II-VI Inc (IIVI) 2007 Q3 法說會逐字稿

Good morning. My name is Miranda and I will be your conference operator today. At this time, I would like to welcome everyone to the II-VI Incorporated Third Quarter Earnings Conference Call. [Operator Instructions]

Thank you. Mr. Creaturo, you may begin your conference.

Thank you, Miranda, and welcome to the Q3 FY07 II-VI Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, April 24, 3007.

The forward-looking statements we may make during this teleconference speak as of today and we do not undertake any obligation to update these statements to reflect events or circumstances occurring after today.

Joining me today is Carl Johnson, our Chairman and Chief Executive Officer.

The prepared comments for today's teleconference include a review of the highlights and key points from a financial perspective and a business and operational review. Following these prepared comments, we will conduct a Q&A session.

There are a few items that I would like to highlight regarding the financial performance of II-VI during the just-completed quarter and the fiscal year to date.

First, the just-completed third quarter was a record revenue quarter for the Company, with revenues climbing to $67.1 million. This level of revenues was 13% higher than the same quarter last year and surpassed our previous record quarter of $64.9 million, which was attained in the fourth quarter of last fiscal year. During the quarter, both the Infrared Optics and the Near-Infrared Optics business units set quarterly record revenues.

Second, the key driver to our increased profitability for both the quarter and year to date is the improved operational performance of our Military Infrared Optics business unit. The segment earnings' improvements for this business during the quarter was approximately $600,000 over the same quarter last year, while the YTD segment earnings has improved by $2.3 million. In spite of lower revenues, this business has done an admirable job of improving manufacturing yields, reducing scrap, reducing rework, and increasing productivity.

At least partially due to this improved operational performance, our Military Infrared Optics business is expecting to win more business on the Apache Helicopter Arrowhead program. We continue to point this business toward opportunities that fit with our skill set in Military Infrared Optics and assemblies, while focusing on building a business with sustained profitability.

Third, despite achieving records in both quarterly bookings and revenues, our Infrared Optics business was challenged during the quarter with certain process and capacity issues. We are working to address some recent challenges we have experienced in our material growth area. These challenges do not appear to be long-term in nature and a significant amount of engineering and other efforts has been directed toward these areas. Additional material capacity is being built and should be online in FY08.

Our material constraints in this business have limited our external material bookings and revenues, as we utilize our capacity to meet demand for our internal optics production. Just to highlight this a little further, in the just-completed quarter the Infrared Optics bookings for optics increased by 9.0%, but for materials decreased by 95% to net to an overall bookings increase for this business unit of 2.0%.

This business also experienced higher costs for internal R&D and for certain material costs. In spite of these challenges, the Infrared Optics business segment remains the most profitable of the II-VI business segments, with segment earnings as a percentage of sales in excess of 25%, even after bearing the majority of our corporate and stock option expenses.

Fourth, the YTD effective tax rate was reduced to 25% from the rate of 28% that was used for the six months ended December 31, 2006. This change to the YTD rate pushed the quarterly rate down to around 19%. Our YTD tax rate reflects the actual profitability of our operations YTD in the 10 countries we operate and our expectations for their profitability for the rest of the FY.

The current effective tax rate also reflects enacted or announced changes to tax rates in certain of these countries. The lower tax rates at our foreign manufacturing locations in Singapore, China and Viet Nam have been and will be an added benefit to the lower manufacturing cost structures of these locations.

Fifth, the just-completed quarter was the seventh consecutive quarter that we reduced our debt. During that 21-month period, we have paid down over $30 million in debt, or about 65% of what was outstanding at June 30, 2005. This includes the $4.5 million that was repaid during the just-completed quarter. The debt reduction was the reason for the decrease in interest expense during the quarter to a level of around $200,000.

We are expecting to make further reductions to this debt as our cash flow allows, and exclusive of borrowings that we would make for any acquisitions that may occur, we may completely pay off our line of credit facility in just a few quarters.

Finally, our capital spending for the quarter was $5.4 million and brought the YTD spending up to $13.8 million. There are several areas in which we are investing capital dollars. These areas include the previously mentioned investments in Infrared Optics material capacity, further expansion of our UV filter capacity and improvements in a number of our coating operations across several business units. We anticipate that our FY's capital spending will be approximately $19 million and at that same level for next FY.

