CMC Materials, Inc. (CCMP) 2014 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Cabot Microelectronics' third-quarter fiscal 2014 earnings conference call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to hand the conference over to Trisha Tuntland, Manager of Investor Relations. Ma'am, you may begin.

Good morning. With me today are Bill Noglows, Chairman and CEO, and Bill Johnson, Executive Vice President and CFO.

This morning we reported results for our third-quarter of fiscal-year 2014, which ended June 30. A copy of our earnings release is available in the Investor Relations section of our website, CabotCMP.com, or by calling our Investor Relations office at 630-499-2600. A webcast of today's conference call and a 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, 2013. 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 announced solid financial results for our third fiscal quarter of 2014, including total Company revenue of $108.4 million, a gross profit margin of 47.7% of revenue, and earnings per share of $0.53, all of which are higher than the previous quarter's results. Our gross margin this quarter was lower than we expected due to certain higher costs we experienced during the quarter. Bill Johnson will provide more detail on our financial results later in the call.

Revenue from our CMP consumables products increased by approximately 9% sequentially, reflecting the seasonal strengthening of the demand environment that we have seen in recent years. Notably, we also achieved record revenue and our tungsten and advanced dielectrics slurry businesses this quarter, and nearly 40% year-over-year revenue growth in China.

Let me start this morning by providing some general comments on conditions we are seeing within the semiconductor industry. Industry reports suggest that most IC inventories are on the lean side of normal levels. This is likely due to the continued conservative management of IC device inventory in the supply chain, coupled with capacity constraints and limitations in availability of advanced node technologies.

Many customers have commented that supply for memory ICs, especially DRAM, will likely fall short of demand through the end of this calendar year and into 2015. Industry sources are forecasting demand growth for tablets and smartphones of 20% to 30% during the calendar year, with smartphone growth in China in particular at the very high end of this range. Growth of these mobile Internet devices seems to be slowing at the high end of the market, but it is still quite robust overall.

Furthermore, it appears we are now seeing a slowdown in the rate of decline of PC sales in 2014, after eight consecutive orders of contraction. Gartner reports that, after declining over 9% in 2013, the global PC market is on pace to contract only 3% in 2014.

In addition, some significant PC manufacturers have recently made public statements indicating that enterprise demand continues to improve, thus potentially enabling some growth in 2014. Gartner's growth forecast for enterprise IT spend is around 2%.

In response to these trends, it appears that fab utilization rates at our customers are generally increasing, with capacity at leading-edge technology nodes at or near full utilization. Certain industry analysts' consensus for digital IC unit growth during the third quarter is between 4% and 5%. Other reports and comments from customers generally indicate a firm outlook for demand in the September quarter.

With the continuation of positive trends in mobile connectivity and some recovery within the PC market, this would imply sustained semiconductor demand and accompanying demand for our CMP consumables products. This industry outlook was further supported during our Company's participation at Semicon West earlier this month in San Francisco.

The overall tone at the conference was generally optimistic for the longer term, driven by a number of technology inflection points such as 3D NAND, FinFET, and multi-patterning. These emerging applications have introduced technical challenges; however, we believe they represent business growth opportunities for a company like ours.

These new device architectures have driven the need for new innovations in fab materials and should drive increased demand for our CMP consumables. Despite a somewhat cautious near-term outlook, as 3D NAND and FinFET have seen a relatively slow ramp, primarily due to technical challenges, we remain confident about the important role highly engineered materials and highly formulated CMP solutions like ours are likely to play going forward.

Turning now to Company-related matters, we are pleased that our CMP polishing pads business achieved year-over-year revenue growth of approximately 4% during the quarter. This represents the second consecutive quarter of year-over-year revenue growth.

Customers continue to actively sample our D100 and D200 pad products for new business opportunities, and we believe our expanding high-quality pipeline of evaluations underway with our customers underscores our attractive pad value proposition of longer pad life and lower defectivity. Roughly 20% of our pipeline of pads business opportunities is specific to evaluations and qualifications of our D200 platform, including several technology-leading customers where we believe our tunable platform can provide particular value.

Our global business teams continue to partner with existing and new customers. And as a result of these collaborations, we won new D100 and D200 business for shallow-trench isolation and advanced node applications during the quarter.

Furthermore, our product development teams are actively working to expand our product portfolio to address market needs and our customers' evolving performance and cost of ownership requirements. We continue to believe our pads business represents a significant growth opportunity for our Company.

Turning to our IC slurry business, our tungsten and advanced dielectrics businesses achieved record revenue in the quarter and year-over-year revenue growth for the second consecutive quarter. We are also pleased with the continued growth we are experiencing with our slurry products for polishing aluminum, as we assist our customers with their ramp of advanced technology nodes.

