Coherent Corp (COHR) 2006 Q1 法說會逐字稿

Good morning. My name is Arnika and I will be your conference operator today.

At this time, I would like to welcome everyone to the II-VI, Inc. FY-2007 first quarter earnings conference call.

[Operator instructions]

Mr. Creaturo, you may begin your conference.

Thank you, Arnika. And welcome to the first quarter fiscal year 2007 II-VI, Incorporated investor teleconference.

As a reminder, this teleconference is being recorded on Tuesday, October 24, 2006. The forward-looking statements we may make during this teleconference speak as of today and we do not undertake any obligation to update these statements to reflect events or circumstances occurring after today.

Joining me today is Carl Johnson, our chairman and chief executive officer.

The prepared comments for today's teleconference include a review of the highlights and key points from a financial perspective and a business and operational review.

Following these prepared comments, we will conduct a question-and-answer session.

There are some items that I would like to highlight regarding the financial performance of II-VI during the just completed quarter.

First, as disclosed in the press release and as will be further detailed in an upcoming Form 8-K filing, we have replaced our current credit facility with a new credit facility.

As of September 30, 2006, we had a $30 million line of credit facility and a $30 million term loan. There were no borrowings under the line of credit facility, while 24.4 million was remaining on the term loan. This facility was replaced with a $60 million line of credit facility.

The interest rates on a new facility improved by 25 basis points over the old facility. In addition, there are fewer restrictions on the use of the facility for acquisitions and repurchases of the company's stock. The facility is also expandable up to a 100 million under certain conditions.

We believe that this new credit facility will support our growth plans, will provide a lower cost of debt, and give us increased flexibility.

I want to make it clear that this facility was put in place for the general reasons I mentioned above and is not in response to any forthcoming or contemplated transaction.

Second, the record level of bookings achieved during the quarter has given us good visibility as we heard further into fiscal year 2007. The 24% growth in infrared optics bookings over the prior year and a 5% growth sequentially, despite the fact the first fiscal quarter is usually a slower bookings quarter, provides further support that the deployment and utilization of infrared lasers continues to grow.

Third, our first quarter financial performance in terms of revenue and earnings per share was in line with the guidance we gave in August. The entire 12% increase in revenues represents organic growth.

Our infrared optics business segment performed well, but was slightly challenged by higher raw material costs, specifically for selenium, as higher dollar inventory purchases flowed through cost of goods sold.

That business segment also bears the largest share of corporate expense items, such as an increased level of stock option and performance share expense.

All of the business segments improved their profitability during the year as compared to the prior year.

Fourth, while the segment earnings of the compound semiconductor group improved nicely over the prior year, this business segment was negatively impacted by warranty and related provisions for one of its businesses, namely, the EV products division.

During the quarter, it was determined that there were some detector fabrication issues relating to one of EV's devices for a particular customer. Carl will address this a little more from an operational perspective. But the financial impact of this issue during the quarter was approximately $350,000.

Fifth, now that we are coming up on a 2-year anniversary of the Marlow acquisition, it is worth a look back to see how that business has performed. We acquired Marlow in December 2004, when their trailing 12-month revenues were 26 million and EBITDA was around $4 million.

Marlow has grown nicely since the acquisition and its current 12-month revenues have exceeded 35 million, while EBITDA now exceeds 7 million. Marlow has truly embraced the utilization of our II-VI Vietnam manufacturing facility and will benefit from this low cost location for many years to come.

Marlow has been a consistent contributor to II-VI's financial results since the acquisition and the transaction has been accretive every quarter so far.

Sixth, our effective tax rate at 26.7% reflects a favorable mix of foreign and domestic earnings. The tax rate for the quarter was slightly better than the 27.1 percent rate from fiscal 2006, excluding the impact of special charges.

We currently expect the effective tax rate for fiscal year 2007 to be at the rate used for the just completed quarter and we will adjust the tax rate in future quarters, as needed, as actual information replaces estimates in our effective rate calculation.

Finally, we continue to focus on growing EBITDA of the business. The EBITDA growth in the past quarter, over the same quarter in the prior year, was 7%, but if you look at the last four quarters, the growth was 19%, before the impact of the special charges.

Because of this higher level of cash generation, we have been able to repurchase shares of our own stock and pay down our debt. More specifically, during the just completed quarter, we paid down nearly $4 million in debit for a 13% reduction from the levels of June 30, 2006.

Our debt-to-EBITDA ratio in the last 15 months has decreased from .95 at the end of fiscal 2005 to .47 at September 30, 2006.

This concludes the highlights and key points from a financial perspective, and Carl will now give a business and operational review.

Carl?

Thank you, Craig. In order to get to today's questions as quickly as possible, I will limit my comments to a few operating highlights and challenges for each of our operating entities.

The first quarter highlight for our infrared optics business unit has to be new orders, which were up an overall 24% from the prior year. Year over year bookings were up 34% in North America, 28% in Asia, and 21% in Europe, where high-powered CO2 laser systems continue to replace punch presses in manufacturing plants and job shops.

Also, and importantly, our market share is growing in the China and Eastern European markets, where CO2 laser system installations are up approximately 40% year over year.

Low power CO2 laser systems continue to enable new marking and engraving applications. For example, the American Bakers Association, via trials at 25 of its member companies, has shown that CO2 lasers can reliably and efficiently mark polyethylene bread bags with time, date and expiration codes.

