher fixed manufacturing costs. For the full fiscal year gross profit represented 49% of revenue, which is above our full year guidance range of 46% to 48% of revenue.

Gross profit margin increased from 47.7% of revenue in fiscal 2012 primarily due to the favorable impact of the weaker Japanese yen and lower fixed manufacturing costs. For full fiscal year 2014 we are increasing our full year guidance for gross profit margin to be between 48% and 50% of revenue. That is up by a full 2 percentage points versus our annual guidance for fiscal 2013.

Now I'll turn to operating expenses which include research, development, and technical, selling and marketing, and general and administrative costs. Operating expenses this quarter of $35.5 million were $2.2 million higher than the same quarter a year ago, and $3.1 million higher than in the previous quarter.

The year-over-year increase was primarily due to higher staffing related expenses, including incentive compensation costs related to our strong financial performance,partially offset by lower depreciation expense and clean room materials expense. The sequential increase was primarily due to higher staffing related costs, including incentive compensation costs. For the full year total operating expenses decreased 1.4% to $135.6 million and were within our guidance range for full fiscal year 2013 of $132 million to $136 million.

Looking forward we are lowering our full fiscal year 2014 guidance for operating expenses to be within the range of $131 million to $135 million. Diluted earnings per share were $0.70 this quarter, up from $0.49 in the same quarter last year and $0.65 reported in the previous quarter. Compared to the same quarter last year, earnings per share increased primarily due to the higher level of sales, higher gross profit margin and lower effective tax rate partially offset by higher operating expenses.

The increase compared to the prior quarter was mainly due to the higher revenue and higher gross profit margin, partially offset by higher operating expenses. Diluted earnings per share for the full year was $2.16, which is up by 23%, or $0.41, from the $1.75 we achieved last year primarily due to a higher gross profit margin, a lower effective tax rate, a favorable impact of the weaker Japanese yen reflected in other income, and a higher level of sales.

We expect our effective tax rate for full fiscal year 2014 to be roughly equivalent to our full fiscal 2013 rate, which was roughly 31%. Turning now to cash and balance sheet related items,capital investments for the quarter were $4.4 million bringing our full year capital spending to $14.6 million, which is below our prior guidance of approximately $18 million for the year. For full fiscal year 2014 we expect capital spending to be approximately $15 million.

Depreciation and amortization expense for the quarter was $4.9 million. In addition we purchased $10 million of our stock during the quarter, and we ended the quarter with a cash balance of $226 million, which is $24.4 million higher than in the prior quarter and $47.6 million higher than last year. And we have $161.9 million ofdebt outstanding. I'll conclude my remarks with a few comments on recent sales and order patterns.

Historically our fourth fiscal quarter is seasonally our strongest quarter of the year,frequently followed by some seasonal softening in demand in the first quarter of a new fiscal year. And we are seeing that softness now. Examining revenue patterns within the three months of our fourth fiscal quarter, we saw demand for our CMP consumables products in July increase by about 10% from the average of the three months in our June quarter.

Then revenue decreased sequentially in August and September. As we observe orders for our CMP consumables products received, to date, in October, that we expect to ship by the end of the month, we see October results trending approximately 7% lower than what we saw in the month of September, and around 10% lower than the average rate over the September quarter.

We think this is consistent with the forecast of certain industry analysts and some of our customers, as we discussed earlier, which called for some softness in demand early in our fiscal year. However, I would caution, as I always do, that several weeks of CMP related orders out of a quarter represent only a limited window on full quarter results. I'll now turn the call back to the operator as we prepare to take your questions.

Thank you. Ladies and gentlemen, your question and answer session will now begin. (Operator Instructions). Our first question is from the line of Avinash Kant from Davidson and Company. Your line is open. Please go ahead.

Good morning, Avinash.

Good morning, everyone. Thanks for taking my questions. The first one I had is related to the past business and, I think, in the prepared remarks Bill did say that the pad business, past business was kind of a bit soft but units were higher. Now going into fiscal year 2014 what should we expect? Do you think pricing pressure to continue through the rest of -- to the next fiscal year? Or you would expect this business to kind of grow based on some of the wins that you may expect going forward?

Thanks, Avinash. If I could let me answer the question maybe a little more broadly. I think we see three things that have been kind of a barrier to our growth in pads. The first is, you know, we underestimated thedifficulty of the qualification process for pads. It is much more, I think, severe and intense than a [requal] or a slurry product and I think we kind of missed that when we first entered the business.

