II-VI Inc (IIVI) 2002 Q3 法說會逐字稿

Good morning, and welcome to the II-VI Incorporated third quarter earnings conference call. All participants will be able to listen only until the formal question and answer session. This conference call is also being recorded. If anyone does object, you may disconnect at this time. I would like to introduce your speaker for today, Mr. along with Carl Johnson, Chairman and Chief Executive Officer. Sir, you may begin.

Thank you, , and welcome to the third quarter fiscal 2002 II-VI Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Thursday, April 18th, 2002. The forward looking statement we may make during this teleconference speak as of today, and we do not undertake any obligations to update any such statement 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 third quarter fiscal 2002 financial results, and a business and operational overview. Following these prepared comments, we will have a question and answer session.

Total company bookings for the quarter ended March 31st, 2002 increased by nine percent to 36.5 million as compared to the same quarter last year. The infrared optics product line reported five percent higher bookings for the quarter. Bookings of the VLOC subsidiary decreased 30 percent. The eV PRODUCTs division bookings increased 30 percent. And the bookings for Laser Power Corporation increased 15 percent.

Bookings for the quarter ended March 31st, 2002 also included contract bookings for the development of silicon carbide of approximately $1.7 million. For the nine months ended March 31st, 2002, total company bookings decreased by 11 percent to 89.5 million, as compared to the same period last year. Revenues of 27.4 million for the quarter decreased 16 percent as compared to the same quarter last year.

Revenues of the infrared optics product line decreased 15 percent. Revenues of the VLOC subsidiary decreased 15 percent. Revenues of the eV PRODUCTS division decreased 40 percent, and revenues from Laser Power Corporation decreased 15 percent. For the nine months ended March 31st, 2002, total company revenues decreased by eight percent to 83.6 million as compared to the same period last year.

The cost of goods sold for manufactured products for the quarter decreased from the same quarter last year, while the cost of goods sold as a percentage of sales for the quarter increased by approximately five and a half percentage points from a year ago. The lower sales volumes for the quarter ended March 31st, 2002 as compared to the prior year negatively impacted gross margins. In addition, during the past few quarters, as the industrial business has slowed, the company has been using its capacity to take on more military business.

In an effort to improve gross margins and take advantage of our worldwide capabilities and capacity, the company has decided to cease commercial operations at the Laser Power Corporation facility in California and transfer that work to other II-VI locations. This will allow the California operations to focus solely on its military product offering.

We believe that this will have the effect of improving margins in both the commercial and military businesses in the future. Contract research and development was negatively impacted during the quarter as Laser Power Corporation encountered continued production issues related to several developmental contracts. More specifically, the increased contract and research development costs were primarily attributable to thin film coating development for the airborne laser program.

While the current technical challenges are significant, we believe this investment in the United States missile defense system will lead to better opportunities in the future. Internal research and development expense for the quarter was 1,153,000. These expenditures reflect expanded silicon carbide crystal growth technology and processing development.

These expenditures also include the company's corporate research and development activities and the research and development activities of eV PRODUCTS. Further, regarding the internal research and development, we are pleased to report that during the quarter ended March 31st, 2002, the company completed the move of the recently acquired Litton Systems Incorporated silicon carbide group to a new facility in New Jersey.

This new group is now operational in their new facility. The financial results of this group have been included in the results of operations of the company since the October 19th, 2001 acquisition date. This new group will increase our near term research and development costs as the company accelerates its pace of product development and reduces its time to market.

During March 2002, silicon carbide development contracts totaling 1.7 million were transferred from Litton Systems Incorporated to the company and a very limited amount of contract revenue was recognized during the just completed third quarter. It is expected that the contract revenue for the fourth quarter of fiscal 2002 will total $250,000 and that these contracts will help offset some of the silicon carbide developmental costs for the next few quarters.

Selling, general, and administrative expense for the quarter ended March 31st, 2002 was reduced by over 20 percent compared to the prior year and as a percentage of sales has been reduced to 18 percent of sales from 19 percent of sales. This improvement reflects the addition of Laser Power Corporation and the elimination of certain redundant expenses, as well as expense and manpower reductions in these areas.

Interest expense of $313,000 for the quarter is the result of borrowings used to finance the Laser Power acquisition. The company's live or based interest rates continue to remain low, and the company's weighted average interest rate currently stands at approximately 3.1 percent. During the quarter, the company entered into an interest rate cap for a one year period to help protect $12.5 million of its term debt against the threat of rising interest rates.