With our worldwide IR optics production facilities running at full tilt, our most important IR challenge is to stay on top of customer demand. We are, of course, working diligently to increase material growth and other capacities.

At our VLOC business unit, the UV filter segment continues to expand and mature. We are nearly completed with the negotiation of a long-term sales agreement covering all of the parts that we now supply to the U.S. Army Counter-MANPADS program through a defense prime contractor. As a result, there is an increasingly likely near-term potential for an approximately $4 million order in the next 45 days, followed by an up to $10 million order during the December-January time period.

Elsewhere within our VLOC near infrared optics business unit, results are being unfavorably affected by YAG segment operational issues or yield and throughput problems in our floor-to-base thin film coating activity.

At our military market focused exotic electro optics business unit, we booked nearly $3 million in heritage program orders during Q1. These are for infrared windows that go into M1 tank, Apache helicopter, and lantern targeting pod applications, all of which we have been manufacturing for a number of years.

That said, our Q1 revenues at EEO fell below target due to two separate delays caused primarily by customer-driven design and/or acceptance test changes.

First, the correction of design flaws discovered during accelerated environmental testing of arrowhead window assemblies has resulted in a 3-month schedule delay, with shipments resuming during Q2.

Second, the correction of joint strike fighter optical system design flaws will require more stringent specifications in the manufacture of sapphire instrument shroud panels and result in a 6-month program delay.

During this delay period, we anticipate receiving an estimated $1.5 million development contract to develop the fabrication processes needed to meet the higher precision JSF requirement.

Within the compound semiconductor group, a highlight for our Marlow division was the achievement of a Q1 average 28,000 per month thermoelectric cooler production rate and parallel ramp-up of revenue at the II-VI Vietnam facility.

Also, led by our Marlow and Singapore-based quality professionals, we are on track to obtain an ISO-9001 certification in Vietnam by the end of Q2. This certification will strongly enhance our position with several medical and industrial customers looking for us to assemble next level TEC containing components in Asia.

At the EV products division, a major quarter one highlight was the receipt of a multi-million dollar yearly blanket order from our largest medical imaging customer for the EV CZT sensors that enable their growing family of bone densitometry dual x-ray imaging systems.

Another highlight was the significant process and staffing of the EV design center activities at our II-VI Technologies Beijing location. Initial improvement targets for this activity are, first, to reduce component procurement costs and, second, to increase the localization of existing products to better address specific applications and customer needs in the China-Asia marketplace.

We missed our EV first quarter shipping and revenue targets due primarily to a customer product-specific CZT detector fabrication problem that surfaced during the quarter. A joint EV customer engineering fix-it team is presently focused on the understanding and resolution of the root causes. We are cautiously optimistic that product shipments to the affected customer will resume during Q2.

Two Q1 highlights were our wide band gap materials division, where, first, the receipt of our second $1 million silicon carbide substrate order for deliver to a galleon nitride-based RF power technology and device customer, the first such order having been received the previous quarter; and, second, an August 24 celebration of the grand opening at our Starkville, Mississippi substrate fabrication and polishing facility, marking a successful next step toward a full-scale manufacturing operation in Mississippi.

A current challenge facing our WDG division is that penetration into the Asian and European markets is proceeding more slowly than planned. We are, however, targeting to complete qualification with at least two key Asian customers during the next two quarters.

During mid-August, IPG Photonics, a company primarily engaged in fiber laser technology, filed a Form S-1. Having reviewed the filing, we anticipate that certain statements or claims will be made relative to some market segments that II-VI serves.

We, therefore, want to share several facts and observations that might be helpful to II-VI and laser industry investors during this period.

First, as we have witnessed during our 35 years in business, laser technology is continuously finding new applications and, specifically, displacing older, more traditional methods in the cutting, welding, marking and engraving of all sorts of materials.

Second, the CO2 laser operates at 10.6 microns in the middle infrared region of the spectrum and has been providing high quality cutting of numerous materials, including a wide variety of stainless steels for many years. There is currently in installed base of greater than 60,000 higher power industrial CO2 lasers that is increasing by about 5,000 units or 8% per year.

Third, there are currently six long established and seasoned manufacturers offering CO2 laser heads to the market at prices as low as $35,000 to $45,000 per kilowatt and more than 15 long established and seasoned laser system integrators deploying higher power CO2 lasers into a myriad of general and custom application environments.

Fourth, as you may recall, 85% to 90% of the IR optics we manufacture go as replacement parts into the servicing of the large installed base of CO2 lasers. This provides a significant measure of stability to our business.

Fifth, the world still needs a multiplicity of solutions for a wide variety of material processing problems. The fiber laser is one of several approaches for generating near infrared one micron light as an alternative and complementary wavelength to that produced by the CO2 laser.

Sixth, the older approaches to one micron light generation including flash lamp pump YAG, dilute pump YAG, and direct IO technologies, while the newer approaches included fiber, thin disk, and ceramic slab YAG lasers.

Seventh, II-VI entered the near infrared field in the mid-1990s via the acquisition of two Florida-based companies that have evolved into our VLOC near IR business unit of today. VLOC currently supplies YAG laser rods to manufacturers of medical, military and low power industrial lasers and systems.

After a considered and careful study, we have concluded that any downside fiber laser impact on our YAG rod business will likely result in a less than 1% decrease from previously projected 5-year corporate revenues.