Now we understand it better, that it takes a very long time to qualify a new pad. We're seeing some of that. The second area is the one we talked about last quarter where we believe that many of our customers that have been using our D100 pad have been slowly but surely increasing the life of those pads and running more and more wafers over them.

We began to see that last quarter, and we would expect to see that going forward. We describe that as it impacts our revenue but, at the same time, it validates our value propositionand that's important for this third point that I'm going to talk about next. And what we're seeing in the pricing environment is, you know, many of our customers, they want lower prices, they don't want lower costs.

That's a big difference there in thatthey asked for a -- simply a drop-in technology at lower prices. We don't do that. We have chosen not to do that. And we've chosen not to chase that opportunity, if you will.

I think as time goes by, and people run out of room on price they'll go back to the cost equation, and we believe that we truly offer our customers lower cost with our pad and our value proposition as well as some of the combinations we're seeing now with some of our slurries and our pads. But, you know, I think the important message here is that we haven't been willing to compromise our value proposition to win market share.

We've held on to our value proposition and not been as willing, as many of our competitors have been, to reduce price in the face of competitive activity. So I think those three things combined maybe caused the drag that we saw in 2013 on our pad business. But we remain really optimistic about 2014, both with the D100 and our next generation D200 technologies.

Say if I did the math, the revenues in the quarter came out to roughly $8.7 million? How much was the pads revenue?

I'm sorry. How much was what?

Was the pads revenue in the quarter?

Yes. That was -- you're right, $8.7 million.

Okay. Perfect. And the next question I had was about the opportunity you were saying in the aluminum and advanced dielectrics. Could you give us some idea in terms of how big it is getting to be at this point and how do you see it growing going forward?

Well, we haven't specifically carved out aluminum, Avinash. We've talked about our metals business, [net] of tungsten being up 13.7% year-on-year. Aluminum is an application that we're seeing and it's being utilized in High-K Metal Gates, and we think that'll extend through to 20 nanometer technology. And, at that point, there is some discussion that the aluminum may be replaced by tungsten. May or may not be replaced but

if it is replaced, it'll be replaced by tungsten, which, you know, for us, it's one of our sweet spots in our business. We are the clear technology leaders in tungsten CMP. So we see this as a great opportunity and it is stimulating a lot of growth in the metals business, net of tungsten.

And, and -- Final one, in terms of the tax rate in the quarter, right? So the tax rates were lower in the quarter, right? And what was that from? And then how should we model it, you know, on a quarterly basis going forward?

Yes. Through the year we had a number of things that impacted or tax rate. Most recently, in the fourth quarter, the tax rate was lower based on earnings in foreign countries where the tax rate is lower than the US tax rate. And, in particular, we had a benefit in our fourth fiscal quarter of greater profitability in our Korean subsidiary. So we built a new facility and established a new subsidiary 2010-2011. It opened in 2011.

We turned profitable in the fourth quarter and so the pre-tax income from that new subsidiary then enjoyed a tax holiday that we got in Korea. Korea tax rates are lower than US rates anyway. So that was a significant impact in our fourth fiscal quarter. So to the extent that that business continues to run we'd expect some benefit going forward not to the extent, necessarily, that we saw in the fourth quarter but that's why we've guided on tax rate to about 31% for fiscal 2014.

And if you look, historically, that's low. You have to go back to fiscal year 2008 to see a lower tax rate for us.

Right because prior to this you were talking about a 34% tax rate, right?

That's right.

Okay. Perfect. Thank you so much.

Thank you, Avinash. We'll take the next question, please.

Is from the line of Jairam Nathan from Sidoti. Please go ahead.

Hi.

Hi, Jairam.

Hi. Thanks for taking my question. I just wanted to concentrate on gross margins a bit here. Can you kind of talk about the different factors that gave you confidence of [upping] your guidance, gross margin guidance, by 200 basis points? You talk about lower available manufacturing cost. So you said better pricing, better cost efficiencies, or even currency?

Jairam, I'll take the first part of that question and then Bill will follow me with some more details [about the currency effects] and some of the other things we saw. You know, I think a lot of our gross margin strength in this quarter, in this fiscal year is the result of execution of our strategies. You know we've talked a lot about innovating new, higher-value products at the leading edge. And I think we're seeing that. I mean, we have two great examples of our aluminum business that's growing very rapidly and our advanced dielectric business that grew, I think, almost 20% year on year.