Under this instrument, which is required by the company's credit facility, the company will pay no more than 4.4 interest on this portion of its borrowing for the next 12 months. Other income for the quarter of $353,000 represents royalty income, interest income, and other income items. Other income for the quarter includes approximately $300,000 of income derived from the transfer of crystal growth assets and technology as settlement of a customer's inability to fulfil its purchase requirement to the company.

Other income for the quarter was offset in part by foreign currency, losses driven by the company's Singapore and Japan operations as these currencies weakened against the US dollar. The tax rate for the quarter and year to date is 30 percent. The company continues to benefit from lower tax rates on Singapore and China operations.

During the fiscal year, the company has initiated several new tax planning projects and strategies. One tax project completed during this quarter, which focused on the Laser Power acquisition, resulted in a reduction of current and future taxes payable and correspondingly reduced good will by $478,000. Capital spending for the quarter was approximately $2 million.

The major components of capital spending for the quarter were investment in the US infrared optics businesses primarily to increase material production capacity and lower per unit costs, investment in the new silicon carbide facility in New Jersey, investment for production improvement at eV PRODUCTS, and investments for production and facility improvements at Laser Power Corporation.

Capital spending for the nine months ended March 31st, 2002 was approximately $7 million and is expected to be approximately $10 million for the fiscal year 2002. During this year, we have actively reduced our capital expenditure requirements and have reduced our planned spending by over 40 percent from our initial fiscal year budget amounts.

Net earnings for the quarter were $1,164,000, or 8 cents per diluted share. These results compare with net earnings in last year's third quarter of 2,435,000 or 17 cents per diluted share. As noted in the press release on July 1st, 2001, the company adopted Statement Of Financial Accounting Standards Number 142 Good Will And Other Intangible Assets, which requires that good will no longer be amortized but instead be tested annually for impairment.

Comparable results for the quarter that ended March 31st, 2001 excluding the amortization of good will were net earnings of $2,874,000 or 20 cents per diluted share. The company's backlog at March 31st, 2002 stood at $51 million, which was up approximately $9 million from December 31st, 2001. The components of this backlog include Laser Power at 22 million, infrared optics at 12 million, VLOC at eight million, eV PRODUCTS at seven million, silicon carbide at 1.6 million, and telecom at 200,000.

Our worldwide employment at March 31st, 2002 was 989 employees. This number compares with worldwide employment at June 30th, 2001 of 1,158 employees, or an approximate 15 percent decrease from that time. These employment decreases have occurred at most II-VI production locations including Pennsylvania, California, Florida, Singapore, and China.

During the quarter, the company repaid $1.5 million under its line of credit facility, consisting of a required $1.25 million term loan payment and a $250,000 line of credit prepayment generated by operating cash flow. That concludes the financial review, and Carl will now discuss current business expectations, Carl?

Thank you for your comments and analysis, . Our just concluded third quarter and the current fourth quarter are as challenging as any in the history of our company. Part of this challenge is produced by two beliefs embedded in the II-VI corporate culture, first, that good companies always make a profit, and second, that good companies are expected to grow both the top line and the bottom line by greater than 20 percent every year.

It pains me to acknowledge that with nine months' revenues off eight percent at $84 million, and a projected fourth quarter similar to our third quarter, II-VI will for the first time in its 31 year history report a decrease in year over year revenues in fiscal 2002. As we face a generally weak worldwide economy and slowed industrial market demand we are focused on finding the best opportunities we can identify or create.

Let me briefly comment by business segment. In the IR laser optics commercial market served by our II-VI and Laser Power brands, OEM orders and shipments are still slow, because the deployment of new CO2 laser processing equipment is down, and some OEMs are still working off pockets of excess inventory. The result is a delay in the placement of annual blanket orders by up to six months.

Sales into the after market are more encouraging. Both the Laser Power and II-VI brands have experienced a pick up in demand based on an increase in the consumption of replacement parts. For the brands combined, third quarter after market bookings were up 25 percent over the second quarter. As stated, we are consolidating the manufacture of these products on a global scale and reducing our production costs as a result.

We are preparing to compete more vigorously than ever in this market segment. In the IR military market, the II-VI business unit has won several large orders that are well matched to its skills and capabilities, especially in precision diamond turning, based grinding and polishing, high performance thin dome coating, and specialized component engineering and quality assurance.

We continue to manufacture critical optics for the global Hawk unmanned aerial vehicle surveillance program, and we are contributing at increased levels to the theater high altitude air defense system and lightning advanced targeting and navigation pod deployment. The exotic electro-optics dedicated military components group at Laser Power Corporation is generating increased interest in its capabilities as evidenced by record bookings of $11 million during the third quarter.

