II-VI Inc (IIVI) 2006 Q2 法說會逐字稿

Good morning. My name is Anthony and I will be your conference facilitator today. At this time, I would like to welcome everyone to the II-VI Incorporated fiscal year 2006 second quarter earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). I would now like to turn the call over to Craig Creaturo, Chief Financial Officer of II-VI Incorporated. Sir, you may begin.

Thank you, and welcome to the second quarter fiscal 2000 options II-VI Inc. investor teleconference. As a reminder, this teleconference is being recorded on Thursday, January 19, 2006. The forward-looking statements we may make during this teleconference speak as of today, and we do not undertake any obligation to update these statements to reflect events or circumstances occurring after today.

Joining me today is Fran Kramer, our President and COO. 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 conduct a Q & A session.

As noted in our press release, effective July 1, 2005, the Company adopted a statement of FAS 123R share-based payment, utilizing the modified retrospective application. This new accounting standard requires expensing the calculated fair value of incentive stock options. For all periods presented, and for all guidance of the Company, the impact of expensing stock options has been included.

For the quarter ended December 31, 2005, the Company recognized $284,000 of non-cash stock option expense pre-tax and reflected this as an increase to cost of goods sold and an increase to selling, general and administrative expenses. For the six months ended December 31, 2005, this expense was $954,000. For the quarter ended September 30, 2004, the expense was $546,000, while the expense for the six months ended December 31, 2004, was $984,000.

Total Company bookings for the quarter ended December 31, 2005, were a record for the second consecutive quarter at 62.7 million, and increased 27% as compared to the same quarter last year. Infrared optics bookings increased 16%. Near infrared Optics bookings increased 89%. Military infrared optics bookings increased 13% and the compound semiconductor group bookings increased to 9.4 million as compared to 9.0 million in the same quarter last year.

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

For the six months ended December 31, 2005, total Company bookings increased by 40% to 122 million from 86.9 million in the same period last year.

Total Company revenues for the quarter were 53.8 million, and increased 25% as compared to the same quarter last year. Infrared Optics revenues for the quarter increased 14%. Near infrared Optics revenues decreased 12%. Military infrared optics revenues increased 18% and the Compound Semiconductor Group revenues increased to 11.9 million as compared to 4.7 million in the same quarter last year.

For the quarter, international revenues accounted for approximately 43% of total Company revenues.

For the six months ended December 31, 2005, total Company revenues increased by 29% to 108.2 million from 83.7 million in the same period last year.

The Company's backlog at December 31, 2005, was approximately 89 million which was up from the September 30, 2005 level. The components of this backlog include infrared optics at 21.5 million, near infrared optics at 22 million, military infrared optics at 24.5 million, and Compound Semiconductor Group at 21 million. Backlog is defined as bookings that have not been converted into revenues by the end of the reporting period.

Gross margin on manufactured products, at 38.3% of sales for the quarter, decreased by approximately 5.5 percentage points from the prior year. As noted in our current press release and our press release from January 4, 2006, and as Fran will further describe in his prepared remarks for each of our business units, a variety of factors impacted our gross margins during the quarter.

The sequential decline in quarterly revenues from the infrared optics business segment, combined with significantly lower gross margins than anticipated from the military infrared optics business segment, lowered our gross margins during the just completed quarter. The infrared optics segment is still experiencing margin pressure due to higher raw material costs, specifically selenium, and is expecting to see more pressure from other raw materials as the prices of these materials are rising and are expected to continue to increase. Rising energy costs impact our businesses.

During the quarter, the weakening Japanese yen impacted our gross margins in a negative manner. The operational costs of recent capacity expansions also had a negative impact on our gross margins. Finally, the addition of Marlow has lowered our gross margins, as the current gross margins of Marlow the lower than the overall gross margin of II-VI before this acquisition.

Internal research and development expense for the quarter was 1,966,000, and was higher than the same quarter last year in terms of dollars but consistent as a percentage of sales. The higher dollar expense is primarily the result of more corporate-funded research and development activities, the internal research and development activities at our Marlow subsidiary, and less externally funded contract activities at our [silicon] carbide operations.

Selling, general and administrative expense for the quarter as a percentage of revenues was 21.0%, which was lower than the 23.4% level from the same quarter last year. From a percentage of revenue standpoint, the addition of Marlow and this business' selling, general and administrative cost structure has lowered this metric for II-VI as a whole.

Also, during the quarter, the Company had lower professional services for legal-related matters than in the prior year. We have implemented cost containment strategies in this area and expect selling, general and administrative costs to grow slower than our anticipated revenue growth for the foreseeable future.