Eighth, VLOC also manufactures and supplies one micron optics and components for end user applications. For example, this year, we will supply approximately 40,000 higher power industrial and medical debris shields per month to the one micron laser industry.

In conclusion, we believe that the increasing presence of one micron fiber, thin disk and ceramic slab YAG lasers in the marketplace and the awareness stimulated by other innovations within the laser industry as a whole will encourage price competition in the laser space, which, in our view, will lead to a whole new range of laser applications and increased market penetration for years to come.

Craig, this concludes my prepared comments.

Thank you, Carl. Before we begin the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements, which are based on current expectations. Actual results could differ materially.

For information about factors that could cause the actual results to differ materially, please refer to the risk factors section of our Form 10(k) for the fiscal year ended June 30, 2006.

Arnika, we are ready to begin to the question-and-answer session.

[Operator instructions]

Your first question comes from Pierre Maccagno, with Needham.

Hi, Carl and Craig. Could you give us the backlog for this quarter?

The backlog for this quarter, it increased by about $3.5 million, based on the record bookings that we had. It stood, in total, at about $88 million.

By segment, that breaks down the infrared optics business at about 26 million, the near infrared optics business at about 18 million, the military infrared optics business at 20 million, and the compound semiconductor group at about 24 million.

Okay. And then in terms of gross margin opportunity, your consideration of Marlow to Vietnam, is that complete now or still happening?

Pierre, this is Carl. We are still in the process of getting that done. We started by putting the actual tech cooler final steps of fabrication over there and now we've gone back into the actual production of the elements that go into the thermoelectric coolers rather than the assembly of the units.

So we're kind of starting with the end device and are working our way backwards and we're probably around 80% of getting all that in place over there and getting it up and running efficiently.

Then another opportunity we see there is because customers are responding rather well to what we're doing there and the quality has been good, when we get this ISO-9001 certification in place in the next couple of months, we believe that we will be able to forward integrate into some additional component assemblies-sub-components or subsystem and component assembly there, because our customers are looking at the very attractive cost that we can provide this service to them to forward integrate into some of their sub-assemblies.

So I would say overall we're making excellent progress, but we are not anywhere near complete with all we want to do there and, also, we still have room to increase efficiencies as we improve the training and as we complete this ISO certification.

We think we still have a ways to go and, of course, we're very excited about it.

And then any other gross margin opportunities, are you acquiring other distributors, lowering costs, anything that you could comment on?

I think we always have things that are going on. As Carl mentioned, I think a lot of the capital spending that we'll be doing going toward yield improvements, I think there's other projects that we have.

As a crystal growth oriented company, we always have opportunities to improve yields. Nothing more specific than that.

I think the only other thing to mention is that, as we've said on previous calls, that really, this year, we're making some significant investments in our thin film coating areas around the world and that will-we believe, over the long term, that will increase our yields in that area.

Carl, do you want to add to that?

Yes. Specifically highlighting on what Craig just said, the thin film coating investment we are making at VLOC has very important gross margin implications, because we really did let our equipment complement there get a little older than we should have. We were a little bit slow to upgrade some of that.

We have installed a couple of new coating machines just in the past six-eight months there and we have two more on the way at our facility in Florida, and we know that these newer machines are going to give us a boost in thin film coating yields and cut down on the amount of rework that we have to do to get products out to customers, and that will certainly improve gross margins at VLOC.

Okay. And, finally, I have a question on fiber-based lasers. Is that an area that you might expand into at a later time?

Pierre, we've had a group looking at fiber lasers and, more generally, at one micron laser technology for three or four years and we've kept an eye on that area during this whole period.

We commented on fiber laser in the prior part of our presentation today. I don't have a whole lot more to say about it right now. We're studying it carefully and looking for the best way for us to participate in the one micron laser marketplace, either through something we might do in fiber laser or with some of the other possible lasers.

We are involved in the United States Government's thrust to look at ceramic slab YAG lasers. We're one of three manufacturers that's under contract to work on ceramic YAG gain material and that contract is progressing. It's a joint technology office and Air Force materials contract.

So we'll keep working in that space and see what comes of it.

Is that a technology then that you have or will you have to acquire it?

Which are you speaking of?

The fiber.

We do not have any fiber laser capability nor diode laser capability. So it's just an arena that we are studying and watching it develop. But we do not have any current capability in the components or parts of what today is fiber laser.

Okay. Well, thanks.

Your next question comes from Lakshminarayana Ganti, with Thomas Weisel.

Hi, everybody. I was just wondering, for the infrared segment, while segment earnings are very much comparable with last year's segment earnings, we see that the segment earnings margins for this have declined by 300 basis points.

Can you help us understand that? Is it pricing or is it maybe higher levels of SGNA for this segment? What exactly is happening in that space?

Sure. That business we touched on a little bit on both the earnings release and, also, the conference call for Primark.

That business unit does bear the largest portion of our corporate allocations and corporate expenses. That business is our largest business segment. So just by nature, it tends to bear a lot of those types of costs.

We also mentioned that there's been a little bit of pressure and that's continued and we've talked about it probably for the last several conference calls relative to one raw material that we use, selenium.

We are continuing to move through some higher priced material. The price of that material has trended downward, but we're continuing to work out the inventory that we have of that material in our system.

So those higher prices, the cost of selenium, should be with us probably for the rest of this quarter and then as we move into the second half of the fiscal year, we will get some relief on that front.