This includes a $6 million order for zinc sulfide Javelin missile domes and an $800,000 order for zinc sulfide missile domes. New opportunities are on the way for additional military orders. But I remind all of us, these opportunities will continue to present multiple technology and performance challenges. That is, these orders typically push to the limits our technical capabilities and are difficult to execute.

On this point, our large optics coating facility at Laser Power Corporation continues to develop the technology needed to produce the very large diameter optics required for the airborne laser program. We have not yet qualified using surrogate parts, a coating process that is reliable enough to process the actual program optics.

We expect to work through this situation over the next 90 days, but during the third quarter our internal R&D costs in this area were up significantly due to this activity. We believe that this investment in technology for the US missile defense system will pay dividends in the long term, but at the moment it amounts to highly challenging work.

At VLOC laser components and related crystals and optics for the military are a bright spot. sales overall are up year over year due to an increase in our market share. We are preparing to be more competitive in the manufacture of polarization wave plates as we have recently completed the move of a wave plate manufacturing sell to Xuzhou, China.

This cell is now up and running at low volume. We plan to transfer a major portion of our wave plate manufacturing from Florida to Xuzhou during fiscal 2003. Our VLOC led Department Of Defense contracts to produce 100 millimeter diameter ingots and to create a low cost domestic capability to manufacture materials are progressing.

These efforts are again technically challenging, and achievements can be elusive. But we believe that this work will create a platform for multiple long lived business opportunities in the future. For eV PRODUCTS, the medical imaging market segment continues to move aggressively forward with the adoption and deployment of cadmium zinc technology in its systems and instruments.

During March the small field of view gamma camera was released to the market in Japan by Toshiba. And the development of a based whole body large field of view gamma camera continues to move forward at an accelerating pace. eV leads over the competition in this area by one to two years, and we believe that our pace of development is at or above that of any competitor.

We are experiencing a significant increased activity related to advanced baggage and package inspection equipment and early threat detection equipment. The world now realized that smart, highly capable radiation detection equipment is necessary and more importantly, portable versions are needed for deployment in more common environments, such as with fire departments, first responders, police, border patrols, and soldiers in the field.

The demand for eV's core products, such as bone mineral densitometry detector rays for General Electric, continues to be strong, and our customers are forecasting another year of double digit growth looking forward. The former Litton Systems silicon carbide electronic materials group that we acquired last October is up and running in its new Pinebrook, New Jersey facility.

This means that we are now generating revenues against two Department Of Defense contracts that we inherited from Litton. Some work on these contracts will be performed by our Pennsylvania based group that has been developing silicon carbide capability over the past four years. Together, these groups form our wide band gap material business unit, which we expect to book additional development contracts during the fourth quarter and enter fiscal 2003 at a contract revenue run rate of greater than $2.5 million per year.

This activity and the associated knowledge generated is accelerating our thrust to demonstrate commercially qualified silicon carbide substrate production capability. We are projecting that small quantities of two inch diameter conducting and semi-insulating products be available in three to six months.

In summary, every II-VI business unit is hustling to get ready for an improved year looking forward. Although we will be down on the fiscal 2002 top line for the first time in our 31 year history, we will be profitable, and we will work hard to get back on our historical growth trend line fiscal 2003. 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 fiscal year ended June 30th, 2001.

, we are ready for the first question.

Thank you, if you would like to ask a question, please press *1 on your touch tone phone. You will be announced prior to asking your question. Our first question comes from .

Good morning, good morning, gentlemen.

Good morning.

Good morning.

Could you give us some insight as to what you expect for a gross operating margin in your manufacturing business the coming quarter and maybe even the coming couple quarters?

That, we, in the prepared comments, we talked about our infrared optics business, our primarily industrial businesses taking on more military work that's more challenging work in general. I think our margins, where they were at in the last couple quarters, 31 to 30 percent range, will be where we are at, where we are going to be at, for the fourth quarter and probably for the beginning of FY '03.

After that, as the industrial business hopefully will come back and that product mix will shift a little less away from the military and a little bit more toward the industrial, that's when we see our margins potentially improving after that, after the beginning of FY '03.

OK, now, you've mentioned in the past that currently the military related business will often have margins that are below the industrial manufacturing side. Do you expect that to change going forward?

No, I think that will be a consistent, that will be consistent going forward.

OK, so then just to confirm, to say that you're increasing your percentage of military sales and you expect that to continue as well with the dedication of that LPC facility, then we could probably expect slightly lower margins going forward even after the industrial materials side improves?

I think we anticipate keeping the overall military content of the company where it's at now about the same, but I think what we're anticipating doing is picking up additional business, and that additional business we believe will come from the industrial side of things, and that will bring with it a little bit higher of a margin product.