Year-to-date revenue from our aluminum business is up approximately 25% year-over-year. Additionally, during the quarter, we won new business for tungsten and copper applications, including legacy and advanced node technologies. As we have discussed in the past, we are focusing our research and development activity much more heavily on innovating game-changing technology for leading-edge applications with technology-leading customers. Our CMP solutions for polishing tungsten, advanced dielectrics, and aluminum are specific examples of our ability to innovate to meet our customers' challenging product performance requirements.

Concluding my remarks this morning, we continue to navigate this challenging growth environment while helping to enable our customers transition to more advanced technology nodes. Technology node transitions are becoming more challenging, with the ongoing introduction of new materials to be polished and evolving device architectures.

As a key technology enabler, we believe our broad and deep technical capabilities as well as our global supply chain management and advanced quality systems differentiate us from our competitors and position us well to continue to successfully partner with our customers to consistently deliver high-performing and high-quality products and services. With that, I will turn the call over to Bill.

Thanks, Bill, and good morning, everyone. Revenue for the third quarter of fiscal 2014 was $108.4 million. We generated 2.5% revenue growth from our CMP consumables products for semiconductor applications over the prior year. However, lower revenue from our QED Technologies business, which is capital equipment oriented, primarily drove the overall 1.5% year-over-year decline in total revenue.

As Bill mentioned, revenue from our CMP consumables products increased by approximately 9% sequentially, which is higher than the 7% increase we had been seeing for the first several weeks of April that we mentioned when we reported results for our second fiscal quarter. Year-to-date, revenue of $308.3 million represents a decrease of 2.7% from the prior year, reflecting lower revenue from QED Technologies and also including a $2.7 million adverse impact associated with foreign exchange rate changes, primarily the weaker Japanese yen versus the US dollar.

Drilling down to revenue by business area, tungsten slurries contributed 38.9% of total quarterly revenue, with revenue up 9.1% from the same quarter a year ago. Our tungsten business achieved record revenue during the quarter, reflecting strong demand from the memory and foundry segments and year-over-year revenue growth for the second consecutive quarter.

Dielectric slurries provided 27.4% of our revenue this quarter, with sales down 3% compared to the last year. Within dielectrics, revenue from our advanced dielectrics business represents a record level this quarter and a second consecutive quarter of year-over-year revenue growth.

Sales of slurries for polishing metals other than tungsten, including copper, aluminum, and barrier, represented 18.1% of our total revenue and decreased 2.3% from the same quarter last year. Revenue from our aluminum business reflects an increase of 3.5% from the same quarter last year.

Sales of our polishing pads represented 8.1% of our total revenue for the quarter and reflect an increase of 3.7% from the same quarter last year. Revenue from our pads business increased year-over-year for the second consecutive quarter.

Data storage products represented 3.9% of our quarterly revenue, down 19.8% from the same quarter last year.

Finally, revenue from our engineered service finishes business, which includes QED, generated 3.6% of our total sales and was down 44% from the same quarter last year. Volatility in our QED revenue is common, given that is primarily a capital equipment oriented business.

Our gross profit this quarter represented 47.7% of revenue. This is down from 49.7% in the same quarter a year ago and was lower than we expected.

Compared to the year-ago quarter, gross profit percentage decrease primarily due to higher variable manufacturing costs, including higher raw material costs and higher logistics costs. In particular, during the quarter we experienced lower slurry manufacturing yields.

In addition, this quarter we sold some inventory that was produced last quarter in a lower production environment, and so it carried higher unit costs. We have seen this transitory cost impact in the past.

Year-to-date, gross profit represented 47.3% of revenue, which includes a 70 basis point adverse impact of the asset impairment charge we recorded during the second fiscal quarter related to certain manufacturing assets. We expect gross profit for the full fiscal year to be around the lower end of our guidance range of 48% to 50% of revenue.

Now I will turn to operating expenses, which include research, development, and technical; selling and marketing; and general and administrative costs. Operating expenses this quarter of $33.2 million were 2.6% higher than in the third quarter of fiscal 2013. The increase was merely due to higher travel costs and professional fees associated with amending our existing credit agreement, which we completed this quarter.

Year-to-date, total operating expenses were $97.2 million, which is 3% lower than the same period last year. We continue to expect operating expenses for the full fiscal year to be between $127 million and $131 million.

