II-VI Inc (IIVI) 2004 Q1 法說會逐字稿

Good morning. My name is Wade and I will be your conference facilitator today. At this time, I would like to welcome everyone to the II-VI, Inc., first quarter conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you.

Mr. Creaturo, you may begin your conference.

Thank you, Wade, and welcome to the first quarter fiscal 2004 II-VI, Inc., investor teleconference. As a reminder, this teleconference is being recorded on Thursday, October 23rd, 2003.

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 first quarter financial results and a business and operational review. Following these prepared comments, we will have a question-and-answer session.

Total company bookings for the quarter ended September 30th, 2003, remained relatively unchanged at $34.6m as compared to the same quarter last year. Infrared optics bookings increased 7%. Near-infrared optics bookings decreased 33% and military infrared optics bookings increased 33% as compared to the same quarter last year. In addition, the company recorded $1.2m of eV Products and $300,000 of silicon carbide bookings from the Wide Bandgap Materials Group during the quarter.

Bookings are defined as customer orders received that are expected to be converted into revenues during the next 12 months. Bookings are adjusted if changes in customer demand or production schedules move a delivery schedule out past 12 months.

Total company revenues of $34.1m for the quarter increased 8% as compared to the same quarter last year and represented a record quarter for the company, surpassing the $32.9m in revenue recorded during the quarter ended June 30th, 2003.

Infrared optics revenues for the just-completed quarter increased 8%. Near-infrared optics revenues increased 9% and military infrared optics revenues decreased slightly as compared to the same quarter last year. In addition, the company recorded $1.8m of eV Products revenues and $800,000 of silicon carbide revenues from the Wide Bandgap Materials Group during the quarter.

Gross margin on manufactured products as a percentage of sales for the quarter increased by approximately 5.5 percentage points from a year ago. The increased sales volume for the quarter as compared to the prior year impacted gross margins in a favorable manner. Also, the company has continued to increase the amount of manufacturing done at its Singapore and China facilities and has recently expanded the China facility for further manufacturing growth in that country. The gross margin improvements for the quarter also reflect a variety of yield improvements and cost reduction programs occurring at our various facilities.

Internal research and development expense for the quarter was $1,087,000 and was higher than the same quarter last year but was comparable as a percentage of revenues. The higher expense is primarily the result of lower external contract support for the company's efforts in silicon carbide. This, in turn, requires more funding to be provided by the company. In addition to efforts in silicon carbide, the company's internal research and development expense reflects efforts focused on corporate research and development activities and the research and development activities of eV Products.

Selling, general and administrative expense for the quarter, as a percentage of revenue, was 24.1% as compared to 22.8% of revenues in the same quarter last year. The company recorded higher compensation expense as compared to the same quarter last year for its worldwide, profit-driven bonus programs. In addition, the company incurred legal and professional expenses during the quarter to defend and protect its trade secrets and intellectual property.

Interest expense for the quarter was $134,000 or approximately one-half of the interest expense in the same quarter last year. The majority of the company's debt has LIBOR-based interest rates. These interest rates continue to remain low and the company's weighted average interest rate currently is approximately 2.4%. The lower interest rate expense also reflects the lower overall debt levels of the company that have been reduced by over $10m during the last 12 months.

Other income for the quarter of $91,000 reflects several factors, including foreign currency income, interest income, royalty income and other income items. Other income was partially offset by the 25% minority interest in II-VI Lot GMBH, our sales and marketing subsidiary in Germany, which is not owned by II-VI, and other expense items.

The effective tax rate for the quarter was 33.5%. The increase in the effective tax rate as compared to the effective tax rate in effect for the previous year is the result of an expected shift in the mix of U.S. and international earnings as our U.S. operations are expected to increase their pool of earnings as compared to last year. This incremental U.S.-sourced income will be taxed at the full U.S. and state federal rates.

One situation that we are watching closely is proposed new tax legislation benefiting international manufacturing companies such as II-VI. For the last several years, II-VI has benefited from the extra-territorial income or ETI or, formerly, the Foreign Sales Corporation or FSC regime. Specifically, these programs have lowered II-VI's effective tax rate by approximately 6% over the last four years.

The ETI program is set to expire on December 31, 2003, and while there are several bills in Congress being studied, there has been no replacement identified to date. As this situation becomes clear in the next few quarters, we will update our effective tax rate accordingly.

Despite the change in our tax rates, the company still benefits from lower tax rates on its China and Singapore operations where the tax rates are currently 7-1/2% and 22%, respectively.

Looking at earnings before income taxes, the results for the quarter were nearly $4.7m or 60% higher than the same quarter last year.

Net earnings for the quarter were $3,114,000 or 21 cents per diluted share. These results compare with net earnings in last year's first quarter of $2,206,000 or 15 cents per diluted share.

The company's backlog at September 30th, 2003, was approximately $58m, which was up slightly from the June 30th, 2003, levels. The components of this backlog include infrared optics at $22.5m, near-infrared optics at $8.5m, military infrared optics at $20m, eV Products at $6.5m and silicon carbide at $700,000. Backlog is defined as bookings that have not been converted into revenue by the end of the reporting period.

Our worldwide employment at September 30th, 2003, was 1109 employees. This number compares with worldwide employment at June 30th, 2003, of 1094 employees.

During the quarter the company repaid $1m under its credit facility. The company's total debt at September 30th, 2003, is $22.9m, which was down over 30% from $33.2m just one year ago.

This concludes the financial review and Carl will now give a business and operational review.

Thank you, Craig, and thanks to each investor that is participating in today's call or listens in over the next few days.

Before I review the first quarter highlights by business unit, please allow me to say a few words about the corporation as a whole. II-VI views itself as a growth company and, as such, remains absolutely committed to continuously improving top and bottom line results. From our board of director and officer groups to every sales and engineering activity to our employees in every manufacturing facility worldwide, II-VI's organization and culture are oriented toward identifying best-growth opportunities, setting growth targets and then planning and executing for growth.

During the just-past first quarter we grew our revenues by 8% and our earnings per share by 40%. I respect and appreciate the efforts expended by all employees in achieving these results, which are positive, but on the revenue side, specifically, not up to the II-VI standard. I say this because our investors, even in a less-than-robust global economy, expect excellent public companies to generate top and bottom line growth of more than 15%. Since all of us want II-VI to be an excellent public company, we have work to do.