So we do anticipate in the long term having the margins pick up. In the short term, though, our margins in the fourth quarter are probably expected to be what they were. They would probably be equal to the just completed third quarter. But going forward as we add that additional industrial business, that should help our margins.

, this is Carl. Looking even a little further ahead, and you said let's look ahead as well, there's another up side push that I can see for maybe the second half of fiscal 2003, could be as eV PRODUCTS builds more standard products and get more products that are being actually made in serial manufacturing, and they learn how to make those better, I think we'll see some improved margins at eV that could help offset.

Because these, what we're targeting, you know, after the long term investments that we've made in eV PRODUCTS, we kind of feel we deserve a very healthy, a profit margin in order to recoup some of that investment that we've made. So we're looking for rather strong margins as eV grows and continues to switch more of its activity from prototype and development type work into really manufactured product activity.

And one of the activities that we talked about relative to consolidating the California commercial operation, we believe that in the long run will help us to improve the gross margins of, again, not only the commercial business that is directly impacted, but will allow the Laser Power Corporation, the exotic electro-optics group, to be more dedicated and more solely dedicated to military and hopefully improve their efficiencies as well.

OK, was the eV PRODUCTS unit profitable in the third quarter?

Um, eV PRODUCTS still continues to operate at a operating margin loss. The losses have decreased significantly over the past two years as they have been starting to get more production level products standardized and out the door. And that, those losses have drastically decreased in the last three years.

OK, what type of feedback are you getting on the new gamma camera, the hand held?

That's going rather well. It is being deployed and used in clinics in Japan as we speak. They have, the Japanese company that actually developed that, , as we said, has contracted with Toshiba in Japan to be their marketing arm there. I can't quote you the names, but they have worked out a similar marketing arrangement for the North American and major elements of the European market.

Those are in place now, and some of the initial production that we're working on over the next six months will be going to all three of those marketplaces. Now, it's interesting because in the US, it's a different way that you qualify through the FDA than through similar agencies in some other countries. And in Japan, it, you can use some kind of a new instrument like this more aggressively than you can in the US prior to a full blown FDA approval or the equivalent thereof.

So I think both Europe and Japan will probably, that deployment will move ahead at a quicker pace, but the clinical data that's generated in those markets will actually accelerate the process of qualifying with the US FDA as well. So the, as we get these things, these devices into the clinics and we hear customer feedback, there may be some adjustments that need to be made, both hardware and software adjustments to the instrument. But that said, I think there's a chance that there will be a delay along the way, but it seems to be going quite well.

OK, can you give us a sense as to how many units you have shipped or are shipping and what you think the outlook might hold for that product?

We've shipped on the order of 20 or 25 units. We have orders for, I believe, including the ones we've done in the past and the present ones in the range of 60 to 70 units. And I think the ongoing orders beyond that will depend on how this is accepted in the clinics and the marketplace.

OK, what's roughly the break even for the eV PRODUCTS division?

Probably a little bit more sales wise than the current level. We, you know, probably in the, just above $8 million, maybe $9 million sales range. That's a group to give a lot of credit to because they have done a tremendous job of controlling the cost and as they have moved a lot of products away from the drawing board and out to somebody's production floor, they have really done an excellent job of controlling their costs.

That has helped improve the operating losses over the past few years. But an additional increase of between 10 and 20 percent on the revenue line for that group really puts them into pretty much a break even type of range.

OK, the military business, how does that break out between II-VI and LPC?

Really when you're looking at Laser Power Corporation, it'll be changed a little differently as we go through this consolidation of operations process, but a little bit more than two thirds of that business, maybe 70 percent of the Laser Power business is military related. Of our IR optics group here, I would say that military content is probably pushing about 20 percent these days. And at VLOC our military content of that group would probably be in the 20 percent range as well.

The biggest driver dollar wise is definitely the exotic electro-optics subsidiary of Laser Power Corporation. That is definitely our largest dollar wise military business.

OK, thank you.

Thank you, our next question comes from .

, do you have a breakdown in sales for different areas?

We've really kind of given the ranges of increases from the, on the press release compared to last year. But maybe in a more macro look at things, I can give some specifics.

OK, do you have, like, VLOC, or you know, the same breakdown that you gave for the ?

Right, I'll give that same breakdown for Laser Power Corporation. This is just in no particular order, but Laser Power Corporation sales, and think this was reported, but $7.4 million. For the eV PRODUCTS division was $1.5 million. For the infrared optics product line was just short of $13 million. And the VLOC group including in their telecom sales was a little bit more than 5.5 million. That's a rough general breakdown.

OK, thank you.

Thank you, our next question comes from .