Diluted earnings per share were $0.53 this quarter, compared to $0.65 recorded in the third quarter of fiscal 2013, which included a $0.05 benefit associated with our permanent reinvestment election in Japan. Year-to-date, diluted earnings per share were $1.39, which includes a $0.06 adverse impact of the asset impairment charge compared to $1.46 last year.

Our year-to-date effective income tax rate was 25.9%. We continue to benefit from increased pretax profits in certain foreign jurisdictions. We now expect our effective tax rate for full fiscal year 2014 to be within the range of 26% to 28%, which is lower than our previous estimate of 27% to 29%.

Turning now to cash and balance sheet related items, capital investments for the quarter were $2.9 million, bringing our year-to-date capital spending to $10.2 million. For full fiscal year 2014, we continue to expect capital spending to be approximately $15 million.

Depreciation and amortization expense for the quarter was $5 million. In addition, we purchased $18.6 million of our stock during the quarter under our share repurchase program, compared to $10 million in the same quarter last year. As of the end of the quarter, there was approximately $131 million of authorization remaining in our share repurchase program.

In late June, we amended our existing credit agreement. The amendment improved certain pricing and covenant terms, brings the total term loan commitment back to its original amount, and extends the maturity date to 2019. We ended the quarter with a cash balance of $265.5 million and have $175 million of debt outstanding.

I'll conclude my remarks with a few comments on recent sales and order patterns. During the third fiscal quarter, we saw an increase in revenue for our CMP consumables products of approximately 9% compared to the prior quarter.

As we observe orders for our CMP consumables products received to date in July, that we expect to ship by the end of the month, we see July results trending roughly in line with the average rate in our third fiscal quarter. 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.

Now I will turn the call back to the operator as we prepare to take your questions.

(Operator Instructions) Dmitry Silversteyn, Longbow Research.

Good morning, guys. I just want to get a little bit more clarification on what demand in your revenues and that demand environment were like in this quarter, and what does it say about the balance of the year. Outside of tungsten and some areas in other businesses, most of your slurry sales were down year-over-year. You keep talking about innovation and new (technical difficulty) more sophisticated products needed, but we are not seeing it in your results.

So how would you characterize where we are in the cycle right now? Is there a semiconductor cycle? Are we in the early stages of it? Is it as good as it gets? Can you talk a little bit about the expectations as you see your end-market evolving?

Well, in terms of an industry cycle, we have talked recently about the semiconductor industry becoming less cyclical and more seasonal. As you have the top five semiconductor manufacturers in the world representing -- I am speaking from memory -- 65% of capital spending of the industry, the industry capital investment has become much more rational. So we think we are going to see less cyclicality in the industry than we have in the past and more seasonality.

And so consistent with that, this is the third year in a row where we have had soft demand environment in the first half of the year and then stronger in the second half of the year. We saw that in the third fiscal quarter, and then we would expect continued strength in the second -- the fourth fiscal quarter.

Dmitry, coming to the second part of your question, I am not sure I'd agree with your statement. I mean, we saw record sales in our advanced dielectricals, record sales in our aluminum product line. We saw growth in our pads business; and our tungsten and advanced tungsten has grown as well.

So we feel like we are doing pretty well at the leading-edge technologies, the advanced node technologies, and growing fairly rapidly in the areas we focused on.

Dmitry, are you still there?

Yes, I am still here. I guess I am looking at how you guys report the results. Your results were down 3% in dielectric; it was down to 2% or 3% in copper and other metals; it was down 20% in data storage. So I understand the cyclicality versus seasonality, but I am just trying to understand.

Are we looking at a flat market, basically, and flat business that is just going to vary seasonally with back-to-school and Christmas demand? Is that the environment that we are in?

Let me address dielectrics specifically, and then I will ask Bill to address data storage after that. And then we can talk about the -- we will try to answer your question about the overall market following that, Dmitry.

We think of the dielectrics market really in three different ways. We think about our legacy dielectrics business, which is the oldest and perhaps the most commoditized of the dielectric applications.

We think of advanced technology and advanced node dielectrics in our dielectrics business. And then we think of advanced dielectrics.

We have put our focus over the last several years on advanced dielectrics as well as what I would call advanced technology in our dielectric nodes. And we have been managing the legacy business for profitability, not necessarily for growth.

When I talk legacy, I tend to mean 8-inch wafers. And older, less-demanding, lower-performing technologies are used on 8-inch wafers.

There's puts and takes in that part of the business, Dmitry. There's times when we walk away from business because we don't like the profitability of it; and this is one of those times when we have walked away from a little piece of business because, as I said earlier, we are managing profitability.

And we are also -- we're focused at leading-edge technologies. For instance, the area of advanced dielectrics is an area where we see a lot of opportunity to extend our reach and grow our margins.