Interest expense for the quarter was $450,000, which was higher than interest expense in the same quarter last year. Interest expense is primarily attributable to borrowings used for the Marlow acquisition. During the quarter, primes under the Company's credit facility were repaid in the amount of 3.5 million. The funds repaid during the quarter were done so under the line of credit portion of this facility. Nearly all of the Company's debt has floating interest rates and the Company's weighted average interest rate at December 31, 2005, was approximately 4.5%.

Other income for the quarter was $101,000 and reflects several items including foreign currency gains, interest income, and other income items. Other income was partially offset by the minority interest from the 25% that we do not own II-VI LOT Suisse, our sales and marketing subsidiary in Switzerland, and approximately $100,000 of startup costs for our new Vietnam facility which were incurred during the quarter. And also other expense items.

The effective tax rate for the quarter was 24.3% and was lower than the effective tax rate used in the first quarter of last fiscal year, and the effective tax rate used in the first quarter of this fiscal year. The year-to-date effective tax rate now stands at 27.3% and based on our current information and our current income projections, should remain at this level for the remainder of the fiscal year.

The lowering of the effective tax rate for the quarter reflects the fact that less of our current year income will be U.S.-sourced income that we had anticipated at the end of the first quarter. The effective tax rate also considers a winding down of the extraterritorial income or ETI benefits which the Company has enjoyed for several years, and a ramping up of the manufacturing credit program.

Net earnings for the quarter were 5,180,000 or $0.17 per share per diluted share. These results compare with net earnings in last year's second quarter of 5,394,000 or $0.18 per diluted share. For the quarter, average shares outstanding were 29 million, 400 -- excuse me, 29,249,000 while diluted shares outstanding were 29,999,000. Net earnings for the six months ended December 31, 2004, were 11,929,000 or $0.40 per diluted share. These results compare with net earnings in the same period last year of 11,033,000 or $0.37 per diluted share.

For the six months ended December 31, 2005, average shares outstanding were 29,237,000, while diluted shares outstanding were 29,959,000.

During the quarter ended December 31st, 2005, the Company purchased 27,400 shares of its own stock under the Company's stock repurchase program which was announced in our press release dated May 18, 2005. The Board of Directors of II-VI Incorporated authorized the Company to purchase up to 500,000 shares of its common stock. And to date, 38,400 shares of its common stock have been repurchased as permitted by Securities Exchange Act rule 10b-18.

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

Thank you, Craig. Our first quarter results did fall short of our expectations. This happened during a quarter when our bookings were a record $62.7 million and our book to bill ratio was 1.16. We missed our expectations in our infrared optics and our Exotic Electro-Optics military infrared business segments. Higher cost and throughput issues caused the IR miss, but lower yields and higher associated scrap costs were the causes of the Exotic Electro-Optics miss.

The infrared optics business unit surpassed its previous highest bookings quarter of $26.6 million, which happened in the fourth quarter of fiscal year 2005 with bookings this past quarter of $30.3 million. Bookings increased 16% compared to the second quarter of last year. Our previous outlook for fiscal year 2006 remains on track for greater than 10% growth in the IR optics bookings relative to the prior year.

Our international bookings remain strong, particularly in Japan, Germany, and Switzerland. Order rates in Japan in Yen have been particularly steady this year, outpacing monthly targets since the beginning of the fiscal year. However, the weakening yen has impacted our bookings and profitability in that country. Bookings in Germany, meanwhile, exceeded forecasted levels in October and November, slowing only over the holiday period.

In North America, a very strong showing last year was on pace again this year in the quarter just completed. Demand for high-power replacement laser optics keeps growing with the install base of laser machines as expected. Meanwhile, demand for low-power laser optics continues to grow at annual rates greater than 20%, driven by innovative new applications for laser marking systems.

One such application for low-power carbon dioxide lasers recently emerged. Because the USDA, FDA and Food Safety and Inspection service are collaborating to achieve a 50% reduction in the occurrence of egg-born illness in this country, date and traceability codes will soon be applied to eggs. Several companies have discovered that CO2 laser beams interact with the calcium in the eggshell to leave distinct marks that are clearly distinguishable by the human eye. Because carbon dioxide lasers are faster than inkjet printers, they have become the product of choice for this application.

Competitive zinc-based material producers continue with product shortages and long delivery times. We have won several orders this quarter because of our ability to deliver high-quality products faster than others. Recent process improvements in our chemical vapor deposition operation increased our capacity by 5 to 10%. Therefore, we're poised to capitalize on further zinc selenide and zinc sulfide material opportunities.

Our diamond turning capabilities provide a clear advantage over conventional optical fabrication processes, in producing non-rotationally symmetric novel shaped optical components that can manipulate laser beams in sophisticated ways. Towards that end, we recently began assessing the suitability of multi-spectral zinc sulfide as a material for high-power YAG lasers.