It is interesting to note, though, that even though, year over year, not much of the gain-the revenue gain was noticeable, not much of a change on the segment earnings, but, sequentially, we did move up segment earnings as a percentage of revenues.

Q4 for the infrared optics group was 24%, moved up to 27% this past quarter. So we're making some improvement sequentially and, as I mentioned, as we move further into the fiscal year, we'll get a little bit of relief. We're starting to see some relief from some of that raw material price, higher prices.

Okay. That was useful.

The other question was about capacity and operations in Pennsylvania, China and Singapore, especially given the fact that you're experiencing strong bookings growth for the IR segment.

How are you positioned to deliver?

We're working very carefully to stay right with our customer demand, but we are running pretty much full tilt in Pennsylvania, Singapore and China. We are adding capacity in our raw materials, Selenides and Sulfide materials growth area here in Pennsylvania.

We are aggressively working to add two furnaces as quickly as we can here to produce raw material. Meanwhile, we're keeping up, but we need some extra capacity because we're running a little bit too close to the top.

In Singapore and China, both places we're adding capacity in the polishing and thin film coating and quality assurance areas, and, primarily, one of the areas that is always constraining or more normally constraining is our coating area, where we're adding-we just recently put a new coating machine in Singapore and we're adding thin film coating capability both here in Pennsylvania and in Singapore.

We also are adding fabrication and polishing capability in Suzhou, China. So we're very aggressively adding capacity at this moment and we believe that we'll just be able to keep up with the increased demand.

Okay. Thanks for that.

Your next question comes from Dave Kang, with Roth Capital.

Thank you. Good morning, guys. The first question is, I was hoping to get more clarity on this CZT issue. Can you elaborate a little bit more on the nature? And I guess that's where the warranty cost for, what, $300,000 or so came from.

Yes. I'll try to do the best I can and not make it too technical, because it quickly gets into the root cause of this problem is a very technical issue in the actual manufacturing of a cadmium zinc telluride detector array.

This is a fairly complex pixilated array product. It is used in a high flux x-ray environment and what we find or what we have found and what was uncovered or came to light during the quarter was that a portion of these detector arrays that we have been putting into the field over time have various pixels drift in their performance.

The output of the detector pixel or the element in the array varies and we had to get in and find out what the problem was. And there are several possibilities, we won't go into all of them, but we believe we have found the root cause and we are working in both our factory and our customer's assembly plant to make sure that we're doing everything we can to make the detector right in the first place and then not disturb it or destroy it in the way that it is deployed in our customer's product.

So it's a team effort of both the engineers from our detector fab line and the instrument engineers at our customer's location to work together and it's a good example of how we can go out and team with our customers to solve this kind of problem, which we've run into before with different customers, but this was the first time that we've had this particular problem.

And so we've got a team of engineers that, interestingly, as a team, have spent time in both our factory and their factory and it's really a good way to go at the problem-solving.

I can't promise that we'll get it done at any particular point in time, but we have indicated what we think is most likely to happen.

So in terms of financially, that cost you $350,000 for warranty costs. And then in terms of revenues, how much did that impact your revenues last quarter and how much will that impact this current December quarter?

It impacted the revenues a little bit, Dave. Like Carl said, as we work on and as we think we've got somewhat of an end in sight or at least some solutions in sight, we will be fishing through that.

That higher level of uncertainty was factored in our guidance that we gave for the second quarter. So that little bit of uncertainty on EV and that one particular customer was factored into our guidance.

So we're not exactly sure what the impact was, but kind of the risk, we did a little risk adjustment to that and put that in when we gave out our guidance.

And then as far as the warranty cost, it almost means that's not going to repeat this quarter.

As far as we can tell, we've reserved for what is the range of potential warranty returns from that one particular application and, like I say, as we go through this current quarter, second quarter, we'll update that as needed.

But as best we can judge and tell, we've reserved for what we need to reserve for.

And then going back to the gross margin question. So you said selenium, you should get some relief from the selenium price, that's been going down, more like next year, next calendar year rather than this December quarter.

So it's not like there's about a lag factor of maybe three or four quarters, not necessarily two quarters.

We think, kind of as we look at our usage and as Carl mentioned, we are really putting out a lot more material. We're starting to use more and more of our own material and that's consuming more and more selenium.

So we're moving through that inventory maybe even a little bit faster than we anticipated, say, three months ago or six months ago, but when we look at how we've purchase that inventory over time, we're going to start to get some relief, as you said, Dave, at the beginning of calendar year 2007, our third quarter.

But then if I look at the chart, price has been creeping back up since May. So is there a way for you to kind of put in a hedge policy to counteract all these wild swings of selenium that's going through the last year or so?

I wish selenium was the only problem that we had on the raw materials side, Dave. We are highlighting the selenium as an example, but silicon, copper, we've got a number of our-tellurium-we've got a number of our raw materials that are all over the place.

And let's just review what happened to selenium as an example, and they don't all happen at the same time, but they all have been happening.

Three to four years ago, the price of selenium was under $4 a pound at the grade that we buy it, at the very highest-one of the higher grades. It's not the very highest grade, but one of the higher grades, four-nines or so that we buy, was under $4 a pound.

In the early part of last fiscal year, it went to over $50 a pound and then over the last part of '06 and through the early part of this summer, I think it was down in the $15 to $20 range. And as you point out, it is now coming back up and it seems to be very dependent on the use of selenium as an additive in steel and architectural glass, which, as you know, are consumed in large quantities in construction.