We are in the process of introducing a new family of products that we think and believe is going to offer our customers much higher performance at much lower cost. And we just think that is a better way to run our business: continue to stay on the leading average, continue to introduce innovating new products.

So the dielectrics, we feel comfortable about the dielectrics position and how we are managing that business, and we are excited about our new introduction. Bill, you talk about data storage.

Yes, data storage is an area where we went -- we were down about 20% year-over-year. And that is an area where we have talked about in the past that there is quite a bit of volatility in that business. Because, unlike the semiconductor industry, design changes happen pretty frequently and not as difficult for customers to change their CMP solutions, so there tend to be more trading around of CMP positions than in the IC applications.

So this current quarter reflects a loss of a business position in that area, which we are actively working on to regain. So that explains data storage, which again is not IC CMP. Within the IC CMP business, we have seen some growth year-over-year.

There is another aspect of the business that we have talked about in the past, and we are seeing it now in some of our business, and that is efficiency gains by customers. So when a customer introduces a new process and as they ramp that and gain confidence and stability in it, then they look for efficiency opportunities.

We have seen that in our pads, where we have talked about a customer or customers extending pad life beyond original expectations, which has an adverse impact on the number of pads we sell, but maintains loyalty with the customer. We have also seen that in some relatively leading-edge slurry applications where, as the customer gains stability in a relatively new process, they are able to either turn down flow rates or dilute and that sort of thing. And we are seeing a bit of that in some of our more advanced products also.

Okay. All right, well, I appreciate the granularity. I guess let me ask the question maybe a little bit differently, in how you perceive your industry or your end-markets or your customers have grown in the June quarter, versus the rate of growth. And I am assuming your average selling pricing hasn't changed that much.

So let's say, ex-FX revenue growth, do you feel like you are keeping up with the market, or leading the market, or trailing the way the industry is growing?

Well, I think we think and believe we are keeping up with the market instead of -- with the exception of those areas we have already talked about, aluminum and advanced dielectrics and tungsten, we think we have had some disproportionate positive growth in those areas relative to the rest of the market. But we don't believe we have lost any share, and we think we have gained positions in those three areas that I mentioned.

All right, thank you.

Jason Ursaner, CJS Securities.

Morning. Just a couple questions on the slurry business. First, if you could just repeat the percent of total for tungsten and dielectric, I just didn't hear the exact number there.

Tungsten is 38.9% and dielectrics was 27.4%.

Okay. Then just to follow up a bit on the discussion we were just having, for the slurries, with some of them at record levels, the last time the industry was at these levels in mid-2012 for you, it wasn't really able to sustain the overall industry utilization levels. So just what is driving confidence in production growth from this point?

You had mentioned mobile growth. You mentioned a comeback in PCs. Just where do you see the market continuing to gather strength from?

Well, we only -- we look at the same thing (technical difficulty) and some of the industry experts, that that is what they do. They are talking some continued robust cellphone and mobile device growth, on the order of 20% to 30%. I think we have been living with almost 3 years of the decline of PC and the impact that has had on the semiconductor demand.

Which we believe, and what we read and hear is that that rate of decline is slowing and may bottom in this calendar year; maybe not. I think I said in my prepared comments, Gartner is talking decline of 3% or something like that.

But I think as we talk to our customers, I think there is a fair bit of optimism about the remainder of this year and next year in terms of demand. The leading-edge technologies, 28- and 20-nanometer, those plants are running almost at capacity. Or they are ramping to capacity, is probably a better way -- the real leading-edge technology.

So we think and we hear and we read that people are relatively optimistic about the remainder of the year. And that growth is driven by -- continue to be driven by mobile Internet devices and connectivity.

Okay. The consolidated gross margin, hitting the low end of the range is implying closer to 50% for the fourth quarter. So with July orders for the slurries business trending in line so far, just what do you see driving that sequential increase?

Is it just a little bit of volume leverage later in the quarter? Or where do you get that growth?

Right, if you look at 9 out of the last 14 years we have had sequential revenue growth from the third quarter to the fourth quarter. And the signs from the industry would indicate some continued seasonal strength. We haven't seen it through -- we are tracking through 3 weeks of orders in July, but then there is quite a bit more of the quarter left when we could see some more of that ramp.

From a gross margin standpoint, gross margin was lower than we expected this time at 47.7%. And there were a couple of things we think were transitory that -- not necessarily long or recurring -- that depressed the margin in the quarter. And to the extent we didn't see a recurrence of that, we could see a bounce-back in margins.

