II-VI Inc (IIVI) 2004 Q2 法說會逐字稿

Welcome, everyone, to the II-VI, Incorporated, second-quarter fiscal 2004 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. (OPERATOR INSTRUCTIONS).

Mr. Creator, you may begin your conference.

Thank you, Jody, and welcome to the second-quarter fiscal 2004 II-VI, Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Thursday, January 22, 2004. 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 Fran Kramer, our President and Chief Operating Officer. The prepared comments for today's teleconference include a review of the second-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 December 31st, 2003 were a record 41.1 million, and increased 28 percent as compared to the same quarter last year. Infrared optics bookings increased 19 percent. Near-infrared optics bookings increased 40 percent, and military infrared optics bookings increased 58 percent, as compared to the same quarter last year. In addition, the Company recorded approximately $900,000 of eV products bookings and approximately $500,000 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 the delivery out past 12 months.

For the six months ended December 31st, 2003, overall bookings increased 13 percent to 75.7 million, as compared to the same period last year. Total Company revenues of 34.6 million for the quarter increased 10 percent, as compared to the same quarter last year, and represented a third consecutive record quarter for the Company. Infrared optics revenues from the just-completed quarter increased 13 percent, near-near-infrared optics revenues decreased 9 percent and military infrared optics revenues increased 12 percent, as compared to the same quarter last year. In addition, the Company recorded approximately $2.2 million of eV product revenues and approximately $700,000 of silicon carbide revenues from the Wide Bandgap Materials Group during the quarter. For the six months ended December 31st, 2003, overall revenues increased 9 percent to 68.7 million, as compared to the same period last year.

Gross margin on manufactured products, as a percentage of sales for the quarter, increased by approximately 3 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 improvement for the quarter also reflects the variety of yield improvements and cost reduction programs occurring at our various facilities.

Finally, the gross margin improvement is partially attributable to sales of infrared optics in Japan, where the strong yen has helped our gross margins. Our II-VI Japan subsidiary accounted for more than 20 percent of the revenues generated for the infrared optics business during the quarter. Although it did not have a significant impact on gross margin for the quarter, effective December 1st, 2003, II-VI acquired a 75 percent interest in II-VI LOT Suisse, which will distribute infrared optics in Switzerland. This new distribution relationship, as opposed to the prior use of a distributor, will add incremental margin for sales in this country. Infrared optics sales in Switzerland are expected to total approximately $6 million on an annual basis. During the just-completed quarter, II-VI paid approximately 1.75 million for its majority interest in II-VI LOT Suisse. Internal research/development expense for the quarter was $1,367,000, and was higher than the same quarter last year, in terms of both dollars and 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 total 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. The internal research and development expense for the just-completed quarter should be similar to the expense expected for the last two quarters of fiscal 2004.

Selling, general and administrative expense for the quarter, as a percentage of revenues, was 22.4 percent as compared to 21.3 percent 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, outside professional services for items such as audit and tax services have increased over the prior year. Also, the Company has added an internal audit department to its general and administrative expenses. However, as compared to the quarter ended September 30, 2003, the Company had significantly less legal expense, as the trade-secret-related litigation for which the Company was a plaintiff ended in the first quarter of fiscal 2004. This is the main reason selling, general and administrative expense decreased by approximately $450,000, as compared to the first quarter of fiscal 2004.

Interest expense for the quarter was 117,000, or less than half of the interest expense in the same quarter last year. The majority of the Company's debt had LIBOR-based interest rates. These interest rates continue to remain low, and the Company's weighted-average interest rate currently is approximately 2.2 percent. The lower interest expense also reflects lower overall debt levels of the Company that have been reduced by approximately $10 million during the last 12 months. Other income from the quarter of 149,000 reflects several factors including foreign currency income, interest income and other income items. Other income was partially offset by the 25 percent minority interest in II-VI LOT GmbH, our sales and marketing subsidiary in Germany, at 25 percent, which is not owned by II-VI, and other expense items. The effective tax rate for the quarter was 33.5 percent, and was consistent with the rate used in the first quarter. 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 flow of earnings as compared to last year. This incremental U.S.-sourced income will be taxed at the full U.S. federal and state rates. Despite the changing our tax rates, the Company still benefits from lower tax rates on its China and Singapore operations, where the tax rates are currently 7.5 percent and 22 percent, respectively.

