II-VI Inc (IIVI) 2006 Q3 法說會逐字稿

My name is Vanessa, and I will be your conference operator today. At this time I would like to welcome everyone to the third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question and answer session. [OPERATOR INSTRUCTIONS] Thank you. Mr. Creaturo, you may begin your conference.

Thank you, Vanessa and welcome to the third quarter fiscal 2006 II-VI Incorporated Investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, April 25th, 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 statement to reflect events or circumstances occurring after today.

Joining me today is Carl Johnson, our Chairman and Chief Executive Officer. The prepared comments for today's teleconference include a review of the third quarter financial results and a business and operational review. Following these prepared comments we will conduct a question and answer session.

As noted in our earnings release, effective July 1st, 2005, the Company adopted Statement of Accounting Financial Standards 123(R), share based payment, utilizing the modified retrospective application. The new accounting standard requires expensing the calculated fair value of incentive stock options and other equity compensation.

For all historical periods presented in the earnings release and discussed during this teleconference, and for all future guidance of the Company in the press release, the impact of expensing stock options and other equity compensation has been included. For the quarter ended March 31st, 2006, the Company recognized $682,000 of noncash stock options and other equity compensation expense pretax, and reflected this as an increase to selling, general and administrative expense, as well as an increase to cost of goods sold. The comparable amount for the same quarter in the prior fiscal year was 625,000.

For the nine months ended March 31st, 2006, this expense was 1,636,000 and compares to the expense recorded for the nine months ended March 31st, 2005 of 1,608,000.

Total Company bookings for the quarter as of March 31st, 2006, were 61.4 million, and increased 22% as compared to the same quarter last year. Infrared optics bookings increased 31%, near-infrared optics bookings decreased 13%. Military infrared optics increased 37% and the Compound Semiconductor Group increased 26%.

Bookings are defined as customer orders received that are expected to be converted into revenues during the next 12 months. Bookings are adjusted if changes in customer demand or production schedules, move a delivery schedule out past 12 months. For the nine months ended March 31st, 2006, total Company bookings increased by 34% to 183.4 million, from 137.3 million in the same period last year.

Total Company revenues for the quarter were a record 59.4 million, and increased 11% as compared to the same quarter last year. Infrared optics revenues for the quarter increased 22%, near-infrared optics decreased 21%, Military infrared optics revenues increased 31%, and the compound Compound Semiconductor Group revenues increased 2%.

For the quarter, international revenues accounted for approximately 42% of total Company revenues. As noted in the press release, our near-infrared optics business manufactured certain products during the quarter, that will be shipped out in future quarters. For example, when these scheduled shipments are made during the fourth quarter of the current fiscal year, the near-infrared optics business will recognize over $2 million more in revenues for this product line than the just completed quarter. This is one of the reasons the fourth quarter of the current fiscal year currently is expected to be a record revenue quarter.

For the nine months ended March 31st, 2006, total Company revenues increased by 22% to 167.6 million, from 137 million in the same period last year. For the year-to-date period, international revenues accounted for approximately 41% of total Company revenues.

The Company's backlog at March 31st, 2006, was approximately 91 million, which was up from the December 31st, 2005 level of approximately 89 million. The components of the backlog are Infrared optics at 26 million, near-infrared Optics at 23 million, Military infrared optics at 21 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 41.8% of revenues for the quarter, increased by approximately 2 percentage points from the prior year, an increase from 38.3% for the quarter ended December 31st, 2005. The greater than 20% revenue increase for the Infrared Optics business unit during the just completed quarter, as compared to both prior year and the December 2005 quarter, had a positive impact on the Company's gross margin.

Also, noticeable improvements in the gross margin of our Military Optics business unit during the quarter was achieved, as compared to both prior year and the December 2005 quarters. This was primarily the result of better operations and lower levels of scrap for this business unit.

While all of our businesses are being challenged with increasing raw material and energy costs that are impacting our margins, the cost of the critical raw materials Selenium, used in our infrared optics business, has steadily declined since the beginning of the calendar year. If this declines continue this is will have a positive longer term influence on our gross margins.