Yes, I, can you just go over your bookings information again, looking at the military. You did mention that there was a fairly large booking, about $9 million, and just wanted to get some feel of the recurring nature to the military business and your booking numbers going forward.

Jason, I'll let maybe Carl kind of reiterate the breakout that he was giving about the exotic orders.

Mm hmm.

I'm not sure that's exactly the question, but what I did say was that the overall Laser Power Corporation orders were about 13 million during the quarter and 11 million of that was defense related or military products, so during this particular quarter the ration was even stronger than quoted earlier, more like a little over 80 percent was military during that quarter. Now, in that 11 million, pretty close to seven million of it, which would be two thirds, was in two orders for zinc sulfide domes.

Six million of it was for the Javelin missile program. That's a fire and forget anti-tank missile, and the other one was for a missile dome, and the is a system that goes up. You launch a missile up over an operating area where there's a conflict, and that missile launches 13 little smart guided parachute drops explosives that goes and finds tanks in a field.

And so that zinc sulfide missile dome business was a pretty good chunk of our order book during the third quarter. There are many, of course there's a variety of military platforms out there. We've added up over the whole corporation, and that includes VLOC, the II-VI infrared group, even eV PRODUCTS, and of course Laser Power Corporation, through its exotic subsidiary, we've looked at all the different programs that we're supporting.

And we've come up with a list of 40 different military or space platforms that we're involved in making parts for. So it's a, and military business sometimes is pretty lumpy. By that I mean some of these contracts are pretty big. You might get a $13 million order on one program, and then not see another one for three years.

Mm hmm.

So it's just, has a lot of different characteristics that are different than the commercial business. I will comment on one other thing. Historically, when we've gone into commercial market slowdowns and/or slowness specially in the industrial sector of the economy, we've migrated before over toward the military with some of our capabilities and skills to do business of that nature during a commercial slowdown. And we in a way maybe have built a reputation that when the commercial comes back we move away from the military.

And maybe it's because of the higher margins that we talked about earlier, but this time we fully intend when the industrial markets recover, with some of the redeployments we're doing on a global scale with our manufacturing, we plan to keep a very substantial effort going of our US factories and our US capabilities to support the ongoing military business and put the growth in the commercial business in our off shore factories. Would you care to add to that, , or does that summarize kind of a change in our strategic plan?

Right, I think that's, a lot of the work in this, been a prolonged effort to expand our military capabilities and capacities, and it's something that when we anticipate the industrial business coming back, it's not that we'll be exiting the military business in any significant manner, if at all, that it will be just as Carl mentioned, kind of adding on that new or revived industrial business on to our military offering as well.

Yes, as an exclamation point on that, over the last I would say two years, we've made some very substantial capital investments, both here in Pennsylvania and in California, certainly in creating specific skills that are aimed solely at the military activities.

OK, thank you.

Thank you, once again, if you'd like to ask a question, please press *1 on your touch tone phone. Our next question comes from .

Hi, just kind of a follow up on that last question, in terms of the military business, and Carl, you've mentioned about the 40 contracts that you were, or 40 programs you were working on various parts for, do you have a sense of, you know, how the military splits out between development stuff versus production?

I don't have a great sense of that. I'll give you an answer, but maybe we really ought to also say we'll go check with our military sales people and follow up with that, . We'll make a note that you asked that question, but, so I'm gonna give you a little more general answer and I'm pretty sure we can be more specific with a follow up.

At any rate, clearly the military is always developing new things, and the development cycle can be as much as even 10 years. And then the life cycle of a weapon system once it's developed is probably also in the range of five to 10 years. So it's pretty heavy on the development side. Also they're always pushing the technology envelope asking you to do things maybe you haven't done before, that no one's done before, or pushing the, the technology right to the edge of its capability.

So that means, that's why these development cycles are so long. I mean, take the airborne laser, for instance. That idea of having a offensive weapon on a flying air platform, they started to work on that around 1970. And they worked on it for the decade of the '70s, absolutely 100 percent development program, a lot of effort and cost went into that.

And they found out that it was too expensive to deploy at that time. Now, here we are 30 years later, and Boeing has a plan and there's budgets laid out in the future to do this, to build eight airborne laser platforms on a 747 air frame. And we're now making the optics for the first one. So is that production or is that continued development?

I would argue that it's more like production than the 1970s, but it's pretty low volume to make eight of these aircraft and then all the parts that have to go on to it. So, but then you go to the , and the Javelin, and many of the others that we're working the thermal weapons side, and a whole long list, and of course we're producing those in the hundreds a month. And that's true of military production. I'm gonna say it's half and half.