Now let's look closer at the first quarter results. In our infrared optics business unit, first quarter revenues reached an all-time high of $19.9m, up 8% from the same quarter last year and 11% from the immediately prior quarter. Bookings were up 7% from the same quarter last year and 24% sequentially.

Activity with industrial laser OEMs in the U.S. and Japan was strong throughout the quarter. However, with the exception of a $3.8m annual blanket order from Distronic, activity with OEMs in Europe was weak due to the expected European vacation period during July and August.

The star application for our infrared optics business continues to be laser marking where we believe the market is growing at between 30% and 40% per year. We have captured all or a majority share of the business with the leading system builders, Kaence in Japan and Laser Ink Markem in the U.S. and the leading laser head builders, ThinRad and Coherent DEOS in the U.S. and Rofe and Zenar in the United Kingdom. We are also making a large effort to capture a majority share at Hans Laser and Woo Han Chupien Laser, the leading marking laser head systems and builders-- laser head and system builders in China.

Innovation continues to accelerate the penetration by laser marking into a market previously dominated by ink jet printing. Beyond the idea of date coding by ablating or engraving the packaging materials, a new color-change process has recently entered the market. A color-change patch is printed onto the packaging material at the same time that other information is being printed. This heat-sensitive patch material later changes color when a low-power carbon dioxide laser writes on the surface of the package. The power required is but a fraction of that required for ablation or engraving and this enables very fast writing speeds. The patch can be applied to a wide range of packaging materials, including metals, glasses, plastics and otherwise non-laser-sensitive coatings and materials.

In summary, we believe that CO2 laser-based material processing activity is picking up because the installed base is being utilized for more turns per week and because the rate of new installations is beginning to grow again.

In our VLOC near-infrared laser optics and components business unit, first quarter bookings were down 33% compared to the first quarter of fiscal 2003. This decrease was entirely due to the timing of a large R&D contract booked during last year's first quarter. Commercial bookings actually increased by 5% quarter-over-quarter. Overall revenues were up 9% over last year's first quarter and commercial revenues were up 19%.

The increase in commercial bookings for the quarter was driven by growth in our medical and military markets. The military bookings were paced by the Lockheed Martin Advanced Targeting Pod or ATP program.

Although we have not yet felt a recovery in the semiconductor market, we were able to make market share gains with our optics products for this segment.

We look forward to sustained growth in our VLOC military and medical-related business. Additionally, we anticipate increased business within the industrial and semiconductor segments as these markets recover.

VLOC continues to work with several of the key multi-kilowatt YAG laser manufacturers with qualification trials ongoing for both materials and optics.

A new and exciting future business opportunity for VLOC will emerge from our purchase of the UV filter products line from Coherent Associates-- from the Coherent Associates Division of-- excuse me, from the Crystal Associates Division of Coherent during the first quarter. These filters are key components in a number of missile plume launch detection systems. This purchase has added new capabilities and materials to our existing product base. We anticipate additional bookings for these materials over the next two quarters, with production ramping up during the third quarter of this fiscal year.

The military market addressed by our Exotic Electro-Optics subsidiary remains strong. Inquiries for the repair and replacement of hardware in use during the war with Iraq and the development of more advanced weapons will provide a number of solid opportunities going forward.

During the quarter just completed bookings were up nicely, about 33%, as compared to the previous quarter and to the first quarter of last year. However, it's important to look at the mix of orders to really understand the story.

Our core military first quarter bookings exceeded $5m. We expect this rate to continue for the rest of the year, which would result in a 10% to 15% increase in core military bookings.

Bookings of $700,000 for sapphire products were below our expectations for the quarter as we anticipated an order from Northrop Grumman that did not materialize. A previous order with Northrop Grumman was de-booked during the fourth quarter of last fiscal year.

As reported in the last conference call, Northrop Grumman decided to compete this order, indicating that dual sources would be needed. To date, we have provided an initial quote to Northrop Grumman, responded to follow-up questions and submitted a best final offer. Northrop Grumman will advise us on the outcome of this bidding process over the next several weeks.

Lockheed Martin's ATP project is driving the other major sapphire window opportunity. We continue to deliver on our current ATP order and it appears that will be a nice opportunity to book additional units with Lockheed Martin in the near future.

Bookings for our large optics coating facility or LOCF activity totaled less than $50,000 during the first quarter. We have decided to exit this product line and are working with our customer to remove the government-owned LOCF coating chamber. Most of the employees working in this activity have been redeployed to our core businesses. Our target is to have the LOCF chamber out of our building by the end of the current quarter.

We know that the 4000 square feet of manufacturing space that this will create can be better utilized by our core product lines. We are currently submitting a proposal to our customer for the cost associated with this effort.

Revenues for Exotic Electro-Optics during the first quarter were nearly $5.7m, down from the fourth quarter of last year by $900,000. This shortfall was totally attributable to the large optics coating facility. Although this significantly impacts the current quarter, this product offering was not well suited to our business. The demand for LOCF products is very sporadic, there are significant costs associated with maintaining such an operation and the key business metrics such as cash flow and profitability are poor.

Revenues in our core military business increased from the previous quarter but were short of revenues from a year ago by about 7%. Core products such as Javelin missile domes, Bradley Fighting Vehicle windows and optical components for the Kiowa helicopter mast-mounted sight make up a significant portion of these revenues.

Production of the sapphire windows continues to improve. During the past quarter we've maintained a production rate for sapphire panels going through our grinding and polishing operation that is capable of supplying more than six ATP targeting shrouds per month.

Although other production challenges associated with thin-film coatings and customer-supplied materials resulted in revenue below expectations, we are optimistic that shipments will consistently improve throughout the remainder of the year.

During the past quarter we have made solid progress in recruiting key technical and leadership talent at Exotic Electro-Optics and employment is up 15% from a year ago.

In our other business segment, eV Products showed improvement over the fourth quarter of last year with an increase in revenues of over 60%. Higher sales, driven by the shipment of a portion of an order for special cadmium-zinc- telluride-based handheld spectrometers for homeland security applications, increased demand from GE Lunar for bone mineral densitometer detectors, and increased contract and research-- contract research and development billings.