Internal research & development expense for the quarter was 1,604,000 and was similar in both dollars and as a percentage of revenues, in the same quarter last fiscal year. The main research & development activities of the Company are from our Compound Semiconductor Group and include activities after our eV products division, our wide band gap silicone carbide group, and our Marlow subsidiary.

Selling, general & administrative expense for the quarter as a percentage of revenues declined to 18.9%, which was lower than the 20.8% level from the same quarter last year. The higher level of revenues during the just completed quarter helped to lower this metric. 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 continue to expect selling, general and administrative costs to grow slower than our anticipated revenue growth for the foreseeable future.

Interest expense for the quarter was 458,000 which was similar to the interest expense in the same quarter last year. Interest expense is primarily attributable to borrowings used for the Marlow acquisition in the prior fiscal year. During the quarter, funds under the Company's credit facility were repaid in the amount of 2.9 million. The funds repaid during the quarter were an initial payment on the term loan portion of the credit facility, combined with payments under the line of credit portion of the facility.

Nearly all the Company's debt has floating interest rates, and the Company's weighted average interest rate as of March 31st, 2006 was approximately 5.3%. Future interest rates will trend higher than the rate as of the end of the quarter, with total interest expense expected to increase as higher rates outpace lower borrowing levels.

Other income for the quarter was 164,000, and reflects several items, including foreign currency gains, interest income, and other income items. Other income was partially offset by the minority interest for the 25% that we do not own of II-VI Lot Swiss, our sales and marketing subsidiary in Switzerland, as well as other expense items.

The effective tax rate for the quarter was 33.5% and was higher than the effective tax rate used in the same quarter of last fiscal year, and the effective tax rate used in the first half of the current fiscal year. The year-to-date effective tax rate now stands at 29.8% and based on current information and our income projections for the remainder of the fiscal year, should remain at this level during the fourth quarter of FY '06.

The effective tax rate for the quarter reflects the fact that more of our current income will be U.S. sourced income, than we had anticipated at the end of the second quarter. The effective tax rate also considers a winding down of the extra territorial income or ETI benefits, which is the Company has enjoyed for several years, and a ramping up of the manufacturing credit program. Also, during the quarter, the Company formalized its plans to repatriate funds from certain of its international operations, to take advantage of an 85% reduction in the repatriation rate under section 965 of the tax code. This caused a one-time increase to the tax expense in the quarter of approximately $300,000.

Net earnings for the quarter were a record 7,450,000, or $0.25 per diluted share. These results compare with net earnings in last year's third quarter of 5,805,000, or $0.19 per diluted share. For the quarter, average shares outstanding were 29,284,000, while diluted shares were 29,931,000.

Net earnings for the nine months ended March 31st, 2006 were 19,379,000, or $0.65 per diluted share. These results compare with net earnings in the same period last year of 16,839,000, or $0.56 per diluted share. For the nine months ended March 31st, 2006, average shares outstanding were 29,253,000, while diluted shares outstanding were 29,952,000.

During the quarter ended March 31st, 2006, the Company purchased 68,700 shares of its stock under the Company's stock repurchase program, which was announced in our press release dated May 18th, 2005. And board of directors of II-VI Incorporated authorized the Company to purchase up to 500,000 shares of its common stock, and to-date 107,100 shares of its common stock have been repurchased, as permitted by Securities Exchange Act Rule 10B-18.

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

Thank you, Craig. We are pleased to report the strong third quarter that Craig has just described to you, and are equally pleased to report that the global markets we serve are displaying a robust and continued demand for the high technology products manufactured by our Company.

In large part, our third quarter results can be traced to the considerable focus, determination and hard work of our employees. To successfully deal with many of the operational and performance issues that plagued us during the prior quarter, and to capitalize on the opportunities presented to us by the vibrant marketplace. I extend my personal thanks and a sincere congratulations to each of the 1650 II-VI employees worldwide.

With bookings of 34.1 million this past quarter, our IR optics business unit surpassed by 13% the previous quarterly bookings record of 30.3 million set last quarter. Bookings increased 31% compared to the third quarter of last year. We expect that IR optics order rates will remain strong for the remainder of fiscal year 2006.