Looking at earnings before income taxes, the results for the quarter were 40 percent higher than the same quarter last year. Net earnings for the quarter were 3,424,000 or 23 cents per diluted share. These results compare with net earnings in last year's first quarter of 2,769,000 or 19 cents per diluted share. For the quarter, average shares outstanding were 14,285,000, while average diluted shares were 14,671,000. The Company's backlog at December 31st, 2003 was approximately 64.5 million, which was up from the September 30, 2003 (inaudible) of approximately 58 million. The components of this backlog include infrared optics at 24 million, near-infrared optics at 10.5 million, military infrared optics at 24 million, eV products at 5.5 million and silicon carbide at 0.5 million. Backlog is defined as bookings that have not been converted into revenues by the end of the reporting period. Our worldwide employment at December 31st, 2003 was 1,167 employees. This number compares with worldwide employment at September 30, 2003 of 1,109 employees and June 30th, 2003 of 1,094 employees. Most of the employment increase during the just-completed quarter occurred at our China facility, where our total employment is now approaching 250 employees. During the quarter, the Company repaid $2.4 million under its credit facility. The Company's total debt at December 31st, 2003 was 20.6 million, which was down over 30 percent from $30.7 million just one year ago.

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

Thank you, Craig, and a thank you to each investor for participating in today's call. The headline for the second quarter at II-VI is strong growth year after year, with a 28 percent increase in bookings, a 10 percent increase in sales and a 21 percent increase in EPS. The continued strong overall performance comes in spite of the fact that there are still no effective improvements in the semiconductor industry reaching our near-infrared business unit. In addition, we are continuing to experience delays in booking development work in our eV products and WBG business units. The IR optics business segment achieved a 19 percent increase in the quarter's bookings, reaching $21.9 million. For the first half of the year, the segment's order intake was up 13 percent. These improvements were achieved as a result of strong OEM activity in Japan, the U.S. and Europe. As in prior quarters, the aftermarket continues to increase worldwide, and our sales to customers for use in laser marking continues an upward trend.

During the quarter, we received orders in the $0.5 to $1 million range for defractive optics and zinc selenide and multispectral zinc sulfide materials for major military and aerospace customers. We are experiencing some cost increase pressure with the raw materials selenium and platinum that we use in the manufacture of these materials. We may need to offset these cost increases with pricing actions.

During the quarter, we acquired a 75 percent ownership position in our Swiss distributor, LOT Suisse. LOT Suisse has been a II-VI distributor for over 20 years. In the transaction, LOT Suisse's backlog of customer orders was transferred to II-VI, resulting in a bookings addition of $2.1 million during the quarter.

In summary, the state of the infrared optics segment is very good worldwide. Industrial material processing is increasing, as carbon dioxide lasers are operated more hours per week, thereby increasing our aftermarket opportunity. We have made improvements in our worldwide distribution channels, which should also allow us to continue to strengthen our infrequent optics margin. In our VLOC near-infrared laser optics and components business unit, second-quarter fiscal-year 2004 bookings were up 40 percent compared to the second quarter of fiscal year 2003. This increase was primarily due to booking $1.7 million of business in a new product line, along with a 6 percent growth in the core optics business. Bookings increased by 50 percent as compared to the first quarter of fiscal year 2004. This reflects a 14 percent quarter-over-quarter growth rate in YAG and optics bookings, plus the new product line. Second-quarter 2004 overall revenues were down 9 percent over the prior year's second quarter, with half attributed to reduced R&D billing and half attributed to lower YAG revenues.

The large new product booking for the quarter was in the UV filter product line that was acquired from Crystal Associates division of Coherent, Incorporated last quarter. As mentioned, there was $1.7 million in new business booked in this product line, with 1.2 million being for production orders and 500,000 in R&D funds to accelerate the transfer. The Crystal growth portion of the acquisition will be established in our advanced materials development center here in Saxonburg, Pennsylvania, while the fabricating portion of the acquisition will be set up in the Florida VLOC facility. It is expected that shipments of this product will start at the end of the third quarter. Excluding the new product line, VLOC commercial bookings were up 5 percent for the first six months of this fiscal year versus the same period last year. This increase is mainly in the standard and polarization optics market, as we have seen increased business at a major instrumentation OEM, along with increased business in the cosmetic laser segment. Our custom Crystal bookings were flat year over year. A slowdown in business with one medical OEM and the cancellation of orders related to new applications that did not materialize as anticipated were offset by increased marketshare gains in other major OEM accounts.