During the quarter, eV was awarded the first year of an anticipated three-year research and development contract from the United States Army Research, Development and Engineering Command. This first-year award is for $760,000. The total contract is expected to exceed $4m over the next three years. As previously reported, this contract is focused on improving the cadmium-zinc-telluride material and detector devices that are being designed into next-generation, state-of-the-art automated explosive detection systems.

Despite higher shipment during the first quarter and planned higher shipments in the current quarter, we continue to experience slow development and deployment of new products by our existing and target customers in medical and industrial applications. To offset the current weakness in new products, we are maintaining our operational cost structure at as low a level as appropriate.

At the same time, we are continuing to focus our marketing and selling activities on certain targeted applications in the industrial, medical and homeland security market segments. We believe that these activities, coupled with a slowly improving economy, will begin to positively impact bookings and sales in the third and fourth quarters of this fiscal year and have continuing positive effects in fiscal 2005.

Also in the other business segment, our Wide Bandgap Materials or WBG Group has demonstrated significant growth in wafer sales consistent with fiscal 2004 plan revenues. First quarter wafer revenues were double those of last year's fourth quarter and second quarter expectations are for continued growth in both bookings and sales.

The bookings backlog for wafer sales remains small, consistent with orders being booked and shipped in the same month. The customer base continues to expand-- to increase as we expand capacity and marketing activities.

We began shipping 3-inch diameter semi-insulating wafers in the first quarter and expect 3-inch sales to be a significant portion of our revenue in the current quarter. Technology development efforts continue to move forward at a rapid pace. Significant progress has been achieved in the areas of material purity, defect density reduction and diameter expansion.

Development efforts have been accelerated for the introduction of new products, including 4H poly type and 4-inch diameter silicon carbide wafers. We expect to begin customer sampling of these products later this fiscal year.

Manufacturing scale-up efforts include a successful transfer of our best-in-industry CMP polishing process to the manufacturing group in Saxonburg, Pennsylvania. This ties in with our ongoing goal to unify and standardize all manufacturing processes at our New Jersey and Pennsylvania facilities. We are also in the process of implementing an ISO-9000 quality system at our New Jersey facility.

Additional crystal growth furnaces have been delivered in both New Jersey and Pennsylvania and will be installed and transitioned into manufacturing during the current quarter. These new furnaces will approximately double our production capacity.

Construction on our new wafer fabrication and polishing facility in Saxonburg, Pennsylvania, has progressed well with completion and initial manufacturing implementation scheduled for the current quarter.

We have formed two strategic partnerships that will provide epitaxial growth of silicon carbide homoepitaxy and gallium nitride heteroepitaxy to the wide bandgap semiconductor industry. These partnerships are with SemiSouth Laboratories and Sensor Electronic Technology or SET, respectively.

We believe that close collaboration with SemiSouth and SET will enable us to make rapid progress in technology development and ultimately lead to lower manufacturing costs. Feedback from the epitaxial material growth and device work provided by SemiSouth and SET will help us to rapidly improve the material quality of our silicon carbide wafers.

In summary, continued success in technology development and manufacturing scale-up efforts have resulted in significant increases in quarterly sales, several joint technology development and marketing agreements with current and new customers and interest from several larger customers regarding the development of II-VI as their primary substrate supplier.

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 factor section of our Form 10-K for the fiscal year ended June 30th, 2003.

Wade, we are now ready for the first question.

At this time I would like to remind everyone in order to ask a question, please press star and then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster.

Your first question comes from Pierre Maccagno with Needham Company.

Hi, Carl and Craig. I had a question on the gross margin. Sequentially they dropped. Could you explain how that came about?

The gross margin for the first quarter reflects a little bit of ramping up of our IR optics group. As we had talked about in previous quarters, we need to take some time to increase capacity in certain areas, specifically in the IR optics business segment, and we have started doing that during this quarter.

During this quarter, we have made investments in expanding diamond turning operations, expanding coating operations and starting to see some of those costs get into that business unit. So one of the reasons that it's down a little bit sequentially is because of the ramping up or the recalibration that's needed for, specifically, the IR optics group.

OK and going forward do you-- I mean, like next quarter did you expect the gross margins to start ramping up again or what expectations do you have?

I think the expectations would be that they would be pretty similar to the just-completed first quarter. Again, we will continue to make expansions throughout the entire year, specifically in the infrared optics group and that will impact margins, but I think they will-- going forward, the rest of the fiscal year, margins shouldn't be drastically different from the just-completed first quarter.

And SG&A also increased quite a bit sequentially. Is that something that also you expect to continue at that level?

We don't expect it'll continue as high as it was at just a little bit over 24% of revenues. We did have higher compensation expense because of the overall profits of the company up, but the bigger piece there was the legal and professional expenses that we needed to incur to protect some of our trade secrets and intellectual property.

OK, so that's just a one-time quarter and then you go back to where you were?

It's something that may be with us during the rest of the fiscal year, but it shouldn't be near the magnitude as it was and maybe I should just give a little background as to-- just explain my comments a little bit further.

II-VI has had a long history of protecting its trade secrets and its intellectual property. As a company, our trade secrets and intellectual properties are really one of the cornerstones of our crystal growth and manufacturing processes. In the past we've defended against what we believe was wrongful use of trade secrets or intellectual property, even when it did not, maybe, appear on the surface to make financial sense. At II-VI, we believe there is no such thing as a minor theft when it comes to trade secrets or intellectual property.

Without going into a lot of specifics, during the just-completed quarter, II-VI was the plaintiff in a lawsuit that was tried in Federal District Court of Western Pennsylvania. This lawsuit was the culmination of several years of pursuing what we believe was a wrongful use of our trade secrets relating to the crystal growth process of our eV Products division. The expenses for the trial, including legal fees and expert witnesses were more than $700,000 during the just-completed quarter.

II-VI received a jury verdict in its favor regarding this lawsuit and we are now in post-trial motion stages. We should have better information regarding the status of this lawsuit and any potential financial impact to II-VI in the next few weeks, at which time we will either have a press release or include more details in our upcoming 10-Q.