Unlike the other common materials used in YAG lasers or near infrared applications like [new silicon], multi-spectral zinc sulfide can easily be diamond turned and may be preferred by customers who require precise control over beam parameters.

During the first quarter, a new coating and office facility in Saxonburg went on-line along with the diamond turning facility in Singapore. The second quarter therefore experienced a full quarter of these additional fixed costs. The Singapore diamond turning facility output reached a level in the second quarter that overloaded our Singapore coating facility, causing throughput delays and rerouting coating work to our Saxonburg coating shop.

The second quarter IR shipments were more than $2 million less than the first quarter due to this production bottleneck. Cost increases in selenium, copper, silicon and energy were incurred, and efforts continue to pass these increases onto our customers.

For our VLOC near infrared laser optics business unit, second quarter bookings were up over 89% compared to the same quarter a year ago. Year-to-date bookings have increased nearly 50%. Our UV filter product line drove both the quarter and year-to-date favor bookings as a result of the customer placing a large annual blanket order during the second quarter.

In addition, increases in medical and instrumentation related optics were offset by decreases in contract R&D bookings. The R&D bookings decrease was attributable to the timing of government contracts.

VLOC revenues were flat for the first six months of the fiscal year compared to last year. Areas of growth were our UV filter product line, also optics revenues increased by 9% this year led by debris shields for the industrial laser market and windows utilized in eye surgery. However, YAG and custom crystal revenues were down 12 and 13% respectively. The decrease in YAG was attributable to ongoing production issues while custom crystals were down due to decreased military requirements.

As noted in our press release, certain revenues of VLOC were deferred into future periods in accordance with conservative revenue recognition principles.

VLOC has continued to address efficiency issues in its optic and YAG business segments. Some progress has been made. However, there's still a long way to do. For example, to address coating capacity and yields issues, a new, larger capacity [income] coating chamber was placed in service during the quarter and has demonstrated encouraging results. A second chamber will be on-line early in the third quarter.

VLOC continues to make progress in pursuing opportunities to forward integrate in the UV filter product line. During the quarter, VLOC shipped its first production UV filter subassembly. We expected to win additional higher level assembly work in the second half of the year. During the quarter, VLOC qualified thin film coatings in our new Vietnam factory and successfully shipped its first finished optics from that location. These optics are debris shields used with lasers in the automotive industry.

Exotic Electro-Optics' military optics business segment booked $6 million in the second quarter, which is up from last year's second quarter by 13%. Bookings for the quarter were driven primarily by heritage programs such as infrared Windows for the Apache helicopter targeting system. Bookings rate for this program and other heritage programs continues to exceed historical rates for repair and maintenance of these systems through the current military deployment.

Revenues for the quarter were $7.9 million, which is up 18% from last year's second quarter. A strong revenue performance was led by increased shipments of infrared windows for heritage programs and the Next Generation program referred to as [Arrowhead] for the Apache helicopter targeting system. Increased shipments of sapphire window shrouds for the Advanced Targeting Pod referred to as the ATP Sniper program used on the F-16 and F-15 fighter jets, and increased shipments of sapphire windows with the Joint Strike Fighter Electro-Optics Targeting System, referred to as JSF EOTS.

Profit margins for the quarter were negatively impacted by process yield and scrap issues associated with the [Javelin] and Arrowhead programs. As a result, income for the core military business segment was a loss for the quarter. The Javelin program is ramping down and was negatively impacted by low process yields in coating and efforts to utilize Javelin related inventory. The remaining backlog for this program is expected to be completed in the third quarter.

In contrast, the Arrowhead program is ramping up to production. While the program continued to have some process issues in the second quarter, the production yield improved substantially over the previous quarter and further process improvements are on track for implementation in the third quarter.

Bookings for the Compound Semiconductor Group totaled $9.4 million for the second quarter. Revenue for the CSG Group were $11.9 million, which is an increase of 12% from the $10.6 million achieved during the first quarter of this fiscal year. All of CSG's divisions have increased revenues in a second quarter versus the first, while bookings decreased due to order timing.

A highlight for the group during the quarter was the technology transfer from Penn State to our advanced materials development center of the transparent ceramic oxide materials processing. This development work is part of an Air Force research contract with our VLOC subsidiary on ceramic YAG.

Marlow successfully completed in December its first year anniversary as a subsidiary of II-VI. Second quarter bookings for Marlow Industries were $6.9 million while revenues were $8.9 million. Second quarter bookings declined due to the accelerated bookings for major customers of several defense programs in the first quarter and a significant decrease in demand for one of our seasonal industrial customers.

Revenues were up 11% from the first quarter results of $8 million.