Then just kind of thinking about your question a little bit more, Greg, I would agree with that. Of those 40 plus programs, I would estimate that 20 of those are definitely ongoing production level programs, and that the other half are somewhere not quite up to production level. Maybe they're in early stages of development, but maybe we are in limited production quantities. But I would kind of agree with Carl's estimation. It's probably about half and half.

And dollar wise, a single development can generate a lot of revenue.

That's correct.

I guess I'm wondering why you made the comment, , about, you know, military content in terms of business mix would be kind of, you know, similar going forward. You know, why wouldn't it go up, I guess, if you've been planting all these seeds, and you know, the defense spending environment is much better, and you know, some of these projects are finally reaching production? You know, why wouldn't we see more growth out of that?

Yes, good question, . I didn't mean to imply that we would not, you know, and that has been one of the limited bright spots in our business over the past 12 months, has been in the military arena. And I didn't mean to imply that we were not gonna continue to grow that business. And we are. You know, we definitely have made a lot of investments in that area.

And we do still continue to anticipate growing that, but the most immediate, you know, expectation the next couple quarters will be an increased industrial demand, which we are getting geared up for, adding that to our military. So thanks for helping me direct that comment a little bit better. I didn't mean to imply that we were not gonna continue to grow the military, which we definitely are committed to.

OK, just a couple other quick ones, eV, do you think it will be profitable in fiscal '03?

eV really has a lot of good opportunities in front of it for FY '03. I'd say again, we really are starting to see a lot of, you know, more production volume related to acceptance of that product. You know, that group is totally committed to focusing on making the business more and more profitable. Will we get there in FY '03? May be a little bit too early to guess that.

But I'm gonna say that I'm sure we're gonna make progress on our FY '03. We're definitely anticipating it being better than FY '02. I'm not sure if it'll get quite to break even then.

OK, and on VLOC you had a program to increase the rod size diameter, or the ingot diameter, any breakthroughs or notables there, too soon?

We, there's a couple of nice positives that are occurring there. Our production diameter on has been in a range of, say, 65 millimeters for several years. And out of this program we are moving now to the 75 to 80 millimeter range with several of our crystal growth, with a substantial fraction of our crystal growth equipment at VLOC.

And that's a transfer of technology directly from the development program into our production area. Meanwhile the development program then at VLOC is working at, say, 85 to 90 millimeter diameter. The, we're teamed with them from the Pennsylvania location as well where we're working on the 100 millimeter diameter. So when this was laid out to the DOD, and it's a three year program, it was, we planned to take it in steps.

First 85, then say 95 and then actually we're shooting for a little over 100. And, but it was anticipated it would be done in three steps. So we're making progress. In the context of this program, we've started up two crystal growth machines at the 100 millimeter diameter level, and we're growing the initial crystals now. The 85 to 95 range, we have, I think it's probably three units that are working at that level.

So we're kind of trying to spread our risk a little bit and make sure that even if for some reason it turns out to be theoretically or practically impossible to grow at 100 or 105 millimeter, that we have some positive fallout from this. And I think our DOD contract monitors kind of like that risk reduction approach as well.

OK, and then, had mentioned other income on the, you had $300,000 from the transfer of crystal assets from a customer. Could you give us more detail what that was about?

Sure.

Is it equipment or actual ingots?

It's actually starting material, and precious metal, and some fixed assets, some crystal growth equipment. We had a customer who had ramped us up to a certain production level. We had made facility improvements, etcetera, to get to that level. They were unable to meet their forecast.

And as a way to in essence compensate us for our time and effort in expanding our facility to take an additional product amount that never materialized, it was agreed upon that this material that we currently do not have the crystal growth technology for, we were doing the processing, that that company would transfer the crystal growth technology to us, again, as compensation for our over capacity position.

On the processing side?

This is on the material growth side. We had done the processing for this company. We had not done the crystal growth. And now we have the technology and ability to do the crystal growth.

Is this ?

It's a material that we're really not, we haven't developed it yet, , so we're not describing it yet. We probably will in the next few quarters talk about it. But it'll have to wait for a couple quarters until we develop the expertise to grow this material.

Yes, to answer your question, it is not .

Yes, correct.

But we're not prepared to say exactly what it is yet. This contract was, which required us to make an up front capital investment really had a take or buy, take or pay feature to it. And they chose not to pay in cash but rather by transferring these assets.

And we had a high value to the technology and the techniques to grow this material, so we perceived it to be a pretty amicable situation for us.

Hmm, OK, and just on the silicon carbide front, you mentioned about R&D going up, but shouldn't we have seen the full impact of that in this quarter? Are you hiring additional people, or?

You're asking about what happened in the third quarter or the quarter we're in right now?