And even though the details of the court case are a matter of public record, what I've just stated is about all we'd like to comment on today and I think that, hopefully, gives some better clarification as to the magnitude of that situation.

And R&D also dropped quite a bit. Do you think that's-- the reason for that and will that continue at that level?

I think it will continue around the first quarter level. The just-completed quarter, I think, as far as margins and spending in certain areas, maybe exclusive of what we just talked about, the incremental spending in SG&A, we're expecting those to be pretty similar for the rest of the fiscal year.

OK. And tax going forward is going to be like 33.5%?

Yeah. We currently believe it's-- we always-- whatever the rate that we book, we believe that's going to be the rate for the fiscal year. We always look out for the entire fiscal year. I articulated a couple of the things that are changing. We finished up last year with a tax rate of about 28% and our first look at it here for this year is where we ended up for the first quarter and we will update that each quarter as we get more actual results in and better information is available.

And, as I mentioned, there's a little bit of uncertainty as far as some of these tax regulations that we have so enjoyed over the last few years. That is a big question and so there's a couple question marks on our long-range view of exactly what's going to happen for the effective tax rate. Hopefully, those will clear up here in the next few months.

Your-- this is because a larger percent of your manufacturing is in the U.S. versus abroad, correct?

Well, it's not necessarily that there's more manufacturing, per se, in the U.S. It's more specific and on the segment information that was included in the press release you can just see that in our other segment, which is all U.S.-sourced operations the profitability of both our eV Products group and also our silicon carbide group has improved and has improved significantly over the last few quarters and specifically year-over-year.

So we're getting a larger pool of U.S. earnings with about the same amount or a slightly expanding amount of international operations. We still get the benefit from being in those two low-tax manufacturing locations in China and in Singapore, but the extra incremental U.S.-sourced income is offsetting that.

Thank you very much.

Your next question comes from Dave Kang with Roth Capital.

Thank you. Good morning.

Good morning.

A couple of questions. First of all, what is the expected revenue contribution from the Coherent unit? And the second question is regarding the semiconductor market. What is the current run rate of sales from the semiconductor market and how big could this be once the semiconductor industry goes through a upturn? And who are some of the key customers in the semiconductor market? Thank you.

I'll take a shot at the Coherent, as far as the UV filter business that Carl mentioned. We will, in the next few quarters, be transitioning that business. Some of that work will be housed here at our Saxonburg Advanced Material Development Center, but the ultimate goal will be that it will be integrated and be eventually moved to our near-infrared optics facility in Florida.

We, over the next few quarters, will probably not see much revenue. In the third and fourth quarter, we'll start to see some revenue. So it's very, very small for this fiscal year, FY-04, but going forward we do think that the run rate will be in the $2m and higher range each year, going forward.

I'd just add to that, of course, the initial opportunity is for these missile plume detection systems that would mount on military aircraft to protect military platforms. And typically what happens is you put four of these detectors on an aircraft and you look in all directions and try to detect the presence of any missile that's been launched with that air platform as a target.

And unfortunately, we have to think not only of military aircraft but, potentially, of commercial aircraft to protect them from this same kind of a threat. Now one of the attractions to II-VI for this UV filter materials business was the fact that there is-- in the future there is the possibility that after the products are proved out with the military application that two-three years down the road there would be a potential commercial application. And, in fact, when you look at the projections by our customers, it would really be a larger market than the one Craig just mentioned for the military.

So that's not here-and-now, but it is something that I thought you should know about that was an attraction to us when Coherent decided, actually, to get out of this particular business.

There was a second question, Craig.

Semiconductor?

Why don't you start with that and I'll mention a few customers by name.

Specifically for our near-infrared business over the past six to eight quarters as we have talked about, I think, on previous calls, that group, as the semiconductor business has been down has done a great job of maintaining the sales level and actually increasing profitability by gravitating a little bit toward the defense and military markets.

Historically, or a couple years ago, semiconductor-related business for our near-infrared optics group was maybe in the 30% to 35% range. It is probably half that right now and that is something that, as Carl was alluding to in his comments, we haven't seen a, quote, full recovery there yet, but we are seeing some good signs in that market.

Carl, do you want to add anything?

Yeah, the products that we sell into that market are used in optical instruments and optical tools for the semiconductor industry and particularly our wave plates and other polarization optics and some of our special crystals that are either laser-gain material-- laser-gain material crystals or non-linear optical materials are of great utilization to people like Zygo, Coherent and Spectra Physics that make some of these optical instruments that are used by semiconductor manufacturers in their processing.

OK. Regarding your revenue guidance for the current quarter, in terms of revenue mix between IR, NIR and so on, should we expect similar type of mix or do you expect-- or should we expect some mix shift from one segment to another? Thank you.

The mix of revenues for the upcoming quarters should be pretty consistent with the just-completed first quarter.

OK. And just lastly on the housekeeping items, can I get depreciation and amortization and what was cap ex for last quarter and budget for fiscal '04? Thank you.

Depreciation and amortization for the just-completed quarter was $2,358,000 and cap ex for-- cash paid for capital expenditures this quarter, $2,838,000. Last year first quarter was $1,766,000.

Thank you.

Your next question comes from Christopher Versace with FBR.

Hi, guys. Congratulations on the quarter.

Thanks.

Just a couple questions. I noticed, Carl and Craig, that a little bit after June you guys signed a new contract for raw materials. Can you talk about the impact that's having on pricing?

Chris, give us a little bit more background on your question.

I think if you look in the 10-K that you guys filed it says you have a new long-lead-time, I think it's 54-month, contract for certain raw materials and I'm just wondering if you're seeing a benefit of any-- you know, if pricing is a little more favorable now than it had been last year for those materials?

OK. That really is-- that is really related to our infrared optics business here. That is one of our critical materials for the growth. It's one of the gases, hydrogen selenide gas it's what's being talked about there. And that really was just the culmination of completing some negotiations and getting into some longer-term pricing.

We have had-- we have historically had contracts with the same supplier for multi-year deliveries. Those had just expired over the period of time and it was just time this past-- this past year to enter into a longer-term arrangement.

We think it was a good arrangement for us. It gets us locked into being one of the few companies they make this specific gas for. But at the same time, it's also-- it gives us the flexibility to continue to make more and more of our own gas here at this facility, which we continue to do on an ever-increasing basis.