Overall, the moderate growth in the core business bookings is being driven by growth in our medical and military markets. Although we have not yet felt a substantial recovery in the semiconductor market, we saw a slight increase in demand for semiconductor-related products over the first quarter. We look forward to sustained growth in our VLOC military and medical-related business. Additionally, we continue to anticipate increased business within the industrial and semiconductor segments, as these markets recover. VLOC continues to work with the key multi-kilowatt YAG laser manufacturers, with qualification trials ongoing for both materials and optics.

Demand for military products, addressed by our Exotic Electro-Optics subsidiary, remains strong. Bookings for the quarter just completed totaled $10.6 million and exceeded the previous quarter and comparable quarter last year by over 50 percent. Orders for our core military products, which is basically non-sapphire-based products, totaled $7.5 million. These orders are for traditional window, dome and other miscellaneous optics for programs such as the Javelin missile, Apache helicopter and countermeasure systems. The war in Iraq has impacted the demand for these products through increased use of spares and repairs to damaged equipment. During the past quarter, Lockheed Martin Corporation ordered an additional 40 sapphire window shrouds for advanced targeting pods on their sniper program. This award represents Lockheed's third procurement of these shrouds from our Exotic Electro-Optics subsidiary, and increases the total procurement to nearly 100 units. We have delivered approximately one-third of the units to date, and should complete delivery of the remaining units within the next 12 months. We have also begun process development for a large sapphire window assembly on the joint strike fighter program. We are working with Lockheed Martin's JFF team to develop the fabrication processes necessary to manufacture this large-area window assembly that represents one of the key technical components of the JSF program.

Quarter two revenues increased 12 percent and 15 percent, respectively, as compared to last year's second quarter and the first quarter of this fiscal year. The most significant increases were recorded in our sapphire product line, where product revenues for the first quarter exceeded $1 million for a quarter. Quarterly revenues from the sapphire product line are expected to increase throughout the remainder of this fiscal year. Higher revenues in our core military product line were also achieved. Although only slightly higher than last year's second quarter, it was 6 percent higher than the previous quarter. With the current order backlog, we expect core military product revenues to show solid growth in the third and fourth quarter.

We're currently working on several development contracts at Exotic Electro-Optics. One of these contracts, awarded on a firm fixed-price basis, has been extremely challenging, and our cost to completing this contract was recently increased by $175,000. This increase was reported as an operating loss in the quarter, as this contract is in an overall loss position.

Progress continues on our previously-announced plan to exit the large optics coating business. At present, we expect the large coating chamber to be moved from our facility by quarter four. This work, which will be completed on a cost-plus basis, will provide approximately 4,000 square feet of manufacturing space in our main facility in Temecula, CA.

Now, in our other business segment, eV products showed improvement over the first quarter, with an increase in revenues of 23 percent. Higher sales were driven by shipments of cadmium zinc telluride-based hand-held spectrometers for a specific homeland security application, increased contract research and development billings and continued demand for GE Lunar for bone mineral densitometry detectors to support their traditionally strong calendar year end. Bookings for the quarter were lower than expected, and were driven by the delay of one order from an industrial customer. We expect to receive that order in the third quarter. The outlook for bookings in the second half should be substantially increased due to expected receipt of blanket orders, while sales for the second half will remain approximately equal to the first half of fiscal year 2004. GE Lunar, currently eV's biggest customer, demand is traditionally weaker for the first two quarters of calendar year. This will be offset by continued increases in contract R&D billings, as we ramp up activities on a previously reported Army contract.

We are maintaining our operational cost structure at eV at as low a level as appropriate. Furthermore, we continue to focus our marketing and selling activities on certain targeted applications, primarily in the industrial market segment. While the medical and security market segments represent more than 60 percent of our bookings today, we believe these targeted activities will grow the industrial segment more rapidly.

Long-range planning indicates that the industrial segment will exceed 50 percent of our total bookings within five years. In our other business segment, our Wideband Gap Materials, or WBG Group, generated wafer revenue at approximately the same level as in the first quarter. This was slightly lower than the planned revenue for the quarter. Product bookings for the current quarter have doubled over that of the first quarter fiscal year 2004. Plans for the third quarter are for significant growth in both bookings and sales. Bookings backlog for wafer sales is at a record level. However, a significant percentage of wafer sales continue to be booked and shipped in the same quarter. Let me repeat that. Bookings backlog for the wafer sales is at a record level. However, a significant percentage of wafer shipments continue to be booked and shipped in the same month. The customer base continues to increase, as we expand capacity and marketing activity with the addition of four new customers. Interest in our three-inch diameter semi-inflating substrates has increased significantly, to 20 percent of our second-quarter sales and 40 percent of our second-quarter wafer bookings.