So if China and India are having these construction booms over there, to the extent that they're using lots of these materials, it swings the world price around. And I think that that probably affects copper for wiring and some of the other materials I mentioned.

So we have not come up with a hedge policy for these materials, but we have been trying to, in a reasonable way, pass along our higher inventory costs to our customers in a sensible way.

Got it. And then just, lastly, on the gross margin case, how much was it impacted by the foreign currency swing and how much of all these capacity expansion initiatives, how much of that is putting pressure on your gross margin line at this point?

I would say, Dave, that the foreign currency was not really much of an impact at all during this past quarter and I would say that the expansion programs may be a little bit of an impact to the gross margin, but that has not been a significant factor.

Carl mentioned that we've got a lot of different expansion programs going on. We've not significantly over-billed capacity in one particular area. I think our capacity adds have been pretty broad based across a lot of different areas of need.

So those aren't impacting, that specifically is not impacting gross margin.

Got it. And then on your stock comp of about 740,000, is that pretty much all reflected in the SG&A line or can you break that out, if it's not?

The better part of that is allocated in the SG&A line. There is a little bit that gets allocated in the cost of goods sold.

I would say, just generally speaking, probably about 80% to 85% of that is in the SG&A line. The other 15-20% is allocated in the gross margin line.

Is that number going to go down or can it remain flat?

The level should remain about the same. It's based and our current quarter is based on the option activity that we had during this past quarter and all the historical activity we've had, as well.

We think the level we had this first quarter should be pretty close to what we see for the next few quarters.

And just for clarification on your guidance, that bottom line EPS guidance, it does include stock comp, correct?

That is correct.

Yes. Okay, thank you.

[Operator instructions]

Your next question comes from [Jihuan Lee] with Sidoti and Company.

Good morning.

Good morning, Jihuan.

I have three or four quick questions for you. Carl, in your prepared comments, you had mentioned, in addition to the issues at EV and selenium, there were some issues with the YAG down in Florida for thin film coating.

Was that quantifiable?

Those were two separate issues. I mentioned operational issues with our YAG rod production and then, separately, the thin film coating yields and throughput.

I already commented on the gross margin opportunity that's associated with upgrading of our VLOC thin film coating capability. Of course, there are many aspects to that, but certainly the upgrading of the equipment and the upgrading of the facility and the infrastructure and then the training and the process control, all those things are important and we're working very hard on those things.

The YAG operational issues, just a matter of having orders that we couldn't get through, not so much on the basis of our process, the processing of the rods, but we do have a limit to the amount of YAG crystal material that we can manufacture and we're running that also pretty hard and we had a couple of hiccups in the crystal production area during the first quarter and that just limited the amount of available material we had to make product for customers.

So I'm not sure I can quantify it. I'd rather not, I believe, try to quantify that. But it did result in some lost opportunity to make shipments of finished products to YAG rod customers.

We clearly had some orders that we didn't get out the door because of limited material supply.

On the thin film coating side, to try to quantify that, it just ends up with late order backlog at the end of the quarter. We just didn't get product out the door because we had to make it two sometimes, even three times because of the low coating yields of certain, not of all products, but of certain particular coatings, our yields are just lower than they should be and could be.

Craig, do you feel like you can quantify either of those things?

No. I think you probably did it best. Really, as Carl said, it's probably more on the missed opportunity side of things than there was really a true direct expense to it.

But in order to relieve, obviously, especially on the coating side, you are bringing in a couple of new coating machines down in Florida. Is that sort of how I understood? And it seems to me that you obviously want to pursue that one micron disk and ceramic slab YAG laser business, as you sort of kind of improve your coating operation.

Is that sort of how I should understand?

Let's take them one at a time. First of all, yes, I did say and it's true that we have on order and will be installing within the next three months, we should be installing and bringing online two new high throughput thin film coating machines at the VLOC location in Florida.

We already have identical machinery in place that we saw yields of certain coatings, coated products increase by 20 percentage points when we installed a couple of machines of this variety about a year ago.

So now we want to extend that success to more of our products and keep ratcheting up the yields.

A separate question is where are the ceramic slab YAG laser technology is going to go over the next three or four years. This is being heavily invested in by the United States Government. We're very happy to be part of that.

I will say, and this is announced, that outfits like Textron, Northrop Grumman and Raytheon are all working in a different part of that program than we are. They're working to build the actual lasers and test the actual lasers and I don't have the press releases in front of me, but I particularly can mention that both Textron and Northrop Grumman have been operating lasers of this ceramic slab YAG design in the greater than 10 kilowatt regime for over a year.

And it is a technology that we should keep our eye on. We are the supplier of some of that, of the components that go into those lasers.

They're still in the laboratory, but you can read in the open literature via press releases, particularly from Textron and Northrop Grumman, about how they're doing with this technology.

It is a scaleable technology and the reason the government is so interested in it is they believe that it is a route to a 100 kilowatts in a reasonable sized and powered system.

I believe it's Northrop Grumman has already operated some of their lasers above 25 kilowatts.

Good. Thanks for the clarification. On a related thing, does your extra investment change your '07, F-07 CapEx goal and if there is one?

The things that we're talking about spending capital dollars on and thin film coating and other fabrication areas and material growth, in general terms, those are all contemplated in our budgeting process.