OK, but just so I'm clear, was there any positive impact, you know, year-over-year in terms of the raw material pricing that you saw from that contract?

No. The pricing that was entered into in that agreement that you're talking about Chris was not much different than what we had experienced before.

Carl, did you want to add?

Only that there has been some shift in that area over the past couple of years as we have brought on significant capacity to produce more of that raw material ourselves and I think what this agreement did was to stabilize that situation, make it clear to the external supplier and to ourselves that we really do intend to have and utilize two sources of supply going forward and we are not going to rely totally on ourselves. The outside supplier is going to have a substantial stake in this and a substantial fraction of our utilization and we just needed to clear all that up and set the security for that-- to make those lines of supply secure over that 54-month period.

OK. And then I noticed with a question earlier about the gross margins that they were down a little bit and I just wanted to try and understand something. You said they were down at IR yet year-over-year the group posted, you know, tremendous operating margin expansion and even though SG&A was up, you know, year-over-year, as well.

So I'm just trying to understand what's going on with the margins there and since you've re-segmented the group, could you give us an idea of where IR operating margins have kind of peaked out in the past?

I think when-- maybe to answer the second part of your question, in general terms we historically have said that the operating margins of the infrared optics group are the highest in the company and really because it has two significant-- it takes advantage of two significant-- it has two significant advantages, let me say it that way. One is the raw material production, specifically with zinc selenide or zinc-based products. The second is the offshore manufacturing in Singapore and in China.

So historically, to answer your question, Chris, the operating margins of the infrared optics group have been historically a little bit higher than we are experiencing right now. What we are starting to do is to recalibrate that group, expand, add some additional people because of the long lead times in the training for some of the opticians and the coating folks that we would hire, starting to do some of that addition. That is starting to impact the margins.

Maybe-- I just want to make sure we're clear. We're not seeing any drastic changes, pricing-wise, in the infrared optics business. It is really more of a-- just a year for us or a period of time for us to increase our capacity that's starting to get a little bit thin in certain areas.

Fair. OK. And then the military business, the operating margins, you had a modest operating profit last year. This quarter you posted an operating loss. Can you just kind of go through that? And I apologize for asking that, because the call kind of cut out for a few minutes there.

OK. The-- we continue in the military infrared optics business to, as Carl was talking about, really get away from some product lines as Carl was mentioning, getting-- making the decision to exit the large optics coating facility.

We have experienced some challenges over the last few quarters. It was pretty significant in the quarter ended June 30th, 2003, with one specific fixed-price contract. We're fortunate that we did not have any significant changes to that contract that hit the expense line for the corporation for this quarter.

But in general terms we are still evolving that business into -- getting into the sapphire business and there's still an investment that's being made by II-VI and by, specifically, Exotic Electro-Optics, in that product line. We are starting to ramp that production up, as Carl was mentioning in his prepared comments, and that's taking somewhat of an investment for us.

We're fortunate that the core military product offering of Exotic is doing very well and we're fortunate to have that base, but as we expand into the sapphire, we are needing to invest as we increase our capabilities and capacity there.

OK.

Chris, I'd like to add relative to the Exotic Electro-Optics business and some of the costs and leadership there, we have not been feeling that we had the total leadership team that we needed there at Exotic and we've made some key hires during this past quarter and specifically we've hired a director of program management, an engineering manager, a coated-- thin-film coating operations manager and an optical fabrication engineer specifically for the sapphire activity and these were key hires and we will continue to look at that operation and decide where it is we need these key leadership and technical people so that we can really improve the operation there and have an opportunity, then, to grow further.

I think a couple of quarters ago I might have made a comment about how growth really wasn't taking place there at Exotic at a rate that one might expect because of overall military activity and increased spending in the United States and the reason that that wasn't happening is we, frankly, weren't in a position to handle more business. We need to-- we need to continue to improve the operations there so that we can actually take on some of these growth opportunities that really are out there. We just-- we just aren't prepared to take them on until we solve some of the operating problems and strengthen our leadership.

So we're in the midst of that and I think that couples to some of Craig's comments.

Great. Thanks, Carl. Thanks, Craig.

Thank you.

Your next question comes from Jason Sam with Seidler.

Good morning, guys.

Hi, Jason.

Hey, just a few questions. Let's start with the current capacity usage rate for all the different business units and a follow-up to that question is, given the current capacity expansion effort at the IR unit, when would you expect to see leverage out of that?

As far as the utilization, I think we are in the 80% to 85% range in general terms in the IR optics group, probably in a similar range for the near-infrared optics group and slightly below that for the military, maybe, in the 80% range, somewhere in that range. We still have a fair amount of head room in the eV Products Division. They did a nice job this past quarter, but still have some room to grow there, so maybe about 70% to 75% utilized there.

And in silicon carbide we're kind of in the midst-- we're kind of in an interesting period. It's kind of hard to gauge the utilization. As Carl was mentioning, we're in the process of doubling the furnace capacity. I think it's kind of hard to gauge that utilization just quite yet.

OK. And the capacity leverage from IR? When do you expect to see that, you know, affecting-- positively affecting the gross margin line?

I think it-- you know, it has the potential to positively impact it, I'd say, toward the latter half of this year and definitely going into FY-05. We-- you know, again, we're making-- we just recognized it's time to make the investment there. We continue to get very good productivity out of that group as a whole, but we need to do some additions here in the next few quarters and may see-- may start to see some of the benefits as early as the end of this fiscal year, but definitely in FY-05.

OK, great. Carl, in terms of the $3m blanket order for the quarter, that's for the whole year, right?

This is the order from Distronic, the $3.8m order. It is a blanket order. We-- it's for certain parts and it is our judgment as to-- that it is the 12-month demand for those parts. However, there could be another half million to a million dollars worth of business that will come from that same customer because in their blanket order they can't foresee exactly all the things that are going to happen and usually what happens is that that gets supplemented by some spot orders or a smaller blanket addition as their visibility improves throughout the year.

So we think that that's the bulk of it, but I don't want to say that's all of it. I think there could be another as much as a million dollars for that account that will come through in the six to nine months.

OK. You know, any additional blanket orders in the works that you could talk about?