Quota activity remains strong across all Marlow market segments. Demand in the defense and medical market segments was strong, and we continue to see gradual improvements in the telecom sector despite the continued industry consolidation. Our Microtek product continues to gain traction and we are now the qualified supplier of choice in many telecom component companies. Expansion efforts into the Asian telecom market are well underway.

We continued to increase our value-added assembly business in the medical and industrial markets. During the quarter, we completed the [thermal weapons sight] program after shipping over 30,000 units over many years. The qualification of our Vietnam facility is now complete and we're shipping product from Vietnam to our telecom, industrial, and medical customers.

Our lower-cost Vietnam manufacturing has increased our competitiveness in the cost-sensitive industrial and telecom markets. We plan to continue to improve our costs by transferring additional processing capability to Vietnam by the end of this fiscal year.

The Wide Bandgap Materials Group continues its focus on the development and manufacture of silicon carbide substrates and recognized 1.2 million in bookings. Revenues of $900,000 for the second quarter did not change from the first quarter of this fiscal year.

Significant progress has been achieved on two DOD-funded development programs. Process optimization efforts as part of a DARPA-funded silicon carbide initiative has resulted in substantial quality improvements in our 6H poly-type semi-insulating substrates for our applications.

During the second quarter, an additional $575,000 contract was received for a Missile Defense Agency and Air Force Research Lab sponsored program for the development of Next Generation 100mm diameter silicon carbide substrates for further power and RF device applications.

Our progress continues in our efforts at [reaching] the global market for silicon carbide substrates, as our substrates are undergoing evaluation, a number of large OEM customers in North America and Japan. As part of the North American expansion plan we previously announced, we completed the shutdown of virtually all of the silicon carbide operations at our Pennsylvania facility.

All silicon carbide activity is now being focused at our tech center in New Jersey and our future manufacturing facility in Starkville, Mississippi located near Mississippi State University and [Semi-South Laboratories], one of our major customers and development partners.

The second quarter bookings at our eV PRODUCTS division were $1.3 million and included orders from existing and new OEM customers across all target market segments. These bookings compare to $4.2 million in bookings we reported for the first quarter of this fiscal year. The bookings decline is a result of accelerated bookings from our major medical customer in the first quarter.

Revenues for the second quarter were $2.1 million, which compares to revenues of $1.7 million that we reported in the first quarter. Increase in revenues is driven by higher demand for products, an increase in shipments to core OEM customers in the medical, industrial, and security markets and billings to the US Army for a multiyear R&D contract that is focused on high-speed x-ray sensors for package, baggage, and munitions inspection.

Our eV unit continues to focus on operational improvements in its crystal growth and sensor fabrication areas. At the same time we're working on crystal growth capacity expansion to address both projected increases in business volume and the deployment of Next Generation furnace technology. We continue to aggressively develop and submit applications for patents that we believe will better protect our business, position us for potential future licensing opportunities, and increase overall shareholder value.

In conclusion, our orders are strong. With the recent capacity expansions, we are positioned to take advantage of these market opportunities. Our projections remain for fiscal year 2006 sales in the $220 to $226 million range and earnings per share of $0.80 to $0.85. Craig, that concludes 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 actual results to differ materially, please refer to the risk factors section of our Form 10-K for the fiscal year ended June 30, 2005.

Anthony, we're ready to begin the question-and-answer session.

(OPERATOR INSTRUCTIONS). Pierre Maccagno.

Can you talk a little bit about what are the margin opportunities going forward that you could see would improve?

I'll start out and then maybe Craig can add to it. Certainly, getting our infrared optics throughput back to the level we were at the first quarter and maybe a little bit higher than that, and so I expect we will move toward that here in the third and fourth quarter. This throughput issue was a big factor that brought down the margin these few points this quarter.

Other items, certainly we're working on our Exotic Electro-Optics group to improve our yields that had a big hit with the scrap. I think our scrap expense will be less in the third and fourth quarter as we go forward. Javelin program is winding down. We'll finish in the third quarter. And the Arrowhead program is coming along and we're getting that more under control. So I think that will be a nice help to margin. Those two are big helps.

And Peter, I would add that as we continue to expand our -- and start to fully staff and utilize our Vietnam facility over the next several quarters, that will continue to help our margins. And also as Fran touched on, our diamond turning facility in Singapore as well as we continue to get that capacity on line, again, those are two things out past the next quarter or two that will poise us to continue to make long-term improvements on the gross margin.

And those two opportunities, are those -- when is that going to be a complete transition?

The Vietnam facility, we did during this past quarter shipped products from both -- or for both near-infrared optics group and also our Marlow group. And again, that is going to be a continued transition. The Marlow group transitioning a little bit faster. It's a little bit of an easier product set to make in Vietnam. The near infrared optics group taking a little bit longer, so that is just going to continue over the next several quarters, over the next -- really over the next couple of years or so.