We said we expect gross margin for the full year to be around the lower end of the range. We are -- our ability to forecast that precisely is somewhat limited just because of things like capacity utilization and product mix and things like that.

But if we saw the kind of normal seasonal increase in revenue in the second quarter absent -- sorry, the fourth quarter, absence of some of these transitory cost effects we saw in the third quarter, then we could get a margin lift in the fourth quarter. Fourth quarter.

Okay. The step-up in R&D was about $1 million sequentially. Any specific large projects in that? Did some of the qualification or wins for the pad line impact the R&D spending?

The biggest part of that was clean room materials. One of the things -- we have seen this before; there is nothing structurally that changed in R&D between second and third quarter.

But we have wafers that we use within our clean rooms, within our three clean rooms, and other R&D or laboratory supplies. We don't inventory these; we expense them as we buy them. So depending upon the order pattern and receipt of those kind of things, you can see some fluctuations in the R&D line.

And that is what you saw this time, I think. Nothing structurally changed about how we're doing our business in R&D.

Okay. And QED, obviously it has been down. I mean, I don't think it is really too unexpected, given the backlog position you had starting the year.

Can you maybe talk about where orders and backlog are for that business now? Just because it is heading into a much tougher comp for the fourth quarter when we think about sequential revenue growth.

Yes. The order book is a little bit better than when we started the year. We are expecting a little bit stronger results in the fourth quarter.

Again, as Bill talked, it is hard for us to predict the order patterns and the buying patterns of our customers for this equipment. But the book is a little healthier than it was at the start of the year. Any more color on that?

When you think about QED, there are a couple things. Dependent upon where we are selling, sometimes there are export license issues; so you could be ready to ship a machine, but until you have the export license for the local jurisdiction, then you're not able to ship and recognize the revenue.

So there are a couple wrinkles, but we do have a stronger order book. But you're right; we are comparing against, I think, what was close to record revenue last fourth quarter. And the order book is not as strong is that.

Okay. Just overall, when I look back the last year and the second half, was it just a one-shot capital equipment cycle? Are you having trouble breaking into some of the niche applications that might require more of a dedicated sales effort there? Or just how should we think about that business longer term from a growth perspective?

I think there is a cycle in this business, and we have seen it repeat itself. Last year was a good year for QED; fourth quarter was really strong. I think Bill said it was at or near record revenue for the Company.

The sales activity, we have taken a dual focus there. We provide services; we provide spare parts and replacement fluids; and then we sell the equipment. We have been building the services business, and we are optimistic that that is a good business.

And when I say services, we polish things for other people in our facility in Rochester, New York, with the equipment that we market and sell.

It is a long sale. These are very technical pieces of equipment and it's a long selling process. But we have confidence and our team in Rochester has confidence that both the equipment that we have traditionally sold as well as some of the new tools that we have developed will do well in the marketplace.

I just think we are living through a cycle now that hopefully will repeat itself and we will get back on our growth cycle. So we like that business and we think it has a future.

Okay. Just last question for me. What are you seeing in terms of acquisitions and the acquisition environment? Obviously you upsized or resized the credit agreement back to what it was. You have some net cash at this point. So just generally how do you feel about that market?

Well, we are probably going to say the same thing we've been saying for the last 5 years, is our number one priority for the cash we generate, the rich cash flows we generate, is to look for ways to profitably grow the Company. And one of those ways is an acquisition or a merger.

The scope of what we think are opportunities for our companies is relatively narrow. We tend to look at materials companies or material-oriented kind of companies that either have some capability we don't have, or we can bring some capability to them. And we haven't come up with a rich field of companies like that, that we think either we can add value to them or they can add value to us. So we have been cautious and careful.

The activity -- you guys know this -- there has been a lot of activity, M&A activity, of late. Semi cap equipment has consolidated very quickly. We have seen several, let's call them acquisitions or mergers in the materials side. There was Entegris-ATMI and there was the Merck-AZ.

So I think activity is at a, I don't know, relatively high level. But our focus, I'd just reiterate; our focus for our cash is, number one, look for ways to grow the Company in a profitable way and where we can add value or someone can add value to us.

And our second priority is to look for creative ways to return that cash to our shareholders. That is what we have been doing and how we have been managing the business.

Okay, great. Appreciate those details. Thanks.

Edwin Mok, Needham.

Great, thanks. Hi, morning. Thanks for taking my questions. First question is just talk about near term. You mentioned that July is roughly in line with the last quarter level. Is that -- have you seen a similar trend last year, where you start off the quarter in line and inventory grows? That is why you still highlighted the fact that nine out of 14 years your fiscal fourth quarter ended up growing?