Well, it was an interesting quarter because there-- aside from that particular one there wasn't anything big that happened in the IR group, yet the bookings for the quarter were pretty strong. So, yes, there are additional-- I don't prefer to name names, but there's a little bit more of that activity coming up in the next quarter or two.

OK. So now the-- you know, outside of the vacation period in Europe, you know, overall booking in IR was strong. Is that primarily OEM or after-market?

Well, it's both. I would say that even though July and August were slow, boy, Germany really has come on strong in September and October. So, you know, it's not that things have slowed down there with the major producers, the major OEMs in Europe, but you've got to remember that a big portion of the orders that we receive from OEMs are supporting their activity in the after-market.

And we've-- we know that the installed base continues to grow and that some of our products goes into the new lasers going into new installations, but our estimate is that somewhere around-- I believe, Craig, it's 85% of all of the optics that are producing and selling either directly or through the OEMs are finding their way into the after-market. That's a big consumables part for the business and we really do think it's in the range of 85% at this time.

And just to follow up on that a little bit, I think we-- you know, one of the side benefits from acquiring the majority ownership of our distributor in Germany last year was that it gets us one step closer to the end customer and I think we are, as an organization, really starting to realize the large majority -- and, as Carl's saying the vast majority -- of the optics are going into the after-market. And, again, one of the side benefits of doing that transaction -- that wasn't one of the reasons to do it -- but we're getting better information and that helps us be a better organization, as well.

OK. Now just a macro question. You know, do you guys have any insight into the updated market share for the IR market for you guys?

We still think it's in the range of something in the range of 60%-65%. Something like that is about where we feel it is. We are-- one thing there, we believe that the information we have from Europe and North America is real good. We feel we have real good information from Japan, but I want to say that one of our challenges in the next year or two is to truly understand where is the domestic Chinese market right now and what is going to happen there.

There is so much manufacturing startup activity in China right now and lasers are going to end up being used there. They're very interested in using the most modern tools. You might think, well, they'll replace capital with labor, but they're embracing a lot of technology over there. An example, for instance, is marking. Laser marking is coming on very strong in China and I don't think that we have as good information there as we probably have in the other markets.

Would you tend to agree with that, Craig, that we have a little homework to do over in China to make sure we understand what is-- what's the base and what's the dynamic of that market? I think the dynamic there will be a little harder to track because it's happening very rapidly. So we have some work to do there and we're about doing it.

Which of your customers are the leaders in China right now as far as laser systems are concerned?

Well, right now, the major suppliers from Europe, in particular, have recognized the importance of the China market so, you know, Trump, for instance, Rofe and Zenar, those two in particular have decided that they better be very active in China and so they're there, but there's some internal China capacity that's developing. I mentioned Hans Laser and Woo Han Chupien. Those are just two of about 10 laser manufacturers, both YAG and CO2 in China that we're going to watch real carefully and be very active with. We want to be their supplier.

OK. Would the eV Products-- Carl, can you comment a little bit more on the handheld scanner that you ship into the homeland security market? Who's it with? Any thoughts on, you know, what type of growth you could see and, you know, what type of ASPs are you getting for that particular product?

That market of these handheld devices, handheld monitoring devices, has two or three tiers to it and this product was the very high-end product for that market that has a lot of capability built into it, a lot of isotope identification capability and data logging and data transmission capability. I am not free to say which customers that is, but it was a very high-end product and I'm thinking the selling price is around $16,000 apiece. So that indicates a very high end for us. And in that case, we built the entire product to their design.

I will tell you that the-- kind of the brains of that particular product-- it was adapted to-- the detector and the detector electronics and the front-end signal processing was all built into a box that we made, but then on to that box would attach a Palm Pilot that really did-- had the computing capacity and the communication capacity with it. So it's an interesting product that really uses an off-the-shelf Palm Pilot as part of its function.

The other tiers are-- let's go to the low end, the low side. I think the average selling price for the low-side product in the market place might be $1500-$2000-$2500 and we are not making the whole product in that case. We're making the detector front end and the front end electronics. I'm not sure what our part of that is, but it's something in the range of maybe, in some cases, $500-$600-$700.

And then you have a middle range-- a middle range product that has some intermediate amount of capability and there an average selling price might be $5000-$6000 for our customer and our content there might be $1500 to $2000.

Oh, OK. Now would-- in terms of profit margins, is there a huge difference between, you know, making the end product versus just doing the modules?

Well, I think the reason that we started to do-- build in the electronics capability and offer this as a service to our customers was to accelerate the rate at which they could put products on the market. In other words, we felt like if we could kind of provide one-stop shopping to them they could get not only the detectors but the front-end electronics or the entire component. We're very flexible about that. We'll make-- whatever stage of integration that they prefer, we'll do, including, you know, basically building a private label part for them and putting their logo on it and shipping it out the door here, fully tested and ready to go to market.

I think we have found that there is a nice margin to be added to the product if we integrate forwards. So I think it's both of those things and we welcome the opportunity to provide the service and then go at the actual execution of the manufacturing such that it does really enhance not only our top line but our gross margins, as well.

OK. So, Carl, of the $6.5m in eV backlog, would you be able to give us a sense of the breakout between medical and homeland security?

I don't believe I can accurately break that out for you.

I guess we can answer, probably, more broadly, Jason, and say I think the majority is still medical, but, as Carl was mentioning, the homeland security and other general detection is starting to eat away at that percentage. Again, medical being the big portion of it, but there's an increasingly larger share that is for general detection and homeland security-type applications.

And not to let this point go by, I think the contract backlog-- if you look year-over-year, the contract backlog is now at about $1.2m and a year ago it was probably close to zero.

That's right. That's correct.

So out of that backlog you have to take-- and that's going to be very steady business for us month after month after month and that's good because it gives us a little bit of a more stable platform to stand on than we had a year ago. So then you've got the medical and the homeland security and industrial that are carving up something like $5.3m in backlog.

OK, great. I have a few more, but I'll jump back in the queue. I'll let other people take a shot. Thanks.

You're welcome.

Your next question comes from Tim Slevin with Parker/Hunter.

Good morning.

Good morning, Tim.