Technology development efforts continue to move forward at a rapid pace, with progress in the areas of purity, defect density reduction and diameter expansion. We continue to focus on product diversification, with recent successes in the demonstration of 4H polytype silicon carbide substrates for power applications, and four-inch diameter semi-insulating silicon carbide substrates for RF applications. Both products are expected to begin sampling later this year.

Manufacturing scale-up efforts continue with the completion of the new wafer fabrication facility in Saxonburg, PA. The complete polishing and cleaning process has been transferred from the New Jersey facility and successfully implemented into the new facility, and will more than double our polishing capacity. Product shipments have been made utilizing the resources of the new facility, with yields and quality consistent with those achieved at the New Jersey site. This ties in with our ongoing goal to unify all manufacturing processes at both our sites in New Jersey and Saxonburg. A significant milestone has been accomplished with the successful implementation of an ISO 9000-compliant quality manufacturing system at our New Jersey facility. The New Jersey facility passed its final certification audit in November 2003, on the first attempt. Preparations are underway for the implementation of an ISO 9000-quality system at our PA facility by the end of this calendar year. New crystal growth furnaces have been delivered in both New Jersey and PA, and have been installed at the respective facilities. Once fully functional in the third quarter, these new furnaces will increase our production capacity by approximately a factor of two.

In summary, for our Wide Bandgap Group, continued success in technology development will lead to additional product diversification, with new product offerings expected next quarter to address power switching applications and larger-diameter substrate requirements. Scale-up efforts have resulted in significant increases in wafer fabrication capacity. The successful implementation of an ISO 9000-compliant quality system will enable II-VI to meet the quality expectations and requirements of large potential customers. Strong product bookings in Q2 have resulted in a significant wafer backlog that will support the increased wafer revenue expectations for the second half of this fiscal year.

Craig, that includes my comments.

Thank you, Fran. Before we begin the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements which are based on current expectations. Actual results could differ materially. For information about factors that could cause the actual results to differ materially, please refer to the risk factors section of our Form 10-K for the fiscal year ended June 30, 2003.

Jody, we are ready to take questions now.

(OPERATOR INSTRUCTIONS). Dave Kang, Roth Capital.

A couple of questions. Can I get CapEx for year-to-date and budget for fiscal '04? And can I also get depreciation and amortization? Thank you.

Dave, year-to-date capital expenditures, just a little bit over $5.7 million, and our forecast looks like we will be spending probably about $10 million in the next six months or so, somewhere in that general range. We've got a couple of larger capital projects, specifically here in Saxonburg, that will be ramping up, specifically as we expand our coating facility at this site. So about $10 million is what we expect for the next six months. As far as depreciation and amortization, for the six months ended December 31st, 2003, it was depreciation and amortization together of 4,745,000, and we expect that to be ramping up just slightly in the last half of fiscal year '04. And we had started to put in some of that information in the last couple of pages of the press release, and so I can refer you back to that, as well.

And the second question is regarding your semiconductor business. I was a little surprised to hear that you guys have yet to see the recovery in this semiconductor market. Can you provide more color? And how big is this business currently, and how big was it during its peak?

This is Fran. Certainly, that affects our VLOC subsidiary. Craig, I don't know if you have the exact percentage it is of our total sales down there?

I think it's less than 15 percent. And, Dave, to answer your question, I think at its peak, we have seen it well up over 30, maybe 35 percent. So it is off of -- basically half or so what it was at its peak, say, 24 months ago or so.

And just for clarification, that 15 and 30 percent -- that's of VLOC numbers; right?

That is correct. That's of our near-infrared optics group.

Tim Slevin, Parker Hunter.

Just a couple of quick questions for you all. In terms of your R&D efforts and activities, do you have sort of a total budget that you look at, that you spread between internal and contract? And kind of what is that target, if that's the way you run at? It seems like you transferred from contract into internal some of the functions that you mentioned in silicon carbide.