Well, last quarter, if you remember, Bill talked about sales where after 4 weeks of the first month of the quarter we saw sales up 7% and we ended up 9%. So it is not unusual for us to not get it right.

I think we have some numbers here somewhere; but our fourth fiscal quarter tends to be our strongest quarter historically, and we would expect no different in the coming quarter. I think the number that Bill reported this morning was 3 weeks of visibility into a full quarter, and he always says that only offers a limited window into what we think the full quarter will be. And 3 weeks out of a quarter is not a whole lot, Edwin.

If you look at what customers are saying, TSMC was talking about 13% revenue growth September to June. I think the consensus on IC units, digital IC units is probably 4% to 5% growth sequentially from the June to September. Other customers are talking about some growth as well.

So we would expect seasonal strength. But we admit we haven't seen it yet through 3 weeks of orders.

Okay, great. That's fair. Can I ask you about competition? You mentioned that you walked away from the legacy business. Is that coming from just some of those local suppliers, because this is a lower-end opportunity there? Or is it -- are you seeing even the large competitors like Hitachi, Daewoo coming back and being more aggressive in those businesses?

I don't know if I want to quantify it that deeply, Edwin. In that business, there is really only -- and let me go back to what I said before. In what I described as the legacy dielectric, interlayer dielectric CMP business, there is really only three of us left that compete there. And we tend to use that business sort of as we manage our portfolio of products at specific customers; that is a product that is -- one of the things we offer our customers is the full slate of products for all CMP applications.

So we have been willing to accept lower margins in our portfolio at specific customers because it aids our business, our overall business. But again, it is one of those things where we would rather focus our quality support, our supply chain support, our R&D support on the leading edge and then higher-performing, higher-value solutions than these older legacy products. So there has always been puts and takes in this business, and this is just one of those times when there is a take and we are comfortable with it.

We have talked about this. The legacy business is highly price competitive, and there is a point at which you say it is not worth going after or competing. In this case there was a bit of business where we decided that.

Great. That's a good lead-in for our next question. On gross margin, it came in below what you guys were expecting. You mentioned that there was some deal issue. But can you give us more color on that? Is that just contained in the fiscal third quarter?

And as you mentioned, is there any kind of pricing pressure that is contributing to the [retail] margin?

No, our ASPs actually went up marginally in the quarter. Our ASPs have been relatively flat for a very long period of time, several years now.

Bill mentioned three specific things that affected our gross margin in the quarter. He talked about, I call them capacity variances; I am sure that is not the correct accounting term. But when we manufacture products in a quarter like last quarter, where we had low utilization rates, those products carry higher unit costs with them into the next quarter. We saw that this quarter, and we have seen that happen before.

He talked about some increased logistics expense, and then he mentioned lower yields. In any quarter, we generate a bit of off-quality, and this quarter was no different. We had a certain level of off-quality, and it is a very low level.

In the quarter we did have an opportunity to work very closely with one of our customers who was doing a node transition. What typically happens with our customers is they like to extend the existing products that we have been selling them node to node to node. And almost at every note transition we both -- both us and the customers -- learn something about the CMP application that we either couldn't discern or we didn't see at the prior node.

We had one of those situations this quarter, where we had to work very closely to reformulate one of our slurries. Not a big reformulation, but a reformulation to help them be successful with their node transition.

It is a tribute to our teams and it is a credit to our Company that that is one of the things that we are really good at. We muster our resources, and we get up, and we really show our customers the value of the Cabot Microelectronics brand, because we can bring so much power to bear to help them stay on their node trajectories and get things moving.

So we had a bit of cost associated with that this quarter. But we are happy to bear those costs, because it cements our relationship and cements our products in those advanced node technologies.

Actually that was good color. Last question, just a quick follow-up on the R&D. If I understand correctly, you mentioned that you have some wafer expenses. Is that -- do we expect that R&D to revert back to what we saw in fiscal second quarter by the fourth quarter, or is the $15.4 million the current run rate for R&D?

We think about operating expense more in total than by particular line item. But you have seen this in the past, where depending upon wafers we replenish our internal stock of test wafers that we use in our labs, and we expense those as we order them. So dependent upon the order pattern, you can see some lumpiness in wafer expense.

I don't have a specific forecast on the quarter, but I would point you to the overall guidance for operating expense of $127 million to $131 million. And there is no structural change that we would expect going into the fourth quarter versus the first three quarters.

Great. That's all I have. Thank you.

(Operator Instructions) Avinash Kant, D. A. Davidson & Company.