Just a couple of questions. Following up, first really, in terms of cash flow from operations, contrasting this quarter versus last quarter or the quarter a year ago?

We tried to give a few pieces on that, Tim, as far as the cash from operations-- or excuse me, the depreciation/amortization numbers, et cetera. It will be-- actually, it will be down and that is primarily because of the payout this past-- this past year versus a year ago for our profit-driven bonus programs, profit sharing for our employees, et cetera, was much higher and historically the first quarter is usually the lowest operating cash flow quarter. So I can just proportionally tell you it won't be as much as last year and that's probably about all I can say.

OK. In terms of the capital expenditures, now, you've had a couple of-- you dropped down to pretty low levels, below $2m for a number of quarters and now have kind of cranked that up to a run rate around $3m. Is that more typical, you think, for the year?

Yeah, I think that for the year-- the quarter that we just completed we will have quarters closer to that range or even higher than that range versus a less-than-$2m quarter, as you mentioned. Because in the last couple of years, FY-03 and FY-02, I think we averaged less than $2m a quarter and we will definitely be averaging more than that and maybe even higher than what we averaged or what we had this past quarter.

So I think overall for FY-04 we are thinking somewhere in the range of $13m to $15m capital spending, somewhere in that general range. And so that's going to be up significantly from the last couple fiscal years.

OK. The-- also the investment that you all made, the acquisition, that's going to be reflected in a separate line item. Was that significant or material or that was relatively small?

The acquisition for the UV filter business was $2m, all told. A portion of that was valuation for a patent. The rest of it was for capital equipment and for inventory and that full $2m asset valuation has been reflected in our September 30th financials.

OK.

Even though we have yet -- I'm sorry, Tim -- even though we have yet to pay out the full amount of the cash, because some of it-- the cash payments are contingent upon that business being transitioned properly from Coherent to II-VI.

Got you. The-- looking at the R&D line, you had a significant shift in kind of one quarter from contract to internal, but in total, you know, it looks like you've dropped down from $4m to $3m and building on the-- you know, prior question, the $3m level for total R&D is about similar and the split between contract and internal for this quarter is more the shape of the rest of the year, that's how you've kind of recharacterized stuff?

That is correct. That is correct.

OK. The-- with the litigation cost down or expected to be down and in the $700K range for the first quarter, should we be expecting to see a significant improvement in profitability in the ``other'' segment, you know, which kind of popped from a $900,000 loss to about a $1.3m loss sequentially?

Yes, we should, because, again, a lot of the costs for that litigation were-- are captured in that ``other'' segment. So you're correct and as we said before we don't anticipate that level of legal and professional expenses to continue, going forward.

OK.

And I'll add to that, this was a very substantial expense for us and it related to and supported a six-week trial in federal court and that is not something that II-VI looks forward to in any future quarter, but it all hit in this particular quarter. That trial started the second week of July and lasted pretty much through-- almost until the end of August. And it's not only a drain on the finances when something like that takes place, but believe me, it also took a lot of people's time to support that.

We just hope that we never get into another tussle like that, but it did happen and it will happen, you know, whenever we have to defend our trade secrets and/or intellectual property. It's part of doing business today, I guess, but it's not something we hope to see any time soon.

In general, in the other product-- in the other segment do you expect-- it sounds as though with the reduction of litigation and in terms of, you know, hopefully, continuing increasing in volume you're going to see significantly improved profit margins out of eV, but I guess the silicon carbide is going to be absorbing more R&D and also having a higher allocation of deprecation from the expansion of the capacity. Would that be correct?

You're right on both-- you're right on those points, Tim. We do expect, though, that the level of investment in silicon carbide that we had last year, FY-03, is going to be pretty similar to the level in FY-04. We should be able to cover the additional capital depreciation, other expenses as we ramp up production, but it will still be an investment for FY-04. But, as Carl mentioned, the prospects and continuing to get more and more wafer sales, we should see that continue steadily throughout the fiscal year.

OK. And just coming around to the tax rate again, you're kind of at the higher end of a band, I think, that you've had over the last 10 years or so of 25% to 35%. And you're still relatively low contributions from-- you know, from military and near-infrared and other, which I assume are kind of heavily weighted toward the U.S., so, you know, is the expectation over a longer run that you should stay at the upper part of that band here as those operations improve? Or do you think that a lot of the growth is going to be happening outside of-- you know, you noted a lack of blanket orders, you know, from Europe and NIR and, you know, an increased focus on some indigenous suppliers for marking in Asia/Pac. So is that something-- you know, in terms of the mix of profits and business, longer run, you know, how do those two things set against each other versus the current effective presumed tax rate?

In the short term, specifically for this year, Tim, we are seeing that we will-- we are anticipating having a larger pool of U.S. taxable earnings. In the long term, though, it's our continued operations-- you know, as they continue to expand in China, other parts of the world outside of the U.S., et cetera, that should help us continue to enjoy some of the benefits that we've enjoyed over the years.

It's kind of-- it's somewhat of a hard subject to articulate, the tax rate for II-VI because even though we're a small-- relatively small publicly traded company, because of our international operations and because of the locations in which do business, we probably are as complex as any Fortune 500 company as far as the tax rate. But the impact can be much more drastic on us when we say, well, the pool of earnings is going to increase in the U.S. 10%. That can have a couple percentage swing in our tax rate and basically that's the situation we're in. We're enjoying some of the benefits of being an international manufacturer and the tax breaks that come with that, but longer-term we do have a lot of strategies in place and have enjoyed being in lower tax jurisdictions.

OK, great. And just the final wrap-up question. Sorry to take so long on this. The-- you know it's kind of a performance-based comp that you have distributed across the organization and this was a strong quarter in terms of-- in terms of relative profits, even with the litigation expense. What kind of sharing is there, generically, between, you know, kind of the shareholders versus the-- you know, versus the-- you know, the employees of II-VI in terms of out-performance versus certain benchmarks? Or what should we expect?

Historically -- and this goes back, probably, around 28 years -- we've been working to have and improve and maintain our performance-based incentive programs. And I think it goes something like this. We look at our operating profits by business unit and -- I'm going to give you some general guidelines, but it's not always exactly this way, but it gets you in the ballpark. And I'm going to use some ranges and then Craig will comment on it.