And then in Singapore for diamond turning, that business is coming along nicely. And as Fran mentioned, as we continue to not only scale up the diamond turning operations in Singapore but also the associated coating operations, and really that's kind of the one-two combination that we have here in Saxonburg, is the world-class diamond turning operations just down the hall from the world-class coating operations.

We have that same setup envisioned in Singapore, so getting both the diamond turning and the coating capabilities set up in Singapore, that will really happen -- that will progress very nicely toward the end of this year.

Can you talk a little bit more about the throughput issue in IR and also the yields in Exotic Electro-Optics? Exactly what were the issues?

Okay, I'll go with the throughput first off for IR. We have developed this new diamond turning business operation down in Singapore. The diamond turn products [coming] very nicely. We always had a plan to bring our coating capacity up in Singapore to parallel this additional product that came from the diamond turning shop.

We didn't get our $0.75 million coating machine down to Singapore yet. It's maybe six months late, so we tried to run more of that product through the existing equipment which was already -- that shop runs seven days, 24 hours, so it's already pretty loaded. So we elected to send more of the already proven product for Singapore back to Saxonburg to be coated and that took a little delay.

So although we are a couple million short in revenue, I think by -- at this time now here in January, all that product has been shipped. So we're running a little bit later on our IR optics deliveries and it really has to do with coating capacity in Singapore. The equipment's been built and commissioned. It is on the ship, on the way there, so within the next three, four, five weeks, we'll be having that -- that will take another step toward being solved.

Once the new machine is there, it takes some shakedown time in coating yield problems. I think it will be much improved in the third quarter, and by fourth quarter should be behind us. That's kind of the essence of that issue.

I think I gave you a pretty good recap on the Exotic, the Javelin program which was winding down. We'll finish all our contract to produce domes for our customer in the third quarter. During the second quarter, to complete that contract, we went to all our dome [blanks] that maybe had been processed once and not been successful. We thought well, we'll rework them. And by reworking, we incurred a lot of costs and end up scrapping a lot that were not reworkable.

So we're now going to buy a few new dome blanks so we can finish the order here in the third quarter. There is a little bit of scrap with those domes as we start out with virgin domes, but this third quarter will be a mix of reworking old domes and putting in some new virgin domes. So I say that scrap costs will be down, but it's going to be there little bit.

And finally, could you talk a little bit more about the material costs like selenium? It's not -- I don't think selenium is increasing all that much, but it's mostly I guess your inventory for recognition first in, first out, that you're increasing the costs there. And what about the other costs? Do you think this is something long-term or do you think there's going to be a change in the future?

I think -- I'll answer the selenium part of that. You're right, Pierre. Our weighted average cost in our inventory of selenium has continued to increase, again, as we continued to increase the quantities that we have at the higher prices that we've seen over the last 18 months or so. That weighted average cost in our inventory and what goes through our production processes has increased. You are correct that we're seeing some downturn in the selenium, but still recognizing it's probably somewhere in the neighborhood of a 10X factor of what it used to be three years ago. So that's really the story on the selenium.

I think just what Craig said, weighted average of selenium will be just drifting up a little bit. A couple of the other ones, we do have cost pressure on -- and they are nowhere near in the magnitude of selenium, but copper -- big, big users of copper. That's been trending up and it has not stopped. It's continuing up. Another one that's an important substrate to us in the reflective optics, which copper is reflective.

The second one that's our big user is silicon. Silicon is going up 40, 50, 60%. That has to do with the semiconductor drive and the photovoltaic drive for the solar industry is driving what we use, which is called mirror-grade silicon, up 50, 60%. So on the copper, selenium, silicon; we are working hard to pass those cost increases on to our customers. Sometimes our pricing might lag and the bills come sooner, but in general, we have tried to stay out ahead of that. So energy is costing more too.

I think all of those three, four items will be factors going forward for the next three, four, five months. I think our weighted average selenium cost will trend up more for the next three, four, five months while we work out our inventory and it won't start trending down until late fourth quarter.

So, in the end, do you think this will have an impact to gross margins since you are passing -- or you are attempting to pass most of these costs to the customers?

It's going to be mixed. I think we're doing well getting our pricing across. I think it's going to the mixed. I would like to tell you I thought it would get ahead of it and stop any margin erosion, but hard to predict over this next three, six months. With the [turning] down right now of the new selenium we're buying is coming in cheaper. So longer trend, it is going to get down there, but in this next three, six, seven months, I think we could just see a little bit of challenge for ourselves.

Jiwon Lee, Sidoti & Co.

Good morning. Just getting back to the booking issues, I'd like to revisit the near-infrared optics. Sequentially the bookings were up almost 160%, and I guess the strength was really from your commercial customers. Could you provide a little more color on that?