Tim, our overall target -- and it does fluctuate, depending on what types of projects and contract we're working on. But those two lines together, the contract research and development expense and the internal research and development expense over the history of II-VI bounces around, but it averages between 3 and 8 percent. And we are currently looking somewhere in the neighborhood of 6 to 7 percent at our current investment rate, particularly in silicon carbide. So as a general range, 3 to 8 percent, more specifically over the last couple of years, probably been in that -- closer -- right toward the middle of that range.

And with respect to silicon carbide, Fran, some of the commentary that you just provided to us -- it looks as though there's continued progress, and the other bookings were down as a result just of a delay in receiving a large blanket order?

Well, in other, we really have three groups. We have eV Products, we have WBG and then we have our advanced materials development center. And in that group, the group that had delay in a booking was eV Products. Maybe we reported it a quarter or two ago. We are also a little bit -- but we told you about that two quarters back in receiving R&D contract bookings for WBG. And I don't think that will recover this year. Maybe the first quarter of next year we would see some more R&D bookings on WBG. But they're doing very well receiving bookings on wafer products right now. (multiple speakers) some of the products that we are offering, the two-inch product that's out there, coming with the three and four. So we are making nice technical progress.

And the orders are transitioning to three-inch right now, and then should be -- the four-inch is an expectation, I guess, for the 2005 calendar year?

I would say right now we are shipping and booking orders on two-inch. We're sampling the three and the four. Both the three and the four would be next year; I think the three-inch obviously will come first. We're just starting to see the movement up to three-inch, I would say. We have one competitor who delivers some at that size.

And so, with the three-inch increasing, you expect to continue to ramp those through the year, I guess, or ramp wafer revenues through the year? And any kind of offset is going to be on the contract R&D side?

Yes. And just to get you straight there, the three-inch revenue side would not be until the first or second quarter of next year. We'll send out samples -- you know, a 10 here, 20 there -- in the late third and fourth quarter. But sales would hit in the first quarter of next year.

The first quarter fiscal or calendar?

Fiscal year '05 starts July 1 for us.

Okay, great. And then, I guess the final question or two questions. Do you have any updated metrics regarding infrared usage? You all had mentioned the hours worked on industrial lasers had gone up, and thus the demand had improved. But are there any kind of incremental metrics that you could point to, or for us that we can get a better sense of that market?

Well, there really is no public metric. For us, the best is to call two or three of the big users we have, whether it's John Deere or Caterpillar or Ford Motor Company, and if they are going from one shift a shift and a half or two shifts in their factories for a month or two, that's good news for us. It's on that kind of trend information that I'm reporting. We see it here in the United States, more hours of use. Now, I don't know whether that amounts to 20 hours of average use versus 21 or something like that; we don't have a real metric. We just have a gut feel.

And the last question really is in terms of minority interest and the impact on other income. Craig, you talked about that as having some offset in this quarter. I was just wondering whether that's going to become a larger item over time, especially with the acquisition of LOT Suisse.

Tim, you're right on. It will become a slightly larger portion. Right now, it's running approximately $50,000 per quarter. That will pick up a little bit as we will also, as you pointed out, have that same minority interest situation with Switzerland. Switzerland, though, is a little bit less than half the size of Germany. So going forward, it should be pretty consistently in the $70,000 to $75,000 range per quarter, something of that nature.

And there's no transition issues in terms of profit improvement, with respect to the subsidiaries, so that's a pretty stable number?

That is correct.

(OPERATOR INSTRUCTIONS). Jason Sam, Seidler Company.

Just a quick question. Craig, you mentioned that more income will be attributed to the U.S. operation, and you will be taxed at the full tax rate. What would that do to the overall tax rate going forward? Should we look to raise that a little bit, or is it about 34 percent, what we're still looking at?

The quarter and the year-to-date, Jason, are the same number. And that is what we expect for the rest of fiscal 2004, so we always -- whatever the year-to-date number is, that's what we expect for the latter part of the year. So we are projecting that it would be still in that 33.5 percent range.

Just to touch on something you said -- I think it's worth bringing up -- is that specifically for this quarter, our U.S.-sourced income did increase, and one of the specifics in that is our eV Products Group, which had a very strong quarter as far as, for the first time, generating a profit all the way down to after-tax levels.

Now, we know that with the expected revenues for that business, we are not sure that that's going to continue for the long term. But that was somewhat of a significant milestone that was reached during this quarter.