When we introduce new products we tend to introduce them at sort of a significant value proposition, which essentially means relatively high gross margins relative to the average for the overall business. So, we've been executing on the top line and, along the way, our team on the operation side continues to find ways to improve productivity, reduce variation and drive out costs. So, you know, we've been talking a lot about execution of these strategies. I think we're seeing it in the numbers.

And we've seen steady progress year in and year out on the cost side. And we're beginning to see significant inroads on that revenue side and the ability to bring value to our customers. So I gave you the high-level answer. I'll let Bill fill in with more of the details.

Yes. For the (inaudible) quarter, specifically -- last quarter we talked about anticipation of a head wind on the order of 150 basis points related to higher costs associated with the new raw materials supply contract with an existing supplier that we expected to be around on a transitional basis. And we did see that. We saw about 180 basis points head wind.

But then we had lower variable costs in a number of areas, other areas, raw material--Another raw material, we (inaudible) saw some significant savings and we had a high, record revenue in our QED business, which is high margin business. We saw increasing margins in pads. So a number of other things more than offset that adverse head wind associated with that new supply contract.

Okay, thanks. And on the OpEx? Again, you seem to have (inaudible) -- You [guys] are [guiding] down for 2014. Is that mostly coming from SGA or you think you will take out some -- something from R and D as well?

Yes. The downward guidance on operating expenses is really pretty modest, right. Just really down by about $1 million on either end of the range. That's really in light of some of the trends that Bill talked about, slower semiconductor industry growth, more seasonality. In that environment we're just going to be more attentive to operating expense. So I don't think there is any particular, one particular area where we had focused more but really just trying to hold operating expenses level.

Okay. Great, thanks. That's all I have.

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

It's from the line of Tony Grillo from--

Hi, Tony.

Needham and Company.

Hi. How are you?

Good. Good morning.

So just a couple of questions for you. You may have somewhat gotten into them a little bit already. We're seeing a lot of, obviously, softness going into Q4 and semi and you guys appear to be doing somewhat well, relatively. I was wondering if you guys could maybe talk about some upside here just for going forward into the first half of 2014, after this quarter.

Well, Tony, we're looking at what everybody else is looking at. TSMC is talking about down 10% in the fourth calendar quarter. Most of our customers are reporting a down quarter for the December quarter, as are the analysts that follow the industry. I think Bill's prepared comments this morning on what we're seeing in the current month of October indicates that we're tracking with the industry.

Okay.

We had a pretty good, a pretty good fourth quarter. We're up both year-on-year and sequentially, which we're happy about. but we're watching what we've seen over -- This will, this will be the third year of this new seasonal trend that we think is here to stay, and it's just the way the business is going to be, I think, for Cabot Micro. We'll start the year probably with -- relatively soft first two quarters and then come back strong in our third and fourth quarter.

Okay. So somewhere -- Taking what he said--

Right.

You guys are [seeing] in line with the industry. No better, no worse?

That's right.

Okay. And then, looking at margins, you guys obviously gave the guide for next year,where do you see a ceiling on margins if you look in the next three, three to four years, in that time horizon?

Well, I think a lot of it -- Again, I think we're pleased with where we are. We're able to increase our guidance for the coming year. A lot depends on the future success of some of the new products that we're currently working on with our customers and the continued success of our operations group and their ability to find opportunities to reduce cost and increase productivity. We've been pretty successful over the years and I'd anticipate continued success.

I think, at this point, all's we're going to say, or willing to say, is that we're happy to increase the guidance that we offer for the full year from the 46% to 48% to the new 48% to 50%. That's a significant increase, I think, if you look at it. And I think that it's just, it expresses our confidence in our ability to do those two things, and it's continue to innovate and continue to find ways to increase productivity.

Right. Absolutely. I guess, my question is if you were to look a couple of years down the line and sitting in that 50% range the Company would be very happy with that.

Yes. Yes. There are a number of head winds, even as we try to take advantage of the factors that Bill just talked about. At the same time, customers always want lower costs. And the easiest thing is lower price. We don't lead with that, but there's always a lot of pressure around that.

Just as we have opportunities for further productivity improvement and things like that, richer product mix and things like that, there are head winds. So the guidance is for the next fiscal year and we'll have some new guidance for you next year at this time.