Last year we spent about 15.5 million in CapEx. Through the first quarter, we have not spent a whole lot and we've only spent about $3 million, as noted in the press release, capital spending in the first quarter.

But that level should pick up and we should get to a level that's pretty close to last year, maybe somewhere in the $16 to $18 million range, something like that.

So that level will be fairly comparable to last year, but may be up a little bit.

Okay, terrific. And could you sort of qualitatively break down Marlow's military versus non-military businesses now, recently?

In terms of revenues, Jihuan, or are you talking...

Yes, revenues.

Maybe I'll just give you a little bit of a historical perspective. When we acquired Marlow almost two years ago, that business was probably right on about 50% dedicated to military, defense, space, photonic type applications.

Right now, Marlow is probably our most diversified, if you would, product offering. They have increased the level of revenues that they're generating from medical products, industrial applications. The telecom businesses have come back a little bit, as well, and they're still maintaining a nice share in the military.

So right now, I would say the military business is probably more like a third of their business, and that's not because the military business hasn't been growing. It's because the industrial and the medical applications, telecom, as well, have been growing faster than the military.

Great. And my final question is it looks like you are expecting some orders on the $4 million and potentially $10 million orders on the UV filters.

How should somebody like us look at your sort of customers' buying power? Because it is a pretty lumpy business, the military order.

Yes. And, of course, it's been a developing business, so maybe that makes it even more hard to track for us, as well.

But it looks like the Army is the end user, the end customer, and as long as we're talking about protecting helicopters and other slower moving aircraft and even some land vehicles, possibly, it looks like we're going to stabilize, at least the talk is about stabilizing at the range of 200 to 240 systems, our little subsystems that we make, per month.

Am I right about that, Craig? We're talking 200 to 240. Now, they want us to tool up and invest so that we could hit the high end of that range, but the guaranteed orders are-there really aren't any. When we talk about a long range sales contract, this will be a multi-year contract, but it's kind of like indefinite quantity, indefinite delivery.

But, yet, they put an order out there for so many of these subsystems that we would be building. So we still, even though we have a long range contract, which is a multi-year contract that sets a price, that's all that's set. The delivery schedule is really not set. So we're still responding to spot orders.

Now, having said that, we're building to hit a 200-a-month capability that could spike to 240 if it had to, maybe not stay there, but we intend to run in this 200 to 240 range for a couple of years, I would say. That's about the visibility that we would seem to have.

Fair enough for me. Thank you.

Your next question comes from Chris McDonald, with Kennedy Capital Management.

Hi, good morning, gentlemen.

Good morning.

Just as kind of a follow-on to the least question. Have you read that run rate on the UV filters business yet or is that something that you'll build to throughout fiscal '07, that 200 unit level?

We've reached that for the last-the second half of last fiscal year. We were there some of the time. I think we're prepared now to be there and stay there and stabilize at that level.

And then the other opportunity we have to generate additional revenue there is as we learn how to make the parts, and there are four parts that go into this sub-optical assembly, SOA, for short.

The customer decided they wanted to have us go ahead and assemble the SOA, as well as to make the parts. So we've started doing that back in the third, late third quarter and fourth quarter of last fiscal year and we're now rolling strong on that program.

We will not be shipping individual parts to them any longer, but rather going ahead to add the value of assembling and testing this sub-optical assembly. And we have an initial order now for even a higher level assembly to see if we can do that.

So this particular customer is interested in outsourcing as much of that optical work as they can and we're excited about helping them do that.

So there's still growth coming to us. If you look at '07 over '06, we have some nice opportunity to add value and in addition to shipping at a stable higher level.

And another one on your infrared optics. You mentioned some of the lost opportunity there relative to yields on the YAG business. Still, the margins were really solid in that business in the quarter. I'm just wondering if there's opportunity for kind of a new plateau there.

It's traditionally been kind of a high single digits margin business. The last two quarters have been up in the 11. I just wonder what the possibilities are for additional upside there.

I think, Chris, you're seeing the impact of us doing very well on the UV filter business. I think we're doing an excellent job of servicing the customer and that portion of our business has continued to grow and we would definitely agree with you that there's a lot of further opportunities in the rest of the near infrared business and the YAG business, custom crystal business, other areas to make improvements.

And I think we're continuously trying to make the right moves to do better there, but I think we would agree with you in saying that there's definitely upside for the non-UV filter portion of the business.

Thanks. And then in both military and the compound semiconductor businesses, I'm just wondering how mix can impact margins there.

Margins in those two segments really seem to move around on a quarter to quarter basis and I know Carl talked a little bit about the arrowhead program and some delays in the military segment.

But maybe if you could just characterize the impact of mix on the margin performance in those segments.

I would say that specifically in the military infrared optics business, really one of the larger drivers for the segment earnings performance is or is dependent upon specific programs, and Carl mentioned a couple programs that have either had some delays or some challenges with.

Those are really the things that tend to swing that business. It's something program-specific.

By contrast, in the compound semiconductor group, because we're providing a much broader, diversified product offering and there's also three businesses inside that compound semiconductor group, it's less program specific and really more operational or performance driven.

It's not necessarily because of one program that we've either done poorly or well on. It's really more just the overall operations, whether it be the yields, whether it be our quality levels, whatever it may be.

It seems to be a little bit more broadly operational dependent than, say, program dependent, like in the military business.

In the military optics business, are most of those contracts fixed price contracts or is there some cost plus business there, as well?