This concludes the highlights and key points, from a financial perspective, and Carl will now give a business and operational review. Carl?

Thank you, Craig. Before speaking to the third quarter's business and operational highlights, I want to thank our employees across every business segment that are working with insight and determination on continuous improvement, as we endeavor to drive manufacturing yields higher, reduce scrap, improve efficiencies, and thereby lower the cost to manufacture our products.

The highlight in our IR optics marketplace centered around the record orders that were received from North American and European high-power CO2 laser original equipment manufacturers, which exceeded any and all previous quarters by 10%.

The European OEMs specifically are known to be targeting growth in the Eastern European and China markets. That said, we feel that the pace of the North American after market has been slowed by the U.S. automakers' reduced hours of production.

In the low-cost, low-power CO2 Laser segment, new models are being introduced for marking and engraving applications and are setting the price point against YAG and fiber laser based systems in the rapidly expanding Asia/China market.

Our UV filter business experienced substantial increases in shipments and performance during the third quarter, which led our Near-Infrared Optics segment to increases of $6.0 million in revenues and $1.8 million in earnings over the same period last year.

In addition, we have once again ramped up our capability to produce UV lenses and assemblies in preparation for shipping at higher levels during the present quarter. Looking back over the life of this activity, we have met multiple customer-driven challenges to expand our production capacity, increasing by 50% during the last 12 months and by 1200% over the past three years.

In our core Near-Infrared Optics business at VLOC, we successfully transferred the volume production of windows used in conjunction with Lasik eye surgery to our Viet Nam facility and completed a rigorous customer qualification process at this new location. Specifically, during the first quarter we shipped 150,000 lasik windows from our Suzhou, China plant and in the present quarter we anticipate shipping 260,000 lasik windows from Viet Nam.

In the crystals and optics activity at VLOC, we are still being negatively impacted by quality and yield problems, primarily within our thin film coating operation, resulting in higher-than-expected costs and poor delivery performance.

We are committed to continuous improvement in this production area, as evidenced by the recent hiring of additional seasoned management and engineering resources. And by the recent installation of two state of the art thin film coating chambers that will come fully online during the present quarter, allowing us to retire three outdated machines.

Within the Exotic Electro-Optics/Military Optics business unit, we produced our first four fully compliant Sapphire window panels against the currently proposed tighter specifications for the Joint Strike Fighter Program. We are optimistic that we can convert this laboratory-based achievement into a manufacturing process to meet the tighter specifications in full production and are continuing on a $450,000 process development contract to accomplish this task.

As announced on March 26th, our Marlow Industries business unit, which is part of our Compound Semiconductor Group (or CSG) segment, signed a partnership agreement with Guangdong Fuxin Electronic Technology, located in Shunde, China. And this agreement is all about synergy.

The partnership links Marlow's high quality, precision-oriented thermoelectric cooler design and manufacturing capabilities in a cooperative arrangement with Fuxin's low-cost, consumer product-oriented tech capabilities. It provides for both groups to utilize the others' capabilities through a contract manufacturing arrangement, to address a broader set of targeted middle-market applications, and we are already cooperatively addressing nine such opportunities.

It combines the purchasing requirements of both groups to attain the best possible cost position on a myriad of raw materials and supply items -- the ceramic plates that are use in the construction of every tech, for example. Marlow and Fuxin will cooperate to jointly develop newer, lower-cost, high performance quality solutions and new applications designed to expand that size of today's global thermoelectric market.

Our minority investment at Fuxin will be treated under the investment method of accounting, meaning that we will not consolidate the operations of Fuxin into II-VI, but rather we'll record as income any dividends that may be declared by Fuxin.

Progress at Marlow Viet Nam continues, as we are now approved to drop ship products directly to many of our customers from this facility. We have built our first integrated tech subassemblies in Viet Nam and begun shipping this to a major medical diagnostic OEM. Along the way, the plant successfully passed through a quality systems audit by this customer.