Good morning, Trisha, everybody else. The first question, of course, you could talk a little bit about -- you talked about the material pricing issue in the quarter leading to somewhat lower margins. Could you specify, which segment did that impact? And what exactly happened?

We talked about this a few quarters ago where we have a new supply contract with an existing supplier, and there are some transition issues associated with that. There are some higher costs, and we talked about working to mitigate some of those higher costs through product formulation or price increases to customers, things like that.

And then there is also just some other sourcing initiatives we have underway that I wouldn't want to go into a great detail, that has caused, one, a bit higher inventory and raw materials, and you can see that in our balance sheet, but also this higher raw material cost. We are continuing to work on mitigating that, but that is something that came with this new contract. And we have been in transition I think since January 1, 2013, I believe.

So the high material costs were more impactful a quarter or two ago than they are now? Or the impact has continued to be the same?

It has probably been the same, because there is nothing structurally different. But it is just, given the supply chain, the long pipeline, and it is something that we have to manage over a number of quarters. But nothing significantly different this time versus a previous quarter.

But as we look at our gross margin this quarter, it is lower than in the past. And we look at what has caused that, and we see three different items, none of which in and of themselves are great big, but each of them contributed. And the higher raw material costs was one that we called out. Not a big change from prior quarters, but it is one of the factors that caused the change this quarter.

Okay. Talking a little bit about ASP -- I think Bill already talked; and he said that your ASPs have been flat for a very long time. Could you give some color on product segment? Like do you think that the ASPs have been flat in every product segment including the pads business?

No, we have had movement in the segments. We have not talked about pricing of the individual segments, but we've certainly -- you've heard me talk about it.

We have seen the pricing on the pad side decline. But however, many of the new products we introduce tend to have higher price points than the average ASPs, if you will.

So over the years, we have been able to manage the declining price of some of our products with increasing price in some of our newer, newly introduced products. So I think that is what has resulted in our ASPs staying relatively flat over that period of time that I mentioned before.

On the slurry side, like whether it be tungsten or dielectric and all those, they had been stable individually too?

When we talk about ASPs, we talk about aggregates. And if our customers had their wish, they would see significant price reductions year on year. Given that we don't have a high fixed cost structure, we don't have significant economies, we can't deliver that through price reductions. We just -- we don't lead with that.

What you would see, though, is occasionally a price-down roadmap with a customer based on volume or a commitment, evaluations of new materials, things like that. But we don't lead with price.

We are the premium price player, and we want to maintain that. We want to price for value.

So if you look at individual products, particularly at the leading edge, we try to price those up and grab -- earn a significant margin covering the technology behind that. So when we talk about ASP trends, we're talking about an aggregate, not about individual product lines.

Okay, and then talking a little bit about the pads business, Bill, of course you know, could you give us some color in terms of how many customers are using your pads in volume production right now?

I think the number is somewhat -- a little north of 30, Avinash, that are either using D100 or D200, or both. As I said in my earlier comments, we remain excited and optimistic about our pad business.

That level of activity continues to be very high. The level of activity around our D200 technology -- this new tunable technology that we have talked about -- is high.

It has been a long road, and we admit that, but we continue to stay on it. This is going to be a marathon for us, and we are in mile 2. And we plan to finish this one and be a meaningful second supplier of pads to this industry.

So we think we have a unique technology and new emerging technologies to follow, and it looks good to us.

The pad revenue this quarter was the highest in the quarter, compared -- you have to go back to the fourth quarter of fiscal 2012 to have a higher revenue level. So during that time, we have grown pad units and also now revenue.

This is an area where we have talked in the past about efficiencies our customers are gaining. In particular, we have a value proposition that gets to our longer pad life. And we see customers that really, in a stable process, start to really push the pad life and extend it beyond the original expectations.

Now talk a little bit -- as the number of customers have gone up much more significantly than the revenue percentage has gone up, the revenue has not gone up in a commensurate fashion. Primarily because ASPs have come down? Or the other customers are not using it at the same volume as one or two maybe?

I think as Bill mentioned, our units have gone up; so that implies that our prices have gone down. So you got that one right.

In this industry, there are big customers and there are little customers. And I think we have a situation where the smaller customers, where we provide support and help, they are really aggressive about making this change because they get the cost savings associated with longer pad life, as well as the benefit of lower defects.

I think one of the things that we are happy about is we went out with a value proposition that we suggested or had data to support that you could run these pads at least twice as long or twice as many wafers than the incumbent technology. And that is as far as we were willing to rep and warrant our pads, if you will.