We wish there were cost plus in certain cases. It seems to be the rule is firm fixed price. And when we're dealing with heritage programs, like I mentioned, the M-1 tank and Apache helicopter and the lantern targeting pods for the Air Force and the Navy.

Those programs are dealing with parts that we've made for many years. We know how to make them, we're tooled, our people are trained, and we do pretty well on a firm fixed price contract there.

But when we get into the sapphire area, which has been building for us over the last three or four years since we entered into it, when you look at the, for instance, JSF delay that we're into now, what happened was over the last two or three years, we've been working on JSF and we end up taking an order or a contract to make windows of a size, for instance, that's never been made before in the history of the world and we're doing something that hasn't ever been done, which sounds like a development project for all of us, and we end up taking that job on a firm fixed price basis and that's very risky.

We would rather do development work on a cost plus basis, but it's really, really hard to get a contract like that with a military prime or directly with the government.

So we've ended up doing development work and getting hurt by it. We've talked about that before on these conference calls, that when we underestimate the difficulty and we're sitting here on a firm fixed price contract, we have no choice but to get the job done and get the work done and sometimes we've even taken a loss on that work rather than just low margin.

But as the sapphire program matures, we hope that we get a better handle on our costs and we can bid our jobs more conservatively maybe and build in the right amount of cost anticipation for things that don't always go right.

But, basically, the problem is pricing developmental work and the arrowhead program is the same exact thing, where we're building parts that haven't ever been made before on firm fixed price.

So this development work can swing us quarter to quarter, depending on how that work is going, quite a bit on margin, whereas the heritage programs, those we can crank out.

And so it is a mix issue, how much of the mix, the development versus heritage program fits into any given quarter and how the development work is going.

Okay. Thank you very much for taking my questions.

Your next question comes from Joseph Garner, with Emerald Advisors.

Good morning.

Good morning.

A couple quick questions for you. Number one, what you guys are showing in terms of the booking growth you had in the quarter and looking at your guidance for the December quarter, it seems that the business appears relatively healthy, but that would be kind of running contrary to what a number of people are looking at out there in terms of a slowing economic environment.

I wonder if you can kind of talk about that a little bit and how the business environment looks to you right now, in general.

I'll try it first, Joe. Specifically, in our infrared optics business, which we're seeing that that business, 85-90% of that business, somewhere there abouts, is really for replacement parts. We really have pretty good visibility into how often large system users are running their systems and really, for the last nine months and for a couple points in this past quarter, those are really at record levels.

We're seeing people add shifts or use their systems more than they did, say, a year ago, two years ago. So that 24 percent bookings growth that was shown for our infrared optics business, a fair amount of that has to do with or is directly attributable to how much people are running their systems.

So, broadly, we're seeing that that is still a positive sign. The other positive sign that we're seeing is that a lot of our laser system customers are OEMs who are building new laser systems. They also are running at high levels, adding capacity, adding facilities, adding shifts, and so that's telling us that their information is also seeing that they're believing that's going to be sustained for some period.

Carl, do you want to add to that?

Yes. I would like to talk about two other business segments, both within CSG, compound semiconductor group.

First, Marlow, the impact of them getting up and running in Vietnam should not be underestimated. It is going to open up new segments of the market to us where we've never been able to be competitive before, medical, telecom, and industrial, to be specific.

Craig already mentioned those are growing very, very quickly now, not because the market is growing so much as we're penetrating into segments we haven't been effective in before, partly because of the cost of making the product in Vietnam and partly because customers are looking, I said this before, but certain medical customers are looking at us being to do more work for them than we've done before.

Instead of making cooler parts and then shipping them to Massachusetts, for instance, for assembly into components, they want us to do the component work in Vietnam, which is giving us an opportunity to not only penetrate the medical market more effectively, but do more work in the medical market.

That's an example. I think Marlow, in the medical, industrial and telecom area, is not limited by what's happening to the general economy at the moment.

Wide band gap is in the similar situation where right now both RF, gallium nitride RF power, technology and device people, and silicon carbide, on silicon carbide power device people, are both looking to buy more and more 3-inch diameter substrates and 100-millimeter diameter substrates, and we are capacity limited at the moment and technology we're limited.

We're both capacity and technology limited. We're able to sell as many 3-inch and 100-millimeter diameter substrates as we can produce. So we're not constrained by any general market condition in some of our particularly newer technology and higher capability areas of our business.

It would seem that what you're saying and what you've reported in your numbers that the business environment looks like it's steadily improving, which is in contrast to what the stock is indicating today. So that's for the confirmation on that.

The second question, I may have missed something a little bit earlier. You had, I guess, commented that selenium, I guess, is run through a pretty wide range, 60 on the high and 15 to 20 on the lower end.

Where are we right now? I think I missed that part of it.

Just about in the 20-25 range.

And in the past, you've been able to put through some price increases or surcharges or whatever may be the case in terms of offsetting that, to some extent.

Are you still able to do that? Are the customers still helping you to absorb some of that cost?

Yes. We are still doing, I would say, a good job at that. The one interesting thing is, Joe, we've educated so many people on the price of selenium when we went out to increase the price.

Now, everybody, like yourself, is educated on how the price has gone contrary. So we're needing to adjust those markups or surcharges or additional prices and our customers are also seeing the price trend down, as well.