The core Marlow activities in the defense, space, and photonic sectors continued to show vigor during the third quarter. For example, our business with both DRS and Raytheon has strengthened, as these prime defense contractors are supporting the replenishment and refurbishment of the U.S. Army's A1A tanks and Bradley fighting vehicles.

Our Wide Bandgap group, which along with eV Products, our advanced materials development center in Marlow as a CSG component, made great strides relative to its third quarter financial performance of one year ago. This is due to some strong gains in its silicon carbide crystal growth quality and yield. The group's continuous improvement focus is a key to our goal of establishing the leadership position in the silicon carbide RF applications space.

Another plus is that the factory loading has become more uniform, as our customers are providing improved visibility via long-term purchasing agreements. Also, we are staying on schedule relative to shipments from our new production facility in Starkville, Mississippi.

During the third quarter, eV Products was able to solve the manufacturing process, product quality and resulting field failure problems that caused us to halt shipments to specific x-ray imaging customers last fall and we have now resumed shipments to these customers. We want to thank our customers for working diligently with us to apply root cause and failure mode analyses and then expeditiously proving out our much-improved manufacturing process.

I want to thank the employees at our Advanced Materials Development Center for the critical contributions they made during the quarter to scale up VLOC's UV capabilities. This is a prime demonstration - out of many that drive us forward every day - as to the value and power of teamwork between two operating groups. Over half of the crystals grown in support of our UV material requirements are produced at the AMDC.

In conclusion, we are engaged in many broad-based product opportunities where our products are being used to increase productivity, improve security, and enhance the delivery of medical and health services to our customers. At the same time, there are a number of specific activities, one being the zinc-based materials area in our IR Optics segment, where we must and are focused on improving performance. We are confident that these efforts will generate benefits in the quarters ahead.

Craig, that completes my prepared remarks.

Thank you, Carl. Before we begin the Q&A session, I would like to mention that these comments and answers to certain questions may contain forward-looking statements, which are based on current expectations. Actual results could differ materially. For information about factors that could cause the actual results to differ materially, please refer to the Risk Factors section of our Form 10-K for the fiscal year ended June 30, 2006.

Miranda, we are ready to begin the Q&A session.

[Operator Instructions] Your first question comes from Pierre Maccagno with Needham.

Hi Craig and Carl. Could you explain a little bit in further detail where the capacity issues for materials and for coating?

Yes, for our -- are you just talking specifically, Pierre, for our Infrared Optics business?

Yes. I mean, whatever capacity issues you mentioned during the call.

Yes. I think the one that we were specifically mentioning is specific just to our material production of zinc-based products for our Infrared Optics business, really not impacting anything in fabrication or coating or quality, other parts of the manufacturing process.

But we've just within this quarter really experienced some challenges and as I mentioned in the prepared remarks, there's a lot of effort, engineering effort and other effort going to looking into and working on improving these challenges that we've been having. They are, as we believe, short-term in nature, nothing systematic in the process or anything that's very long-term in nature.

We're also in the process of adding capacity. That capacity is going to come on toward the middle part of FY08 and that will significantly improve the material capacity that we need to run that business.

It's probably worthwhile mentioning that about 70% of what we manufacturer in that business is made from our own grown material and so it's important for us to continue to work on the challenges, but also expand the capacity as that business continues to grow.

So was it a yield issue that suddenly came about or, I mean, something unexpected?

Pierre, this is Carl. I would say that there is a yield issue. We've had a shrinkage in our yield, not all that great. It's just when you're in a tight supply situation like we are, every little bit is a squeeze that you feel.

We have been migrating that process slowly toward trying to get more production out of each run that we make and it's not appropriate to go into detail. But let's just say that as we've migrated that process, thinking we were going to get a little higher yield, sometimes you step in the wrong direction.

So we've got to go back and just try to get that small percentage that we've lost back. It's not a major percentage. It's a small percentage and our engineering staff and the whole team is working very hard on that and we're confident that they can creep back to where we were. And that will help.

The other problem - and Craig mentioned the capacity coming on in '08 - we actually thought that some of the capacity would be on right about now that would have helped us out. Certainly the facility is ready to go. The equipment is coming in and getting set up.

But we were delayed on that program by I'm going to say four months by permitting. The business of permitting industrial processes, especially if there are any toxic materials involved, has gotten more and more and more complex.