European high powered laser system builders are producing at a record pace, and the resulting order rates at our European subsidiaries have been above forecast. In particular, bookings in Germany and Switzerland continue to be very strong. Likewise, high power laser system manufacturers in Japan are experiencing heavy demand for their products.

Sales of laser [via hold] drilling systems for PC boards has increased significantly over the past six months, and the suppliers of this equipment have doubled their output in response to the higher order rate. Meanwhile, quarterly bookings from our North American OEMs were trending up strongly. Up 37% over the second quarter, and 63% over the first quarter of this fiscal year.

Several of the largest OEM high power laser manufacturers are increasing their manufacturing capacity, thus driving higher optics consumption. In parallel, others are developing new differentiating laser system models, which resulted in several large orders for prototype optics.

Most importantly, the demand for replacement laser optics is propelling sales as the installed worldwide base of laser machines continues to grow at a record pace, especially in eastern Europe and China.

The materials segment of our IR business unit contributed strongly to growth this past quarter. We continued to win orders because of our ability to deliver high quality products either from stock, or faster than our competitors. Critical to our success was the performance of our materials growth team, which turned out products in record volume.

To-date we have increased our bookings forecast for zinc selenide and zinc sulfide transparent materials, by over 250% since the beginning of this fiscal year. For our VLOC near-infrared laser optics business unit, third quarter bookings were down by 13% compared to the same quarter a year ago. This was driven by the timing of a large yearly UV filter blanket order that was received during the third quarter of last fiscal year, but in the second quarter of the current fiscal year. All other product lines achieved quarter-over-quarter growth.

Bookings for the first nine months of the fiscal year have increased by 25%, primarily driven by the UV filter product line. Increases in Medical and Instrumentation related optics have been offset by decreases in contract R&D bookings. The R&D bookings decrease is attributable to the timing of government contracts.

VLOC revenues for the third quarter were down by 21% compared to last year's third quarter. While revenues for the first nine months were off by 8% compared to a year ago. The quarter's shortfall was due primarily to lower UV filter revenue recognition, and decreased custom crystal military shipments.

Certain UV filter revenues were deferred into future accounting periods in accordance with revenue recognition principles, specifically, during the last two quarters, VLOCs has produced but held on premises and not reported revenue for UV filter lens filaments, which have been accepted and paid for by the customer. VLOC will utilize these parts in the production of value-added UV filter assembly that will begin shipping in quantity during the fourth quarter. Only then will revenue be recognized for the already completed lens elements, plus the value added by the assembly operation.

This circumstance has limited our revenue and earnings over the past two quarters, but will have a positive effect on UV filter revenues and earnings for the next three quarters. Following up on what Craig reported, during the just completed quarter we recognized less than $400,000 in UV filter revenues, whereas during the fourth quarter we anticipate revenue recognition of over $2.5 million.

On a year-to-date basis UV filter revenues have increased by 10%, and optics revenues have increased by 8% led by debris shields for the industrial laser market, and windows utilized in eye surgery. However custom crystals revenues are down by 35%, due in part to thin film coating inconsistencies. Contract revenues are down by 18%, due in part to the completion of certain contracts, and YAG revenues are down by 9%, due in part to ongoing production and quality issues.

During the quarter VLOC continued to make technical advances in its thin film coating operation. An additional larger capacity coating chamber was placed in service, and is meeting expected performance levels. Also continued improvements to our coating processes, resulted in yield increases for certain products during the past quarter.

During the third quarter, we achieved full production rates for industrial debris shields at our Vietnam manufacturing plants, and initiated the transfer of additional product lines to this facility. The Exotic Electro-Optics military optics business segment booked $6.3 million in the third quarter, which is up from last year's third quarter by 37%.

Bookings for the quarter were driven primarily by orders for Sapphire window shroud assemblies for the advanced targeting pod, or sniper program in support of F-15 and F-16 jet fighters. And orders for Heritage programs, such as Infrared windows for the Apache targeting helicopter system.