We've said before that I think we've done kind of an okay job at that. That was really the first time we ever had to go out and do a direct surcharge or do a direct cost add-on because of the significant change in the price of selenium.

But overall, we've got some of those arrangements that will be rolling off. I'd say we've done a pretty good job of offsetting our costs, but we haven't done it dollar for dollar.

And I think you indicated in the second quarter that that may still be an issue for you, the materials cost.

Can you give us an idea of how much margin compression you might be expecting to see in the second quarter?

I would say we're not expecting to see any margin dterioration from the levels we were at in this first quarter. I think it's more the upside, that as we roll out of the second quarter, into the back half of the year, we'll start to get a little bit of relief.

To try to quantify it, Joe, is a little bit difficult to do that, but suffice it to say that as we've modeled it out and looked at it and understand our usage, we're going to get that relief beginning this calendar year.

Great. Thank you very much.

Thank you.

Your next question comes from Dave Kang, with Roth Capital.

Just one clarification question. Did I hear you right, Craig, that you expect rates to be around 27% for the rest of this fiscal year?

Yes. We expect it to be, Dave, at the rate that we ended this past quarter, which was 26.7. Our last year rate was 27.1 and the way we are looking at our effective tax rate, whatever the year to date is, that's what we think the rest of the year is going to be.

So we think it'll be at that 26.7% percent rate.

And one more, if I could. How do you expect your depreciation to change going forward?

It should be trending up just slightly from the level we ended this past quarter. This quarter, we ended just around, a little bit less than 4.1 million depreciation and amortization together.

And as we add on some of this capital spending that we've talked about, that will trend up a little bit, not drastically, but it will trend up a little bit from that 4.1 million level we did this past quarter.

Got it. Thank you.

Your next question comes from Scott Blumenthal, with Emerald Advisors.

Good morning, gentlemen.

Good morning.

Just a couple of quick clarifications. Carl, you talked a little bit about the risks involved in pricing development work and I was wondering if you could kind of give us an idea of the percentage of what you're doing that you see as-that you would quantify as development work and how much of your total, I guess, product portfolio is involved in this type of risky endeavor.

Well, the only place that-thank you for the question. The only place that this really is a highlight is at our EEO military optics facility out in California.

And this is a little bit historical, but if you go back two or three years, we had some development contracts that were very, very difficult that we had taken a firm fixed price basis and, frankly, we had a period of time where we were writing off three to $500,000 a quarter for, Craig, something like over an 18-month period.

We just kept looking at it. We were tied into this firm fixed price development work. There was no relief from the customer and we took aback over it.

So, believe me, we're getting better at this and we're no longer taking losses over this kind of thing, but we do find our margins swinging around quite a bit.

And, Craig, I'm going to guess that the actual development work that we have right now is no more than, what, 25% of the total work that's in the EEO and it's mostly on the arrowhead program, where one quarter we'll have our-our technology will be improving and we'll get on top of it and we will do very well during that quarter of shipping parts and getting contracts completed on time.

And then we might have a backslide, where some part of the process we didn't understand gets out of bounds and we'll have a quarter where we don't do so well. But we're no longer losing money.

Management is doing a better job. We're doing a better job of pricing that kind of work and we're doing a better job on the engineering and operation execution side.

So things are improving.

Another example, though, is on the JSF contract, where the system performance-during the past quarter, we found out that the system performance was-the customers came in and said, "Look, it's not working as well as it should work and we're going to have to tighten the specifications on the products you make for us. Not that anything you've made doesn't meet specification, it all does, but now we have to tighten them."

So now we have to take a delay in a program going forward and going back and figure out how to make parts against these tighter requirements, which I said is going to take up to six months, but we do anticipate-I mean, we're not going to do this for free and we do anticipate receiving something on the order of a $1.5 million contract to do the work, to improve the process, to meet the tighter specifications.

It will be a firm fixed price development contract, but we'll price it carefully.

Okay. So to clarify, we're looking, for example, this quarter, military infrared was about a little bit more than 10% of the total overall business.

You said that the pricing of this development work is maybe a one quarter event. So really we're looking at maybe a 2.5% to 3% of the total overall business as being this type of development work.

That's correct.

Okay. I just wanted to clarify that. And when you're competing on these types of development projects, who else-I mean, we're talking about the U.S. military. I wouldn't imagine that they would consider foreign sources.

But who else would you be competing with on something, for example, like the sapphire panels for the joint site fighter?

There are two or three other companies in the United States that have the capability to do this work with sapphire at the present time.

I don't think it's usually our policy to name them in particular, but they're long-time suppliers to the U.S. military that have the kind of large equipment and the processing equipment and the measuring equipment to do this kind of work.

We have competed with them over the last three or four years and it's always a competition to see who will be able to perform and who might take the work at a lower price even.

But there is always competition. One of these companies is a company approximately the same size as II-VI and the other one is a much larger outfit.

Fair enough. And just one other question for Craig. Did you mention how many total thin film coating machines you have in Florida?

Yes. We had not-rough order of magnitude, Scott, would maybe be around 20 or so.

Great. Thanks very much.

At this time, there are no further questions.

If there are no more questions, I would like to thank everyone for participating today.

Our next earnings release for the quarter ending December 31, 2006 is currently scheduled for Monday, January 23, 2007, with a conference call to follow the next day, Tuesday, January 24, 2007.

Thank you for participating in today's conference call.

This concludes today's conference call. You may now disconnect.