Yes, actually, the biggest portion of the bookings increase and Fran touched on it during his comments, was really for our UV filter product line which really (technical difficulty) -- and application area is military. And really, the timing of that -- and it's really a large contract that was booked during the just completed quarter. That was probably the most significant impact for VLOC.

I think Fran might have touched on some of the businesses at VLOC doing better. Some -- and his comments were more revenue wise, but I think you could also take the comments from a bookings perspective as well. In some other areas of the business not doing as well as we would like, but the main driver of the increase bookings-wise is primarily military end use for those products.

Last year, if my understanding is correct off of the top of my head, UV filters were about $5 million. Is that accurate?

Somewhere in there. Somewhere in that range. That's correct.

Okay, but your quarterly booking for your infrared optics was nearly $17 million.

And again, it has -- and a large piece that is in there again is the UV filter product line. That is a product line that has come on very nicely since we acquired it a couple of years ago. We have worked very hard at our near-infrared optics group in Florida have done a great job of servicing our customer, and also with a lot of support and diligence from our advanced materials development group here in Pennsylvania. They have really done very well.

That's a product line that we continue to ramp up. We continue to add capacity where need be. And again, we see that has been so for a very nice growing business for us and hopefully that will continue.

I made the comment in my prepared remarks there; we did ship our first assembly for these UV units. So we're moving ahead to try to integrate to help our customer by taking the optics that we manufacture and wrapping metal around them testing them and sending him off to our customers. So that's ramping very nicely.

And this product is really going to continue to go with -- at least one of these three helicopters shot down this past week, one was an Apache. There's just an incredible amount of attention on protecting those helicopters, which there should be. So this is going to move really rapidly.

Okay, but the biggest customer for UV filter so far is the Apache helicopter, correct?

That's true, but they are buying right now for even all fixed winged aircraft on top of all helicopters, so many, many different platforms.

Okay. And could I hear a little bit more about your Apache exposure? In addition to UV filters, you know, what else is there? (multiple speakers) I am [really] curious about this Apache exposure.

Yes, and I think you were right as far as the end use for the UV filter product line. Fran also touched on the program that we refer to as Arrowhead for the Apache helicopter, a different system. That system that is made by our military infrared optics business is used for targeting navigational systems on that system, and so it's a different platform, different materials, different end use. One is for navigation. The other is for the targeting --

The targeting. Because that is based on germanium, correct?

I'm sorry?

The targeting system is based on germanium I think.

That's correct. Yes. We have three or four significant parts in that targeting system we produce, and our yields are coming along much better. We have started a higher rate of production in the first and second quarter, and we did have significant yield problems, but we're starting to get those behind us.

Pierre asked you a number of questions on military optics. But again, which program affected you most negatively in second quarter within the military IR optics? Is that really the Javelin or --?

I don't have those scrap numbers exactly, but it's almost going to be equal for Javelin and Arrowhead.

Okay. I see. Okay. Anything else that you could quantify scrap [cost] or what we could expect going out for the rest of the year? Because it looks like it's going to linger out a little bit.

I think we made, as Fran mentioned in his comments, we've made good improvements quarter two over quarter one in the Arrowhead program. The Javelin program -- we do see the end in sight as far as that program for us. So it's -- as he mentioned, we will -- we're not out of the woods and we are anticipating needing to work very hard in the next quarter or so, but we do see the end in sight for the Javelin on program. That should and that will alleviate the problems we've had on that program.

Okay. And as for Marlow, booking in the quarter was kind of week in the quarter and you attributed sort of lack of blanket orders as opposed to the first quarter. Is -- I'm trying to think what portion of your bookings are really -- or customers really give you such blanket orders annually and try to better grasp this business going forward.

That's a good question. It's a tough question for us to answer. I'll go with more of the first part of your question, and that is the Marlow bookings, we did take a lot of bookings in the first quarter, had a very, very nice bookings quarter. Over 13 million in the first quarter. And at that time, we recognized and noted that there was several blanket orders in that quarter.

And I think we have and we feel that we -- in the Marlow business we have good visibility really in two areas. One is in the programs that we have historically made at Marlow. And the second is as we start to get out and start to now sell that manufacturing capability that we have in Vietnam, we're starting to get more and more bookings for products that either are right now being made in Vietnam, or will over the next quarter or to be made in Vietnam, so I think we believe we have good visibility in both of those product types.

Okay. And then lastly, a couple of housekeeping items -- the foreign sales -- it just kind of went over my head. Was it 43% of total sales?

That is correct. For the quarter, it was 43%.

Okay. And could you just quickly go through the backlog for each segment?