Now, in terms of eV, what are you guys doing -- what type of projects are you working with on the homeland security side? Any updates on the scanner project that you were working on before?

A couple of points there. We had the homeland security products that we've finished shipping on. This was a handheld spectrophotometer. We've delivered all those units; I can't say much more about it than that. We're also working on a contract we call ARDEC, and this is to help us improve the cadmium zinc telluride material for use in baggage inspection systems. At the same time, if we improve it for that, it will be better for a number of different industrial gauging applications. We have that contract going forward.

The third thing to report is we have started to develop more of a family of standard products, in our eV unit. We've just come onto the market with a market we call the Evaluator 1000. This is a detector setup that we can sell to a number of different people who are doing liquid fill measurement, whether it's pop or beer. And there may be three, four or five accounts worldwide. We have sold to one account, maybe six to seven years ago, a custom-designed product. Now we have come out with a standard product that at least five to six customers worldwide are expected to buy. We'll probably take our first quarter for that Evaluator 1000 in the third quarter.

But in general, Jason, I'd say we are really targeting ourselves to develop a few more standard products than in the past. We should have more on that in the upcoming quarters.

Now, on the medical side of the business, the OEM business has been sort of in a low for a little bit. Have you seen any renewed developments in that space, or is it pretty much sort of capitalizing on the commercial shipments that you guys could only have with existing customers?

You were talking about the eV Products segment?

Yes.

It's just the way you summarized it; the medical part seems to be the longer-term opportunity, but our products that we ship to GE Lunar has been done very, very well. As I said in my comments, that will be a little slower in the first three or four months of this calendar year, and then that speeds up. It's going to be good business; we'll have a good booking from the Lunar osteoporosis measurement equipment here in the third or fourth quarter, coming up. But the Neopro (ph) product that we make, the breast cancer detector, is going okay. But still, the big opportunity in the bigger scanning system is delays. So we been working hard in the industrial portion of our product offering, and that's the area that we think will be stronger in the second half of the year.

Now, on the Wide Bandgap side, how many furnaces do you have now?

I would rather not comment. We said in our notes that we had doubled our capacity. I just think we're getting to a point where we are getting sensitive on that, because I think we're going to be more important in the competition now in the next year or two. So let me just hold off on that.

Now, in terms of just the wafer diameter transition, you're shipping two-inch wafers right now, which I assume competitive in terms of quality. How are you doing on yield on the two-inch? And also, in terms of the three- and four-inch transition, it took a few years to really get the two-inch to a point where it's "commercial ready." What's your visibility and confidence level, in terms of transitioning to the bigger diameters over the next year or so?

I'm not going to comment about our yields; that gets very tricky. Two-inch product is really what we are producing. We have a few furnaces devoted to the three-inch and one toward the four. It will take us some time, and just what you said is correct; it took us two to three years, three to four years on the two-inch.

The market for these substrates splits into maybe three different areas -- the opto, the RF and then the power market. And we are new in the opto market; it's been going on quite a period of time. So it's a little tougher to break in there. But we have some nice customers on the RF side of it, and the same in the power. So I think there's a lot of opportunities within the two-inch size. The opto is moving to three and four quickly; the RF and power -- they'll move to three, but they are at two right now. We're talking that two-inch power in RF, opto -- we're late coming to the market. It's a little more complex than just two-inch, three-inch and four-inch. Within each one of those sizes, you have the 6H semi-insulating product and the 6H ntype and the 4H ntype. So there's quite a variety, and we are targeting -- probably, because we came late -- not to have a big portion in the opto market.

Now, in terms of if you would have to put a stick in the ground, I guess, to say that, which category of products are you most strong in right now, of all the products that you're producing?

Well, the 6H semi-insulating is going to be our best, we think. Sales more than any other area.

Dave Kang, Roth Capital.

A couple of questions. First, regarding the telecom, it looks like the telecom market is showing signs of recovery. Any activities with your add-ons at VLOC?? And the second question is, how much of a drag on earnings were eV and the silicon carbide units, and what are the breakeven points for those two units? And are there any significant milestones or even goals for these two units this year? And if that are not met, is the Company prepared to make some changes, such as pulling the plug or making acquisitions to strengthen them?

Craig and I will kind of share this question. But first, on the telecom side of it, no; we have not attempted to bring any orders in for passive components, add-ons, that type of telecom product. So we are not planning to be active in that business at this time. Go to our eV and WBG -- what kind of a drag on earnings -- Craig, do you want to comment?