Revenues for the quarter were $7.7 million, which is up 31% from last year's third quarter. The strong revenue performance was led by increased shipments of infrared windows for heritage programs, and the next generation Arrowhead program for the Apache helicopter targeting system, combined with increased billings for Sapphire development contracts related to the joint strike fighter program.

Profit margins for the quarter improved substantially from last year's third quarter and from the second quarter of this year. Significant process improvements were implemented for core military products, resulting in higher production yields and accelerated shipments, in particular for the Javelin and Arrowhead programs. In addition, process improvements were implemented for Sapphire products, resulting in productivity gains and accelerated shipments for the JSF program.

We are beginning to see positive results from a substantial engineering effort to improve production yields on several programs. Our third quarter results indicate solid progress toward meeting this objective.

Bookings for the Compound Semiconductor Group totaled $12.3 million for the third quarter. Marlow Industries which we acquired in December of 2004 accounted for 9.1 million of these bookings. An increase of 32% from the prior quarter, and a 44% increase from the orders booked by Marlow during the same quarter last year.

The remaining CSG business units, namely eV Products Wideband gap materials and in our advanced materials development center, recorded third quarter bookings of $3.2 million, which is a 28% increase from the prior quarter, but a 6% decrease from the bookings generated by these groups during the same quarter of last year.

Third quarter revenues for the Compound Semiconductor Group were $12.4 million which is an increase of 4% from the revenues achieved during the second quarter, and a 2% increase of revenues generated during the same period last year. Marlow Industries revenues were $8.7 million, which is a 2% decrease from the second quarter revenues, and a 6% decrease from the revenues generated during the same quarter last year.

The remaining CFG business units have third quarter revenues of $3.7 million, which represents an increase of 20% from the prior quarter, and a 24% year-over-year increase from the third quarter of last year. Third quarter performance highlights within the Compound Semiconductor Group included first, the receipt by our wideband gap group of an additional $2.1 million in funding for a missile defense agency and resource laboratories sponsored program, for the development of a next generation 100 mm diameter silicone carbide substrates, our future RF device application.

Second, the successful transfer of all Pennsylvania based silicone carbide crystal growth activities to our WBG Technical Center in Pinebrook, New Jersey, and silicone carbide substrate finishing equipment to our startup manufacturing facility in Starkville, Mississippi, where we are targeting to begin initial substrate processing by the end of the current quarter.

Third, a 38% year-over-year revenue increase at eV Products driven by higher shipments to core OEM customers in the medical, industrial and defense markets, as well as consistent revenue generation for work on a previously reported U.S. Army research and development contract.

Fourth, the eV products startup of two advanced cadmium zinc telluride crystal growth systems that were designed and built in conjunction with our advanced material development center. These furnaces will produce ingots with diameters nearly 30% larger than can be produced in our previous generation furnaces. When fully operational, the new furnaces will produce twice as much CZT per growth cycle, which we believe will make CZT a more cost competitive x-ray/gamma ray [sensing] material.

Fifth, Progress at Marlow Industries and the expansion of our presence in the Asian telecom market through the effective promotion and demonstration of our extra small form factor microtext, or tunable laser source, and sixth, the successful manufacturer by Marlow of both large and single stage tech modules in the new Vietnam manufacturing facility, with the accompanying improved competitiveness for our most cost-sensitive industrial tech markets.

Overall the Compound Semiconductor Group business unit is staying focused on its five top drivers. Profitability, product and technology leadership, operational excellence, globalization, and speed.

In conclusion, we are very pleased with what II-VI accomplished during the third quarter, and with the worldwide strengths in the markets we serve. Our bookings are trending up and our opportunities are many, solid, and growing. With recent and planned capacity expansions, we are positioned to take advantage of these opportunities.

As a result of the strong third quarter performance, we are increasing our forward guidance on fiscal '06 revenues to the 229 to $231 million range, and on fiscal year 2006 earnings per share to the $0.89 to $0.93 range.

Craig, that concluded my prepared comments.

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

For information about factors that could cause the actual results to differ materially, please refer to the risk factor section of our Form 10-K for the fiscal year ended June 30th, 2005.