Sure. The backlog -- we were up about -- up to about 89 million as of the end of the quarter. Infrared optics, 21.5 million. Near-infrared optics 22 million. Military infrared optics 24.5 million, and the Compound Semiconductor Group 21 million.

[Chris McDonald].

Good morning, guys. Just wondered -- do you have any other facility moves or facility startups that are ongoing? You mentioned the Singapore ramp up as well as Vietnam. Is there anything else out there that we should kind of keep our eyes on?

We're working slowly but deliberately to -- we closed our silicon carbide operation here in Pennsylvania, moving it all to New Jersey. Then over the next 6 to 9 months, we will start this little facility down in Mississippi. So we have now leased the space down there. We have hired a few people. That's coming along slowly. It's not going to be rapid.

I think the next six months we will build it up a little bit. It's not going to be such a big cost, but there will be some challenge for our WBG Group as that cost starts to hit their P&L which is -- it's a smaller P&L but will have a little impact there. That's the facility work we're doing. The rest of our sites are pretty good. That's pretty much it.

And then on the Arrowhead scrap, is that kind of just scrap that results from the natural ramp up on that program as you would expect to get more efficient going forward there? Is that kind of how I should think about it?

Yes, that's the way you should think about it. It was more than we ever expected when we priced the job. But now we're getting down to the rates of yields we expected and we put it together. So yes, going forward, it should come down nicely.

[Jenny Jones].

Yes, I just wondered in terms of the amount of cash you currently have, and I understand that you are going through some transitions here in terms of facilities, but why has there not been a larger use of cash relative to the buyback? And what are you foreseeing over the next year in terms of how you intend to deploy that cash?

We continue to work on and will -- and anticipate we will work on that open stock repurchase program that we have. As we noted in the call, we still have a lot under that existing program. We have been -- I would say over the last three to four quarters, working to pay down the debt that we have for our Marlow acquisition, and then also funding some pretty significant capacity expansions -- the ones that Fran touched on and we've touched on at other points during the call.

As Fran just mentioned, we're really not seeing that level of capital investment that is needed that will allow us to utilize that cash for stock repurchase or acquisitions or other matters there. And so that high level of capital spending that we saw in FY 2005 and also the first half of FY 2006, we see that trending downward, and then that will free us up to do some other things with that cash.

[Gary Davis].

Good morning, guys. Just kind of and macro view. I know there is (technical difficulty) [concerned] about the degradation of the gross margins, and I'm wondering if you could just analyze on a gross basis across all your various divisions and sectors, military and government [speak] as opposed to the commercial.

Gary, your question overall, if you look at all of our businesses and you added up the military end use and the military content of all of those businesses, obviously the easiest one to look at is our military infrared optics business. That is 100% dedicated to the military. But if you looked at all of our other business -- our three other business segments and weighted them all together, you would come up at about 30 to 33%. Somewhere right around one-third of all of those products or all of those end uses being military related.

Probably second only in our overall business mix to the industrial markets. Those broadly are first or higher -- a little bit higher than the military, but military is a solid second as I mentioned, between 30%, 33% -- somewhere thereabouts.

Gary, in your question about margins for those businesses, the gross margin, the operating margin, the segment margin at Exotic [as it] has been difficult for the first two quarters. It will improve in the third and fourth quarter, so that will be the biggest lift I think for the military work.

However the VLOC Group, which does the work on a number of different military programs including the UV filter business, that UV filter product shipment rate will be good, maybe even better in the third quarter. We're having a little bit of a challenge on how we bill that customer. So we're working through a contract issue that might or might not clear up in the third quarter.

If it won't clear up, it will be a deferred sale I guess. If it does, we will sell those products, but that shipment of those UV filters is very nice in terms of a margin -- has a good margin. So it has an uplift to the margin that we have in our military business as we ship more of those. And our Marlow business, which is maybe 40% defense or military, doing very well and that business there should continue pretty steady I think in the future quarters. So if you average those three segments together, I think our military margins will be improving.

[Terry Ledbetter].

This is a general question. As far as -- you talked about forward integrating into the UV filters. I have seen you do this in other products where you don't just do the materials but you get into the assembly, subassembly and things. And I was just wondering if you could help us understand what -- why that makes sense, why that's natural for you all, what you bring to the table that makes that a natural progression?

Okay, wherever we're making the components or the parts for an OEM customer or a military prime, wherever we're supplying it to usually takes quite a yield issue -- quite a hit as they try to assemble these objects together and not damage them, and test them to get them optically aligned. Or if there are other parts that we vertically integrate, whoever is doing that work takes quite a hit on yield.

So we are able to get a nice margin on the integration ourselves because obviously, we're going to take the yield hit. But I think we understand how to deal with these more fragile products, so our yields are probably a little better than what the integrator has. So the margin on that integration step is usually pretty good. It might be close to what we make on the specialty material or components.