But basically we look at all the revenues and we put all the costs on the table and we look at what our-- we call it our bonus operating profit, you know, by business unit and then we say, ``OK, we have three things left to do. We want to pay an incentive to our employees. We have to pay our taxes and what's left will accrue to the benefit of the shareholders.'' And so whatever that bonus operating profit is, we look to fund all of our incentive programs with somewhere between 15% and 25% of that bonus operating profit and then whatever's left -- we just talked about the tax rate -- and so whatever's left, the next slice that comes out of that would be for taxes. And that also has historically been in a range, let's say, from 30% to 35% or maybe 28% to 34%, something like that. And then whatever's left accrues to the shareholders.

Craig, am I in the right range there?

Yeah. Maybe, Tim, just a broader answer to your question, I think, overall as a company, you know, every employee has probably at least 10% of their compensation at risk and as that moves up in the-- to the supervisor and the management and the executive type of level, that increases and, you know, just if we look at the report of the compensation committee of our board of directors, you know, the base salary for our top executives is being set at 75% to 80% of the comparable peers' base with a lot more at-risk compensation. That's really been the philosophy.

It manifests itself in different ways at different locations. As Carl's articulating, it takes site-- for the most part, it's a site-specific program so that the employees can help control their own locale's bonus pool and bonus pot. And so in general terms, that's usually how it shakes out.

Great. Congratulations on the quarter.

Thank you.

Thank you. Just in adding about our philosophy toward our bonus program, I would add one more thing. The way we have it structured it always allows us to remind ourselves and go out and remind every employee that whatever percent it is that the employees are sharing of the bonus operating profit, just to remember that x percent of zero is still zero.

You guys are very mathematically based.

Your next question-- you have a follow-up question from Christopher Versace with FBR.

Hey, guys. Just a quick question. All this talk about the potential IR business in China as that market really develops, is there-- what percentage of your bookings or backlog is currently coming from that market place there and when do you think we might see a pickup in that?

Chris, it's very, very small right now. Even though we do, you know, from a fabrication perspective 80%-ish of our fabrication when you look at parts is done in China, Carl and I are just looking, it's a very, very small, not even a few percentage points, probably, as far as sales into China. So that really does represent a nice opportunity for us, as a whole.

Carl, do you want to add anything?

It's small. It might be something around -- I'm just going to guess -- 3%. And it could be, someday, 25%. You know, it could be-- you got to watch what kind of manufacturing activity is coming on in China and there is-- don't leave out Vietnam and some other locations in that region. It just is a very strong thrust that's going on right now in the world.

OK. And then just one other-- let me sneak one other quick housekeeping item in there. Anything going on the quarter yea or nay in terms of foreign exchange for you guys?

No, it's very small, only about $75,000 of favorable impact for the quarter.

Great. Thank you.

You have a follow-up question from Jason Sam with Seidler.

Hey, just a couple of follow-ups. Craig, the contract R&D revenues for the quarter of about $2m, is that, you know, what you guys are expecting for the rest of the year, about $2m per quarter?

We should see that pick up a little bit. It won't-- You know, we ended last year, FY-03, exactly $11m in contract sales. We had previously stated that we will be lower than that. I think it will tick up a little bit. We have specifically, as Carl was mentioning before in eV, some contract revenue that will-- has-- really had not yet started in the first quarter will start in earnest here this second quarter. So I think it will be up a little bit from that. It should put us in the range for the year, maybe, in the $9m to $10m range. We won't quite get back up to the $11m where we were last year.

OK. The Coherent unit, is that going to be a stand-alone unit?

No. It will be reported in-- the results of that will be reported in with our near-infrared optics business unit.

OK. Just a quick question on the lawsuit. If-- you know, the jury-- the verdict's in your favor. You know, is there any kind of monetary-type reward at the end of the rainbow that you could talk about?

We-- there could be, OK? But we're not going to comment on that today because we are in a post-trial motion stage and it's going to take however long the court takes to get through that stage and so the answer to your question is unclear, therefore we better just leave it as it is that, you know, we could have some compensatory damages awarded to us, but we really don't know. It-- post-trial motions are something-- we haven't been through this before and just don't know what the outcomes could be.

OK, so, Craig, any idea in terms of, you know, how much to budget over the next few quarters?

For what?

For the lawsuit?

We really don't have a good guess. I think we'll know better. You know, it's one of those things, as Carl was mentioning, we could see some conclusion to it here shortly. We don't think it will be near the level of the $700,000 that we spent this quarter. There may be some ongoing efforts. We haven't-- you know, this has kind of been in the works, we've always had some type of small activity relative to this. This is something that's been ongoing for several years and it just finally got the magnitude and really culminated with the trial here, but we don't envision it being near the level of what it was this past quarter.

Very specifically in this current quarter, I think it'll drop way off. If it comes back in the third or fourth quarter or the second quarter of next year, we don't know. But I do feel safe saying-- I mean, we're halfway through this-- not halfway, but we're a third of the way through this quarter right now and it's dropped way off.

That's correct.

OK. That's great. And for silicon carbide, how many customers do you have now?

On the order of 15 to 20.

Twenty and the 3-inch product, is it currently being sampled or are you actually shipping?

We're actually shipping small quantities.

OK. And in terms of, you know, just the overall product quality, you know, would you-- you know, how would you compare to the leader?

We-- we have gone to our customers and really offered two grades, as does the major competitor offer two grades. We call it prime grade, which would be our highest quality product and then the second grade we have is a development grade where there are some identified and agreed-to deficiencies. One could be that there's a portion of the area of the substrate that is not going to work for the customer in terms of being productive for their process and the product they would make. In other words, some-- maybe it would 10% or 15% of the area just isn't going to produce product for them. So we-- it's still usable and salable, but at some kind of a discount and we call that development grade.

So we have prime grade and development grade and I'm very pleased to say that our prime grade product technically in the specification that we're meeting there and the quality of that product is 100% competitive with the leading products in the market place.

OK, great. Thank you.

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 31st, 2003, is currently scheduled for after the close of the market on Wednesday, January 21st, 2004, with a conference call to be conducted the following day, Thursday, January 22nd, 2004, at 10 a.m., Eastern time. Thank you for participating in today's conference call.