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

At this time, [OPERATOR INSTRUCTIONS] We will pause for just a moment to compile the Q&A roster. your first question comes from the line of Dave Kang of Roth Capital.

Morning, gentlemen. Nice quarter.

Thank you, David.

Fist, Craig, on the tax situation, so sounds like 30% for fiscal fourth quarter. Correct?

That is correct. We think it will end at the same effective tax rate that we have used for the nine months, that is correct Dave.

And since you gave guidance for fiscal '07 should we use the same number for fiscal '07 as well?

We're not going to give any specifics on that fiscal year FY '07 guidance. I would say that in general terms, we don't expect any significant changes in our tax rates, but we are stopping short of giving a specific rate, Dave.

Okay. And then -- fair enough. On the SG&A 18.9%, certainly a nice improvement, considering you guys have been running above 20% before, so is this sort of a new level for you guys going forward, with the record level in sales and all that?

I think if we maintain the level of sales that we have just completed this quarter, and then as we mentioned in the guidance, we think next quarter is going to be another strong revenue quarter, and then leaning into the beginning of the fiscal year FY '07, we think that metric is going to continue to trend down.

I don't have any specifics to give you as far as targets, but we think it will trend down and again, primarily because the revenue growth rate that we're experiencing is definitely outpacing the admin costs that we need to have that support that.

Got it. And on your gross margin improvement, I was wondering if you could provide more color on the Selenium prices and scrap costs, how much those two factors led to, or attributed to your margin improvements.

The Selenium decrease, as I mentioned in my comments, we've seen the prices come down. Because we maintain a quantity of inventory on hand, we will see the benefit to that, primarily in future quarters. And so we will see the, really the longer term benefits of that if the Selenium pricing remains down at the levels that it's at, that will be a more, that will have a longer term impact positive on our earnings. It really didn't impact us too much this past quarter.

As far as the scrap costs, that really was one of the key drivers for our military infrared optics business, making a positive segment earnings contribution this quarter after two quarters of losses. And really that, the operational performance and doing better on the contracts, both the legacy or the historical contracts that we have, and also some of the newer contracts that Carl mentioned, those really were the key driver for that business turning around its financial performance.

I don't have any specifics to give you, Dave, either by program, but definitely suffice it to say, that we did a much improved job in the area of scrap at our exotic subsidiary this past quarter.

Got it. Just going back to the Selenium, so it sounds like that, assuming that it stays where it is, could that show up for this current quarter then?

We may experience a little bit of that, Dave. We have again, we will see that flow through as our inventory levels flow through at the lower prices. It's kind of hard to exactly quantify because we don't know the exact usage that we're going to have, as far as grown material, but I think the broader piece that we were communicating was longer term, lower Selenium prices will transfer into better margins for our main business unit, the infrared optics business.

Just a couple more. You talked about foreign currency having negative impact previous quarter. Can you talk about what happened in the March quarter?

Yes, it was a very slight impact this past quarter. We actually had a little bit of foreign currency gain this past quarter. Really not a very significant number in the just completed quarter.

Okay. And lastly, CSG was profitable but just wondering whether silicone carbide and EV were profitable in the last quarter.

And you are exactly right. The second straight quarter that the CSG group as a whole has been profitable. I think we mentioned last time during the last conference call, that the eV products group was profitable that past quarter. We have some significant improvement in our silicon carbide group this past quarter, and we've always said that those are two businesses our eV products group and silicone carbide that we are still investing in, but again, the levels of investment are significantly lower than they had been even say a year ago or two years ago.

So Marlow improved performance. Carl touched on that, as well as a lower level of investment for both silicon carbide and eV products that led to another positive quarter for CSG. So the investment levels for both of those groups are not very good and on occasion, one or both of them can get up over breakeven.

All right. Thank you very much.

Your next question comes from the line of Jiwon Lee of Sidoti Capital.

Good morning, gentlemen. A few questions for you. First, Carl, you issued guidance for fiscal '07, and your high powered CO2 laser optics were stronger than a lot of people have thought. So going into, you know, planning for FY '07, what do you think the growth will come from especially looking at the commercial laser optics, and if you could comment on your visibility and seasonality there?