The just reported, the third, March quarter, you know, you bought it in October, right?

Right, now here is why we didn't receive the benefit of much, I mean, just a small, small amount of revenue during the third quarter attributed to this activity. Here's what happened. When we acquired the Litton Group in October, they were sitting in a plant in Morristown, New Jersey, that because of past ground contamination, the whole operation that was there, not the silicon carbide portion, but other things happening in that plant.

They had been told by the EPA they have to tear that plant down. We literally had no choice but to move to a new facility. If we'd wanted to stay in this old Litton facility we couldn't have. So we had to during November, December, January, locate, design, build out, a new facility for this group and get them moved. And Litton actually cut the power off in the building at certain times and made it very, very difficult to do any billable research in that facility.

So we got the building ready to go in mid-February. We moved the Litten Group from the old facility to this new Pinebrook, New Jersey facility. And then we had a, the issue of getting all the equipment up and running and, and starting up the facility. And I think only in the last two weeks of March did we actually start doing billable work against these contracts. One other reason why we found that very difficult to generate revenue was we, the process of moving these contracts isn't as easy as we made it sound.

We said we inherited them, or they got transferred over. That's a pretty complex process when you have multiple agencies of the government, and a company the size of Northrup Grummond, which owns Litten Systems, involved. It was a lot of paper work and a lot of different offices and so forth. So we really only got them transferred over, again, in about the last two weeks of March.

And Greg, maybe to answer your question we are, we do not have any, we do not have much significant man power additions for that group. But what Carl's referring to is that we'll be significantly ramping up the New Jersey operations, which have been in a little bit of a state of limbo for the last couple, couple months. Three, four months, maybe. Those operational expenses will now start to hit here in the fourth quarter. Probably anticipating those being offset by some of the contracts that have been transferred over to II VI.

In addition, we are, as I mentioned in my comments, we will be using some of our Pennsylvania group also to do billable work on those contracts.

OK, thanks for the clarification.

OK.

Thank you. Our next question comes from .

Hey guys, this is actually Brandon.

Morning Brandon.

If we look back historically, I guess you said that the after market has started to pick up prior to the larger systems to the industrial laser market.

Yes we have pointed that out before. That generally after market comes back before the OEM market.

OK, and do you see any visibility as to when the OEM market might come back, or you're not seeing that as of yet?

Yes, we're really not seeing that yet, Brandon. We are obviously in contact with the major laser system, OEM's throughout the world. There is probably a mixed reaction from all, if you would poll all those system builders there's probably a mixed reaction. But we are kind of unable to, to, to say that that business has improved.

As Carl mentioned in his comments, we really had not improved. The after market is where we are seeing a little bit of improvement.

And we looked at the actual numbers, if we judge that the fluctuations are, are kind of at the noise level, we find it very difficult to answer your question in a, really in a strong positive, or negative way. But, but with the after market rebounding by 25 percentage points in, in the third quarter over the second. We feel that that's, shall we say, statistically significant. It's, it's above the noise level. So that's why we felt like it was a good indicator for you.

Are there any historical trends as to, you know, the typical time that the OEM market might come back after the after market?

I would say three to six months.

OK, great. Thanks very much.

Thank you. We have a follow up question from Nathan Churchill.

You'll have to bear with me with the noise in the background if you can hear that. But anyway, I wanted to know if there was any pricing pressure that you're seeing on your industrial optics business, given the slow down?

Of course there's always a price competition. And I would say actually we've, over the years we've continued always to work very hard on cost reduction so that we could be full participants in the, in the market competition. And our consolidation has, that we described, by eliminating commercial production at our laser powered California location. And putting that into other II-VI factories around the world, where we can do it at lower costs is just another step along the track of generating lower costs on just a continuous basis.

So we're fully prepared to continue to compete on price when it's necessary. So I, but I actually can't say that it's any more than two years ago when the market was growing 20 percent a year. It just seems the same to me.

OK, then what are you seeing geographically as far as sales and order trends?

I think that all, with the decrease we showed in revenues, clearly all the major markets are down. Whether you look at Asia, geographically, Asia, North America, Europe. It seems like Europe, it took Europe a little longer to either, in reality, experience this down turn. Or maybe to recognize this down turn. I think North America probably was the first, and then Asia, and then Europe, in that order. Or recognizing the down turn.

And so then the order followed along in that fashion. But now I would say all three are, are experiencing it. Is there any one that looks like it might come back faster than the other? I can't see that that would be true. Now I'm speaking of the industrial segment of the market. Whether it's high powered lasers, or high powered steel two lasers, all that industrial product is experiencing this.