Dave, in the press release, we started putting in some segment information on the other segment, which, as friend mentioned before, is primarily our eV Products and WBG Group. You can see, from an operating level, the drain on earnings that they have had. It is those six months this year versus six months last year, about 25 percent less of a drag on earnings. That is specifically because of the cost containment efforts at eV, and also, as Fran mentioned, the increasing amount of wafer sales that are helping offset our costs. I think we have said before that the eV Group, at a $7 to $8 million range, is probably right on its breakeven. As far as for the silicon carbide group -- again, an emerging group. It gets maybe a little harder to gauge that group, but it's somewhere in the range of maybe about $5 to $6 million would be the breakeven for that group.

I'll make one comment, and then I'll let Fran finish it up. But as far as being committed in those two material-intense businesses, we've invested what we refer to as patient capital -- knowing those businesses have long gestation periods, just like the infrared optics business did and does, so I think we're very committed to both of those businesses. We see nice improvements in both of those businesses this year, both at the sales level and also at the operating level -- not quite, obviously, where we went them to ultimately be, but are making slow progress, as is indicative of those businesses. And I'll let Fran make any final comment.

I'd just add to it that in both eV and WBG, we've made significant investments over the last 5 or 10 years. We've got a lot of money invested. To be patient for another few quarters, another year -- that's what we intend to do. We do have good opportunities in both of them -- some delay, but in the longer term, we think they're both nice opportunities. So we will tend to be patient, and to work through any time that we expect to be above breakeven, and if we miss it by a quarter or two, we will be patient.

And regarding my original question about the semiconductor market, I was cut off. Can you provide more color in the semiconductor market?

I think kind of implied there that maybe we had a 2 million shortfall from the peak of our VLOC business that was related to semiconductor, maybe 2 million compared to 4 million at the peak. So we are 2 million short. Those factors that come around to improve that business for us -- we're about the second or third step down on the food chain. First, we've got to have more semiconductor products sold, then new instruments and new manufacturing equipment put out there to measure and to go to smaller line widths and so on. And it comes down to the people who measure all that, and then we supply the components to those people. So we are down in there, and it just hasn't happened yet. We keep watching the semiconductor indices, and they are trending up. That's okay. The trend line is slow and we are far back in the chain. So we haven't felt it yet. I think it's going to be another few quarters.

Nathan Churchill, Sidoti & Co.

I was wondering if you could just give us a little additional detail or thoughts on the military shipment schedule over the next year? We had a big bump-up in orders this quarter. And also, do you think that this represents the bulk of the orders you're likely to see from the Iraq activity, or is there a potential for more to come?

I can answer at least that portion, that latter part. This would be a good piece of what we'll see the bump from Iraq. We had some spares, replacements and so on, so it will be a nice piece of it. To try to look at our order rate for that business all year -- I would not annualize this quarter. It's going to be lower than that. This is an up quarter for us. I think our business there is trending up. I reported the difference between our core business and our sapphire business, and reported $1 billion in sapphire business. That is going to continue upward, and our numbers are heading up. It's a lumpy business. So the second quarter was a good lump of business brought in, and we will tend to ship that out at an expanding rate, and I think we have the numbers for that segment in our reporting also. So in the quarter, 6.5 million -- we'll trend that up, third and fourth quarter, each a little bit.

Now, turning over to the contract R&D gross margin, it bumped up quite a bit this quarter. Was that due mostly to the completion of the large optics coating facility efforts?

Nathan, the large optics coating facility really was not historically a huge drain on the contract gross margin there. I think, overall, it's just getting to a little bit higher level of activity. Specifically, our eV Products Group had more contract revenue this quarter then last quarter, and then also, a little bit better contract overall activity, even in spite of the one specific contract that Fran mentioned at our Exotic facility. Overall, better execution contract-wise for all locations. So no one real contract that really helped us, no one contract that really is absent that had previously hurt his. I think it's just doing slightly better on all the contracts that we are working on,

Now, do you think we could extrapolate a rate like this going forward?

As far as the profitability for the contracts, Nathan?

Yes.

I think it's probably pretty difficult. I think this quarter, it's 17 percent -- as far as gross margin per contract, should be fairly typical for the rest of the year, with only exception -- again, as we continue to work through that one specific challenging contract that we have at Exotic, we take hard looks at that every month, and make adjustments to our estimated cost to complete. Obviously, we think we are where we need to be right now, but that would be the only thing, Nathan, that I would say. It's still out there; we're still working through that contract, and will be for the next few quarters or so.