Well, I don't think that there has been a whole lot of seasonality. There's a slight amount, a little bit of a pause in the summer with the order book from Europe in particular, but you can hardly call it seasonality. I think it's been so steadily growing this past year, the deployment to lasers, the utilization rates of lasers that are already deployed, it seems like at this particular time the market is very receptive to the CO2 laser technology, and we are in fact planning as part of our FY '07 to continue our capacity expansion, in order to step up to the opportunity so we don't see it slowing down actually.

Another thing, you say well, can you say there's a particular area of industry that is utilizing lasers more than others, I'd say it's across a pretty broad front. The one thing I did point out is this laser via hole drilling approach for electronics and printed circuit boards, that one has definitely almost doubled in the past six to nine months. I doubt that, you know, that won't go on forever, but the electronics industry has definitely stepped up in its deployment of CO2 lasers for that particular application. It will continue to grow, but I don't know that we can count on it to double again in '07.

Craig, do you have any further insights into that?

I think your comments are right on, Carl. I think we have are just seeing strong growth. I think the other point to maybe reiterate is that as more and more of our products in that business are for replacement as Carl mentioned, the seasonality impact has decreased over the years.

Carl is correct in saying that we see some softness sometimes in the July and August timeframe, but that's primarily from new laser system builders, people who are utilizing and running their systems need optics regardless of the season, and regardless of the time of year, so as that component of our business, as that replacement component of our business has continued to increase, that seasonality has lightened up a little bit.

Great. And the UV filters, that's sort of a new business for you. You had a nice growth last year. I'm trying to better understand, you alluded that fourth quarter you're expecting, you know, a large blanket order to finally come through. Is that something, you know, this type of blanket order that we should expect going forward, or is that just one of those things?

We have the order for the parts that we will ship in the fourth quarter. That order has been in house since the second quarter of this year.

Okay.

And in fact, that's what has caused us this circumstance where revenue recognition has become difficult to explain. We in the past, we have made only the lens element, and we've shipped them to the customer, and they've done the assembly.

Now with this new order that was placed in the second quarter, we have stepped up to actually do the assembly of those items, and a few other items into a first level component, but that has meant that we have not shipped the current production of the lens elements offsite. We're holding those to back up the lens assembly, which is starting as we speak.

So we had to transition from making elements only to making assemblies. It meant that the product, that we've continued to produce the product, but we were not able to recognize the revenue, particularly in the third quarter, a little bit of that was going on in the second quarter, and in the third quarter we had far more production than we were able to recognize.

I said we recognized less than 400,000 of actual production, and I can assure you the actual amount that has been put into inventory is, and that's how we have to carry it is as inventory, I believe that's correct, Craig, but we're now sitting here with these parts, and we're going to be assembling and shipping these assemblies in the fourth quarter, and that revenue will go up over 2.5 million, but some of it is truly delayed revenue recognition from the second and third quarters.

Okay. So a little bit of yield issues, and are you suggesting the lead time is now a little bit longer because you're taking on more work? Is that what it is?

I think that Jiwon, during the process to get a final unit has gone an extra step, as Carl mentioned there's some additional assembly, and we have to wait until that piece is completed, and the units actually ship out to the customer before we do the revenue recognition.

There's been no problems on the yields or delivery to the customer. Really that business has done a great job as you mentioned, that's a relatively new business that we bought, now almost going on three years ago. Have done a great job of posturing that business in a relationship with the customer, that's really a business that's led in the customer relationship, and the interactions are really from our near infrared optics group in Florida, with support from our facility here in Saxonburg, Pennsylvania, they have done a great job in servicing the customer, so it's definitely not a reflection of any pushout or delays or anything of that nature.

In fact, I would say without a doubt, that -- that particular product line is carrying the best yield of any product we actually make, in terms of, I'll say it this way. The lowest warranty returns, fewer of those parts have ever come back from the customer, than just about anything that we've ever produced as a company, and our on-time delivery, well, most are on-time delivery and our customer acceptance are over 99%.

It's not a matter of us not being able to produce this thing. It's just the fact that according to the contract, these parts won't start shipping as assembled parts until really the fourth quarter, a tiny bit of that and the third quarter, and until those parts leave our premises, we cannot recognize the revenue.