Right. Of course. Well, thank you for your help, guys. I really appreciate it.

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

Is from the line of Chris Kapsch from Topeka Capital Markets. Your line is open.

Hi, Chris.

Hi. Good morning. I had sort of a follow up on the gross margin look going forward but more specifically in fiscal 2014. I appreciate the up guidance and the midpoint of that guidance would be sort of replicating the full year 2013. So I'm wondering what sort of things could happen that would result in the margin coming in at the high end of that range?

Would it be -- I know you mentioned continued focus on operational excellence and driving productivity and the manufacturing supply chain but in terms of the product mix is there things that could happen as the course of fiscal 2014 ensuesthat would drive towards the higher end of that range. For example, tungsten demand recovering or the continued growth in some of these more innovative leading edge applications, that sort of thing.

That's a great question, Chris. On the positive side if we continue to see growth in some of these new applications, for instance aluminum and advanced dielectric and some of the materials that we're currently working with customers on that are, what I would describe as sort of in development or early stage development, those always help our gross margin. The instruction of those new products.

We've had a bit of a mixed swing in the last couple of quarters as a result of the weakness in the DRAM market and the PC market. Our tungsten business has been a little sluggish. We would expect that business to come back with the return of growth in PCs and the utilization of DRAM technology.

I'm trying to discuss upsides here. On the down side -- the other upside is I expect, and I know my colleagues expect, to find opportunities to reduce costs again next year through the productivity we work and the work we do and the variation reduction work we do. It's more of a continuation of the same. Bill talked about some head winds and I think when we, when we give gross margin guidance for next year, we tend to be conservative, and I think for good reason.

There's some unknowns come at us during the year that we need to manage and address when they come. I think we feel really good. Our yields are running really high right now as a result some of our activity on the ops side and our R and D teams is pretty excited and motivated about some of the projects we're working on with some of our leading edge customers.

I think our guidance is where we think it will be. You know, if that changes through the year, of course, we'll tell people but that's -- we're feeling pretty comfortable with being right up there close to 50% gross margins, which we think is a pretty powerful number in the supply side to the semiconductor industry.

Got you. And then just following up on that. If you lookeven more granularly on the sequential basis, the impressive gross margin in the fiscal fourth quarter in spite of that -- I think you said 180 basis point head wind from the raw materials supply contract and higher fixed manufacturing costs -- Can you-- When you talked about the head wind from the raw material it sounded, though, that you would hope to offset that over time.

Not with other sort of margin enhancements but, really, through possibly looking at selective price increases, I thought. So I'm wondering is that something that you feel is not necessary given the margin performance in the quarter in spite of that head wind and given the soft end market backdrop, particularly looking near term? And can you talk to, more specifically, what was the higher fixed cost manufacturing related to?

Yes, last quarter we talked about higher costs related to this new raw material supply contract with the existing supplier that we expected to be on a transitional basis because we think we have the number of means to mitigate that higher cost. So [what] we saw the higher cost this quarter. We'll see some of it next quarter. Over time we think that we can mitigate it over the next couple of quarters or so. And it's a number of different things, approaches that we can take to achieve that.

So we'll manage that, we think. The other thing that specific with the fourth quarter, we did see a high level sales, high level production [served], capacity utilization was pretty strong and that was another benefit that I didn't mention. But yes, we expect to manage the transitional effects of that have new supply contract and manage that over the next several quarters.

Right. So the high sales and high production rate speaks to, I think, lower variable manufacturing costs but you did also mention in the press release high fixed manufacturing costs. I'm wondering was there incremental capacity added recently that I'm missing or--?

Yes. No, that -- sorry, I didn't address that part of your question. The higher fixed manufacturing costs were really mostly related to higher compensation expense around incentive compensation. We have an annual bonus plan, and given the strong performance for the year and the fourth quarter, the same thing that drove higher operating expense sequentially also had an impact on the COGS side.

Okay, good. The other question is, then, looking at the OpEx guidance and -- sort of a follow up to another question but you came in at the high end of this past year's range, you're bringing the range in a little bit. If you were at the midpoint that would suggest lower overall op expenses for the full year. I'm assuming that there is annual merit raises and so forth. Looking at that OpEx expense and figuring that R and D is a big opponent of component of it --

Against the backdrop of your comments about collaborating with the bigger leading edge customers and trying to develop innovative solutions with them, I'm just wondering what are doing with your R & D dollars to continue to pursue your strategic objectives in collaborating with those customers? Are you able to increase the R and D dollars even though overall OpEx is going to be lower or are you just concentrating the programs more on the bigger customers?