Our customers have found ways to push that pad life further than we expected, which, although it dampens our revenue growth, we're delighted that our customers can get additional value in the form of cost savings from our pads. And, as Bill said before, it makes them loyal to our technology and interested in our next-generation technology.

So that is the story we have seen. We continue to get wins. We'd like to see wins at some more of the really big customers, and we are working very hard on it, and we think we will get there, Avinash.

Thank you so much, Bill.

Chris Kapsch, Topeka Capital Markets.

Good morning. Hey, I wanted to follow up on this variance in the gross margin. I know you mentioned several contributors, including the sequential cost accounting issue, and raw materials, and then the slurry yields. I am just wondering if mix is also contributing there.

Because you mentioned that, for example, that tungsten was at record sales or at least up year-over-year; and traditionally we think of tungsten as being one of your higher-margin products. I am just wondering if, with QED sales being sharply down, even though it is a small piece of the overall sales number, and with the hard disk drive slurries being down, do those carry with them higher gross margins and therefore is contributing to the year-over-year variance here?

Yes, that's -- you have that pretty close to right. We have always talked about our strength in tungsten, in the market also that is a higher than Company-average gross margin product. Likewise, when QED sales are high, that's also a higher than average gross margin product.

So we had strength in the mix through the relatively high tungsten revenue, but partially offset by the QED -- lower revenue in QED. So on balance, the mix was slightly favorable; but these other factors more than overcame that favorability.

Well, then if your comments about QED being higher margin when the sales are strong, I mean, looking to the fiscal fourth quarter, that tough comp, given we are likely to be down in QED sales this fourth quarter, so some mix drag there. Will the diminished effect of some of these other issues going into the fiscal fourth quarter be enough for you to get to that, call it 50%, to get to the low end of your full-year guide on gross margin?

Well, it is full-year guidance and we have seen fluctuation quarter-to-quarter on gross margin, like we did this time. But as we look at the cost drivers, the decreased gross profit this quarter, they seem to be of transitory and episodic. So we would still point you to around the low end of the full-year guidance for the full year.

Okay, well, I mean maybe transitory and episodic for maybe the yield; but like it seems like the raw material costs might persist. And on the cost accounting, was the production -- your inventory building rate, your production rate, strong enough during this quarter to help the cost accounting, the unit cost issue going into the September quarter?

Yes, since we see seasonal strength in this second half of the year, what we would be selling now would be produced in a higher production environment, the third quarter and into the fourth quarter. So that -- the cost accounting, the way you refer to it, you wouldn't expect that to persist.

The slurry manufacturing variances, that is kind of episodic. It depends upon activity with customers in the quarter. But it was higher than it has been, and we wouldn't expect necessarily an increasing trend there.

Okay, thank you for that. Then just wanted to follow up on the comment about your customers achieving efficiency once they get a stable process up and going. I am assuming that refers mostly to leading-edge node applications like, for example, 28-, 20-nanometer nodes.

So I am just wondering. Like, to the extent that your sales mix is skewed towards obviously some of these bigger semiconductor producers who are most advanced in terms of launching those sorts of nodes, I am just wondering: How long does that process play out in terms of them gaining efficiencies at those nodes?

Does it take them -- is it more like a couple months or a couple quarters for them to get those nodes up to steady, stable production yields where you would see that, and then gain those efficiencies where you would see a dampening in your demand before a more normal demand pattern? Just wondering how acute that issue was in what most would probably view as a soft top line against -- compared to the revenues of some of your key customers.

Well, I think, I would start off by saying this drive for efficiency is not something that is new. This has been around since CMP first started. Our customers are very aggressive about finding ways to minimize their spend, and one area that they focus on is CMP and CMP consumables.

Your question specific to how long does it take them, I think it is very customer dependent and process dependent. I think it is on orders of quarters, not months, Chris. It takes a while.

They are very -- the fabs and the men and women we work with, the fabs tend to be very cautious and very risk-averse, so they sort of step into these things. If a flow rate of 300 milliliters per minute works, how about 280 milliliters per minute? That kind of stuff. They just back it down little by little by little until they feel like they can't go any further, and that takes quarters.

But like I say, this is nothing new. This is something that has been part of our business since we started, and it is going to be around forever.

I think what we are seeing is on the formulation side. We are selling concentrates now, and we work really hard to try to understand how far you can dilute those concentrates, and then we try to price accordingly and capture the value of the performance we bring in the form of those concentrates. So on our side, we are trying to manage that efficiency best we can.

But it is in our interest to help our customers run their process as efficiently as they can as well. So no, that is part of something we do at the same time.

Okay. Thank you for the color on that. Appreciate it.

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