Is that going to be an annual thing going forward, or can you just not predict this?

Well, we don't think it will be, because --

I see.

Remember we were transitioning from being a parts producer to a components producer, and it's since that transition that we've gotten, the revenue recognition has gotten caught up in making that transition.

Okay.

We anticipate that this product line will benefit from a annual, a rather large annual order by the customer every year, in either the second or the third quarter. That's kind of how we're getting it set up to run.

You'll be able to recognize it a little bit more smoother. Okay. Military IR. I was a little, I was encouraged that you're finally making you know, operating contribution here, but where do we go from here? It seems like you're sort of out of the woods with, you know, the yield issues that you had earlier on.

We have made a lot of progress. As we said in the comments, the amount of engineering effort that's gone into improving things, at improving processes at EEO is tremendous.

We've hired into our engineering areas, we still have more of that to do. One thing that we're pushing hard to complete, it's started and it's part way completed, is to push all of the quality in-line, quality control out onto the shop floor, and get the supervisors and the personnel on the line, doing as many of the quality tests as we can. That has really improved. That's a very good way to run a factory. And then the engineers, of course, back all that up.

We've had what we call a manufacturing excellence program, MEP programs that we started about two years ago, that is nearing at least a completion of a very large first stage. There's always more to do, but we're just about, almost complete with our first stage of that program, it takes a long time. Just moving the quality out on the shop floor was part of that. I just think there's been a lot of progress there.

We still in our coating area particularly, we still have the equipment upgrades, and process upgrade to complete. A little bit more, maybe we need another engineer in there as well to help, we said a couple years ago, that we were going to be pleased if we just took it a little slower at EEO, and solved the production process quality problems that we had, and I think you're correct.

We're coming out of that phase, very happy to tell you that, and I think if you want to know where we go from here, if we can continue to improve the processes, continue to improve our quality, there is a lot of room for EEO to grow in that marketplace. There is a great need for what we make if we can make it effectively, make it in the right cost, because we've made all these improvements in our factory, then there's a lot of potential growth.

I don't want to overstate that, but on the other hand, we intentionally have passed up on some growth, because we wanted to do a better job. So I think that the people at EEO can look forward to a rather bright future of growth by taking on more of the same and new and different challenges. There's just a lot of potential in that business.

Okay. And finally, could you comment on your Asian transition project, the progress you're making there?

Specifically for our Vietnam facility?

Let's talk a little more about Singapore, and then we can talk about Vietnam.

Okay. Yes, Singapore, we're continuing to do more and more of our infrared optics work there. As you can tell from the numbers, the business is continuing to grow very nicely, so that has entailed mainly two main areas of expansion over the last nine to 12 months. That's doing some diamond turning operations that we have historically only done here in Pennsylvania. We're starting to do some of that work in Singapore, and the other area is in our coating operations.

During this past quarter, we transferred another coater over to Singapore and starting to, starting to get some products out of that. That was one of the challenges we have had a few quarters ago was needing to do some work here in our Saxonburg Pennsylvania facility, instead of doing that in Singapore. That additional coater and some other coating expansion, as Carl touched on before, those are some things that are in the works to continue, for us to ramp up and meet the demand in infrared optics business that we're seeing.

As far as our Vietnam facility, transitioning to that, that's a facility just by way of reminder that services both our Marlow thermoelectric cooling business, as well as our VLOC, our near-infrared optics business, and the ramp up there has gone very well for both businesses.

We are now employing about 130 employees in Vietnam. That's up from about zero this time last year, so the ramp up of that facility has gone very nicely, and we are really starting to utilize that facility more and more each quarter.

This is really the first full quarter for both VLOC and for Marlow for utilizing that factory, and obviously they have better and brighter plans for that facility in the upcoming quarters, and into the next few fiscal years, so that transition and that ramp up of that facility has gone very well.

Great. Thank you for answering all my questions.