If we weren't saving money in the whole process, I don't think our margins would be allowed to be as good as what we see. But we see good margins and this UV filter assembly work is going to be a good margin add for us, and it will help of the overall cost of the system. So the people we are supplying to, when they do a make versus buy analysis, they are going to buy from us cheaper than they make themselves.

[Jim Hollister].

Good morning, gentlemen. A couple of questions. The first one is it sounds like you got blips going right now with the scrap problem and with catching up the pricing (indiscernible) [through] raw materials. Do you perceive that this fiscal year will be the last one that you will have to look for serious problems in, that you will restore to your 15% to 20% annual growth rate after this?

The two problems you refer to of scrap and pricing to catch up with cost, I think we are going to -- in this year, we're going to get close on those to get those where we want. But they are a little disconnected from the 15 to 20% annual growth. Topline growth in one or two of our segments, I think IR optics, which is certainly the driver of our business, that topline growth might be in the low teens. It's not going to be in the high teens or 20s.

So if we are able to get back to the rate of efficiencies and returns that we have been having, I still think the bottom line growth might slow a little on those couple key businesses. In order to get to a 15, 20% overall growth, I don't think it's going to happen this year. It's going to be a little later. Our other business, our CSG businesses will need to start growing some. And we're making progress, but I think were going to have a little bit of a slowdown in overall growth of topline, and then the bottom line follows with that.

There will be a bottom line improvement with getting the scrap behind us and a throughput issue at IR behind us, but get that overall ongoing 20% earnings growth, we'll have that, but it's only going to be on -- fix up this problem that our markets are little slower growing right now.

Thank you. The one other question I have is, I have been watching eV PRODUCTS now for, what, 10 or 12 years you've had it in the business and you had maybe one or two quarters profitability. Is there in [any light] on the horizon [on] that or should you be looking [about] selling it or shutting it down?

Well, we have had one or two quarters of profitability with eV and this quarter was one of them. It was a very good quarter for the group in general. We need to book, ship, produce products, greater than 2 million a quarter in order to be profitable there. We finally achieved it here in this quarter, which was a really nice quarter.

The next few quarters, we're going to be close to that number. As we look out, you got to be north of 2 million and we might be just a hair short of that right now as we look. So we're teetering around the edge of getting to profitability. Longer-term, one, two years out, I would like to be able to give you an answer that yes, you can count on us being profitable. We're right on the edge again. It's always dealing with one or two applications that we are pursuing, getting them into our orderbook. We got two or three base load products that are very good at eV, but we need a fourth and fifth.

So I can't tell you we have them. We have two or three we're working on, but about the time we're ready to go into high rate production, we experienced it a half-dozen times, the product just doesn't get launched -- doesn't make it. So we've got two or three were hoping for, but I can't tell you it will happen one to two years out. I am unfortunately telling you we are right around that same amount of uncertainty on when we will hit breakeven.

I think your other question was should we sell it or do something else. We like that business. We're working hard to make it real successful because we know we have a product there that is very unique, so we're working hard to make it successful.

Pierre Maccagno.

Regarding CapEx, what do you expect for fiscal 2006 and then can you talk again about tax? I guess I missed -- what is the tax rate that you are using going forward?

Yes, for capital spending, through the six months we spent just a little bit more than -- just a little bit under 10 million. We, as I mentioned before, we see that run rate slowing down, slowing down over the next three to four quarters as we -- or in Q3 and Q4 quarters as we have less large capital spending in terms of facility renovations and additions and expansions, et cetera.

So we think the capital spending will be somewhere in the neighborhood over the next -- or for the fiscal year, somewhere in the neighborhood of say 15 to 17 million, somewhere in that range. And again, that will be down from the level that we spent back in FY 2005.

As far as the tax rate, the overall effective tax rate year to date now stands at just a little bit more than 27% -- 27.3%. The shifts that occurred during this quarter -- and it is a multifaceted tax rate, as you can imagine, as many countries as we do business at around the world. But the primary factor is that we're going to have -- because of some of the challenges that we've been talking about, primarily with Exotic and some of our other U.S.-based businesses, we will have less income sourced or produced here in the United States. And so it -- that has impacted our tax rate.

Basically our Singapore, China, Vietnam operations are continuing to do very well and perform very well. And all of those locations have lower tax rates than the United States, so when we have less U.S.-sourced income, the direct correlation is we would have a little bit less effective tax rate.

At this time, there are no further questions in queue.

If there are no more questions, I would like to thank everyone for participating today. The date and time for our next earnings release and conference call for the quarter ending March 31, 2006 will be announced in early April 2006. Thank you for participating in today's conference call.

Thank you again for your participation in today's conference. You may now disconnect.