Now the military, we really don't do any military business of any substance outside of the U.S. I mean we have the right to export to NATO countries, but the Europeans really like to buy European. Now having said that, we do have some opportunities to sell zinc selenite and zinc sulfide raw materials to European finished optics manufacturers. So our opportunity in Europe is really to sell materials. In, in Asia our military activity is even less.

products, Craig, you might want to add to this. But I would say our opportunity is just about, it, it looks like a third, a third, a third to me. The Asians are very excited about this technology. And for instance, on this baggage and package inspection, and early threat detection, the Europeans seem to be actually ahead of the other two geographical markets in recognizing that this could be pretty handy equipment for, for these, I use the current term, more common environment.

Police force, first responders, soldiers. There's a lot of interest in Europe in portable equipment to do baggage package inspection, or even early threat detection. Such as the presence of nuclear materials in a, in a storage facility or, or a portal, or something like that. So I would say that to some of the German manufacturers, this kind of equipment are ahead of the rest of the world. So that's, that's the way I, I would describe the geographical spread, depending on what business you're looking at.

OK, excuse me if I'm not mistaken for the zinc selenite and zinc sulfide for material sales. Those, as I understood, were a pretty small percentage of sales. Are you increasing your focus on sending, selling the raw materials?

No, we're keeping that consistent, you are correct, Nathan, that that is a small percentage of sales. I think Carl was just kind of giving the overall over view of where there are areas, kind of military related, not in the U.S. And that is probably the only one small opportunity that we have. But we are keeping our mix of internal consumption versus external sales of material pretty much about the same.

OK, and lastly, I recall maybe a quarter or two back, you were trying to increase your focus, if I remember correctly, in the Asian markets for your after market optics. How is that going? Is it still an effort of yours?

We definitely are trying to, you know, expand our sales and marketing efforts, you know, away from the countries that we have, or are continuing to expand it beyond, I should say, Japan, and, and start to get into more of a dedicated sales and marketing effort in China. We do have an initiative for this upcoming fiscal year to expand our direct selling force in China, into mainland China and the Shanghai area to be specific.

But there are other areas of opportunity in Southeast Asia that we are continuing to develop. We do see that as an emerging, you know, opportunity that we can fulfill, or supply some optical components to system users in that area. So we are continuing to develop that and, and hopefully can get some market share gains from going into countries we haven't historically been into.

I would add, though, that again, there is a geographical difference in how people feel about the after market. And I'm saying how end users feel about buying the replacement optics. The U.S., somebody that's got a substantial requirement, maybe five to 25, 50 thousand dollars a year of these replacement optics they need to buy. If they could save 15, 20 percent by buying from someone like us, rather than from the OEM, they would do it in a minute.

As long as, you know, we were capable of supporting the product and so forth. So Americans are quite ready to, to buy a, to benefit from the economics of buying from someone other than the OEM if that's true. Europe is starting to wake up to the idea that they need to cut costs. And I think that that the European market is, is a little, is starting to be more aware that someone like ourselves, selling into the after market, can offer them benefits. I'd say the Asians are very, very prone to buy their replacement optics from the original equipment manufacturers.

And I think it's just going to take probably, I'm going to guess at least five years before the Asians develop any level of comfort of buying from kind of a third party in the after market.

OK. One last question I had. Laser power sales were down 15 percent in the third quarter. And that includes roughly 70 percent military. 70 percent of your military exposure comes from laser power, which is a pretty good sized piece. I was wondering how the military sales did for laster power during the quarter. Are they down?

They are, quarter over quarter, March quarter over the December quarter, they are pretty much flat. You are correct in saying that overall that breakout is about the laser power, it is about 70 percent military and 30 percent commercial, yes.

OK, so that would imply a rather dramatic drop, then, in the commercial business if that's only 30 percent. But across the overall .

criator. Yes that's right, and again, more specifically in the OEM area, as we're seeing a little bit of rebounding in the aftermarket, it's definitively the OEM business is still down and the commercial business.

OK. Did you get any guidance for your tax rate for the rest of the year?

We believe it will be in the 30 percent range. It's our effective rate for both the quarter and for the year to date was 30 percent. And we believe we'll be there for the, for the end of the fiscal year as well.

OK, thanks Carl, thanks Craig.

You're welcome.

Thank you. Once again, if you'd like to ask a question, please press star one on your touch tone phone. I'm showing no further questions at this time.

If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the fourth quarter in the fiscal year ending June 30th, 2002, is currently scheduled for after the close of the market on Wednesday, August the 7th, 2002, with an investor teleconference call to be conducted the following day. Thursday, August the 8th, 2002, at 10 AM. Thank you very much.

Thank you. This conference call is now concluded, you may disconnect at this time.