Chris, again, a great question. We are -- I think the way you finished that question is right on it. We are concentrating and focusing our activity on what we describe as the leading edge technology development customers. We've categorized our customer base andyou can guess who those are. I think the other thing is, and stepping up a bit, in this environment of slowing industry growth and consolidation we just, we just feel that it's on our -- being responsible about it, we think we need to try our best to keep our OpEx as flat as possible.

And I think that's what we're trying to indicate in our guidance. That we will do our best to keep our OpEx flat and get the leverage off any growth we get on the revenue [line]. Our intent is to not scale back our R and D activities. Our intent is to focus our R and D activities on those opportunities where we think we can bring the most value and the best solution to our customers.

So I think you hit it right on your question. It's a question of focus. It's not a question of shrinking the overall program. It's putting our best scientists on the best opportunities to create value for our customers and, ultimately, create value for us and our shareholders.

Okay. Thank you.

Thank you, Chris. We'll take our next question, please.

Thank you. (Operator Instructions). Our next question is from the line of Jay Harris from Goldsmith and Harris. Please go ahead.

Good morning, Jay.

Good morning. Given the fact that revenues are growing at, roughly, we'll say a single digit rate, what was there about your operating expense increase that was strategically important and will the operating expenses, relative to revenues, will that ratio come down during the next fiscal year?

Yes, the -- if you look at, through the year, Q1, Q2, Q3, we ran operating expense around the $32 million, $33 million per quarter. It was really, in the fourth quarter, where we saw that increase up to [$35.5 million] and,as I mentioned, that increase was largely incentive comp around the strong financial results.

So to the extent, now, we set guidance at [131] to [135], so the mid point about [133], and that implies the similar run rate that we saw in the first three quarters of the year, $33 million or so and change. So nothing real--no change in strategy in the fourth quarter. Like Bill talked about, we'll try to manage those operating expense going forward.

You know, in the past we've talked about trying to set a goal of operating expense of 30% revenue or less, and there have been a couple of years where I think we achieved that, a few quarters, but that's the goal. It's a simple goal, grow operating expense slower than revenue, but we're trying to keep it, or get it, below 30% of revenue.

If we could go over to the pad business for a moment. In the longer life that your customers are experiencing with your pads when do you think you'll start to get the benefit of that in terms of top-line growth.

Well, Jay, I hesitate to even try to answer that question. I think we continue to believe that the pad opportunity is probably the single largest incremental growth opportunity in front of us today. We have a lot of confidence in our technology. We have a lot of confidence in our value proposition.

What I said in my comments earlier is that we're disappointed in the pace and rate at which we've been able to penetrate some of our customers, and their reluctance to change a pad because of their qualification process as well as -- You know, this industry, like I said earlier, people who want -- many of our customers, they just want a lower price. They're not interested in doing the work to get a lower cost.

At some point we believe that will come to a head and they're going to have to go after the cost becauseI think many of the customers that we sell to today are enjoying the cost benefit that we provide with our longer pad life. At some point there will be competitive pressure in the channel, and we think people will turn to us for our pad. But I can't predict when that's going to happen, Jay. I think it would be amiss for me to even try.

But we're working very hard at it. Our field teams are out there every day with the customers. They have pads on tools. They're doing the work that we need to do to qualify our pads.

I presume that when a pad gets qualified in (inaudible) [fab] that a customer owns you still have to go to the other [fabs] and they, independently, do their own qualification. And on that assumption how many fabs have qualified your pads at this point and how many are in the qualification process?

Well, let me address your first question first. The assumption that if we have to requalify it every fab is very customer dependent. Some of our customers run a central purchasing technology approval process where once they accept the technology they very quickly implement it across all their fabs. Other customers have what I would describe as this intramural approach where you've got to sell pads factory by factory.

Today we have some 30 customers that are buying our pad. Which we think is significant. We continue to have trials and qualifications and discussions with -- I thin there is another 30 or 40, something like that. So the activity is still robust and, I think, rich. It's just taking a long time, Jay. So that's the answer.

Well, wait and see. Thank you.

Yes. Thanks.

Thank you, Jay. We appreciate your questions. That is all the questions that we have this morning. Thank you for your time and your interest in Cabot Microelectronics.