Craig, I might just add to that, to the comments on Vietnam, I do want to make a projection here that we are going to get that facility to be ISO approved, some time during the first quarter of next fiscal year, and that's pretty good. We had hoped to do it in the fourth quarter of this fiscal year, but it's a big undertaking. All of your equipment, your facility, your processes, your training, your people, and all the documentation that goes with an ISO certification, and especially with two businesses in there, some way or another we're going to get this done by, in the first quarter of next year.

A lot of work there, but that's important because both VLOC and Marlow have some customers that will not take products from that factory until it is ISO certified. They just want that level of assurance that the factory is really, really well organized and so forth, but fortunately that's not all customers, so we're currently producing as Craig said, the startup has gone well. We're producing some electric coolers in volumes. We're producing industrial debris shields in volumes, we're moving more thermoelectric product designs over there every month, and we're moving, starting to move some windows for medical applications into the VLOC portion of that factory as well. So I concur with Craig, that it takes a lot of support and a lot of work, a lot of travel back and forth, but the startup has gone very well.

Great. Thanks again.

Your next question comes from the line of Chris MacDonald from Kennedy Capital management.

Good morning, guys. Congratulations on a great quarter.

Thank you.

With the success that you've had and kind of moving up the value chain in the UV filters business, where you're going from [visline] settlements, to now actually doing some assembly work, I'm just curious if there are other opportunities like that in maybe other parts of your business, to kind of go one step further for what you're providing for the customer.

We're always looking for those opportunities. We are a very loyal parts suppliers, high technology parts supplier, and you always have to make sure that it's something your customer wants you to do. So this particular customer, we went to them with that idea, we knew that they were working hard on it, but struggling in some cases in their own shops, and we convinced them that we could do it cost effectively, and do it very well.

It's not something that is always possible, because you always need to look at, you know, the customer and their needs and their desires, and what they're doing in their business, but we're constantly looking for those opportunities, and we've done more of it probably in the eV products business, than in any business that we have.

We started out thinking we would be able to sell x-ray or gamma ray detectors, and for the most part now we're selling components, even to the point where we just private label them for the customer, put their label on it, and send them without even our own name on the outside. So we're looking for that opportunity. eV is doing a lot of that. That's primarily what they're shipping today. We're constantly looking for those opportunities.

Okay. Thanks. And then just one more. I was hoping you could outline in a little more detail your capacity expansion plans, you did touch on it earlier, but I wanted to get a summary of the plans there?

Craig, why don't you because you've been so intimate with the budget process of late. Why don't you summarize where that's going to be pretty heavy, and I think in fact, it is going to be heavy in the first half of '07.

Chris, to answer your question, really, our capacity expansion plans really are in a couple significant areas. One area is to continue to grow into the coating expansion that we've done in our facility here in Pennsylvania, and as we've had the foresight and ability to expand that facility, now we have the ability to add coating chambers and equipment that we need for future growth.

So in the coating side of things in our infrared optics group, primarily what we'll be doing is adding equipment, not necessarily so much on the facilities side, really the at the beginning of this fiscal year and the end of last fiscal year, really the theme was expanding our coating facility. Now we're really focusing on expanding the coating operations, or the equipment inside there.

We have several other areas as well. I think on a call or two before this one, we mentioned that the coating area in general for really all of II-VI businesses, is going to be an area of focus that we're saying will probably continue for the next 9 to 18 months. We see that we can improve our yields, and get some nice returns if we improve the coating capacity and quality in certain of our locations, so that will be an overall area for improvement.

And I think there's some other areas that we're not at liberty to talk about in specific detail, about what we will be looking at as far as new business development, further extensions as you've mentioned, maybe not into doing integration, but maybe doing a different product line than we have done before. Those are also areas for future expansion.

Great. Thank you very much.

[OPERATOR INSTRUCTIONS] We will pause for just a moment to compile the Q&A roster. At this time, there are no further questions.

Thank you, Vanessa. If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the quarter and fiscal year ending June 30th, 2006, is currently scheduled for after the market closes on Monday, August 7th, with a conference call to follow the next day on Tuesday, August 8th. Thank you for participating in today's conference call.

This concludes today's II-VI Incorporated fiscal year third quarter earnings conference call. You may now disconnect.