Progress on the silicon carbide wafers -- Fran had given us a pretty good outline on that, but can you just give us a quick overview on how you're progressing relative to what your expectations were to this point, and if your goals and targets have changed?

For this fiscal year, I would say we're about on our plan. The setback a little bit is the amount of contract R&D orders we won. If we had won that business, we would be able to move faster. Those contracts are parallel to the development work we want to do. So, when we don't win that level of contract R&D, we compromise. We're not going to go as fast, but we're going to focus harder on sales and bringing what we have into production, and that's where we are. Overall, we're pretty much on target when we started our plan for this fiscal year. And then we're going through a planning process right now, five-year planning process and budgeting cycle, as we adjust for new thinking, new data that has come to the market. That's kind of what I gave you the output of, so we want to hit hard into the RF and power. So when you bring on more products like that, let me just call it a different recipe for making the silicon carbide to address one market then the other. It slows us a little bit, because we have to change the mix in our furnaces, and it divides up the capacity into three or four buckets, rather than having it all headed toward one market.

So that has a little slowing effect. The final thing I'd comment on is the move to three-inch and four-inch in that opto segment or any other segment -- we had expected it to be a year or two out, but I think it's only going to be six months or so out. So that's coming a little quicker.

Did you give any guidelines as to what the capacity expansions were targeted toward for the furnaces, as far as three-inch, four-inch, two-inch, et cetera?

I didn't catch one word you said. What was --

I'm sorry. Did you give any guidelines as to what the capacity expansions for the furnaces were targeted toward?

No, no. I tried to stay away from that. I did not tell the number of furnaces, or where we are in terms of how we allocate them, because it changes; it really does change quite frequently.

Jason Sam, Seidler Company.

Just a quick follow-up. Craig, can you give me the basic share count for the quarter?

Yes. For the quarter, it was 14,285,000 shares.

And, Fran, on the IR side, any thoughts on the mix between aftermarket and OEM? Are both segments growing equally well, or is one segment stronger than another?

It's a little bit more from the aftermarket. We reported over the last two or three quarters the number of lasers coming down the assembly line -- 3,500, 3,600, getting back nearer to the 4,000 units that was the peak a couple years ago. That's still about where we are. The installed base growing a little bit, and the more hours of work, I think, is making the aftermarket a little bit more active. But in general, for our order intake, we had nice growth in both areas. So improvement in the OEMs and the aftermarkets coming along nicely. Third peace, just to mention laser marking, are the smaller optics that are being demanded as more markings done -- we're seeing a good piece there also. So all three of those have helped us move the IR optics business up.

So, it's safe to assume that the aftermarket is a bigger portion of the IR revenue for the quarter?

I think it's going to be the same number, Jason. I don't have that split out, because it's hard for us to track that as we go through, but my gut feel is about the same.

Remember, our aftermarket sales, some of them, go back to the OEMs, and they sell the aftermarket. So what we ship to the OEMs is a mixture of assembly line products and products they're selling to the aftermarket.

(OPERATOR INSTRUCTIONS). Jim Hollister, II-VI Incorporated.

Good morning, gentlemen. You anticipated one of my questions by commenting on the labeling market. The other one is, can you break out the sales between international and domestic for the two periods that you reported?

Yes, Jim. Let me just give it to you for the year, which I think is probably the more accurate -- not the more accurate, but the more indicative of the full year, of the two. Foreign sales as a percentage of our total, 68.7 million sales, or almost exactly 50 percent. Domestic sales and then also combining our contract R&D, those two together are the other 50 percent. So we are seeing good strength, specifically as I mentioned in the comments, in Japan, with the yen really helping us out there. That business overall has really been a good driver for the infrared optics business for the last couple of quarters. And again, we get the extra boost by selling in a weak dollar or strong yen environment. So we think that that about 50/50 ratio -- that should be indicative of the last half of the year, as well.

There are no further questions at this time, Sir.

If there no more questions, I would like to think everyone for participating today. Our next earnings release for the quarter ending March 31st, 2004 is currently scheduled for after the close of the market on Wednesday, April 21st, 2004, with the conference call to be conducted on the following day, Thursday, April 22nd, 2004 at 10 AM Eastern time. Thank you for participating in today's conference call.

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