And the truth is, knowing what we know today, we should have started six months before we did to go after the permits that are required to start up this additional capacity, because it really did put about a four month delay into our schedule. So, instead of having that capacity today, it's going to be first quarter or even toward the end of the first quarter before we turn that equipment on.

So, right now, to understand it better, I mean, you're just capacity-constrained regarding the materials but not coating issues, correct?

No. It's -- and here's how it's come out. We've tried to tell this story that we have had to back off selling just the material only to people who want to buy material and fabricate and coat their own optics and we've been in that business for a long, long time.

But because we're so tight on material, and as Craig said, we have record optics orders in our Infrared Optics business this quarter. So we need all the material that we can produce just to use internally so that we can scale up to the higher optics orders that we're getting.

We just don't have any opportunity to sell -- we just don't have the material to sell on the outside and Craig, if you will, I think it's useful to talk about YTD maybe how -- we know that we've lost sales opportunities. Would you care to comment on that?

Sure. The comments I made in the prepared comments were more focused on the quarter. If you take a little bit longer look, look at YTD FY07, our optic sales - again, we talking about completed optics using our own provided material - that's up over 15% for the year. But our material sales are about 40% of what they were last year.

So that's that kind of balance that we're working on, is using the capacity that we have for the demand in optics, which has been very, very strong throughout the year, but at the same time, needing to bring on more and more capacity.

And Pierre, we feel it, because we know if we'd been able to even ship the same level of material sales that we did a year ago, it would have improved our profitability in our IR Optics segment by a recognizable amount.

Is this why your guidance going forward is slightly lower than consensus?

Well, I think, Pierre, that in our guidance that we have looked at and tried to evaluate kind of the impact of the material challenges that we're having over the next few quarters, where we think that's going to be, as Carl said.

We've also looked at when the capacity is going to come online. I think that is something that's been factored into the guidance and I think there are a lot of other factors that go into the guidance as well. But that is one factor that we've updated in this guidance that we gave with today's release.

And my final question is selenium. I guess we expect margins to drop next quarter. Is this because continued selenium pricing and how do you expect that to develop later on in the following quarters?

Yes, we're continuing to move through selenium. We are -- the pricing of the selenium has at recent date has been trending upward and we are watching that and monitoring that. There are some things that we've changed internally to help, do some purchasing in more smaller quantities and not run the risk of buying large quantities at either high or low prices. So those are some things that we've changed.

We have made our way through what was our highest level inventory of selenium. Now, when I say we've made it through that, I mean that we have put that into production and that needs to wind its way through production, because we use selenium in the manufacturing of our hydrogen selenide gas.

But then, beyond that, its growing zinc selenide and working its way through the optics that we make. That takes quite a while for that whole process to go through, till it ends up touching an end customer. But overall, the dollar-wise value of what we have in inventory - selenium - at the end of March is a bit lower than it was in December. But we are monitoring where the trends are going in the current price of selenium.

Okay. Thank you very much

Lakshminarayana Ganti, Thomas Weisel International.

Hi Carl, hi Craig.

Good morning.

Good morning, a couple of questions. First, could us split the revenues in terms of domestic versus international?

Yes. The international revenues for the quarter were approximately 44% and for YTD, they are running right at 43% of total.

Okay, got that. The second question was on the reduced guidance. I know you talked about capacity being one issue and there have been several other. What I wanted to know was if you could run us through what's changed, getting into Q3 versus where we are now for the full year guidance. There seems to be some pricing at the top line, whereas the EPS numbers have not changed much. So can we get your thoughts on that?

Yes. I would say that, again, the biggest, where we have probably put the most thought or most kind of advanced thinking in the last 90 days from our guidance that we gave back in January, has been around our Infrared Optics business.

I would say that, again, with all the other business, with all the other five businesses that we have making up three other business segments, we've taken the pluses and minuses of those businesses as well. so I would say, though, that the one change that has had the most impact in our current thinking versus 90 days ago is in the Infrared Optics business.

Okay, so where is the weakness, if I might put it that way? Is it in the Midwest region, that's the big three, cutting down on production and that's impacting your IR optics sales or where exactly is the weakness?

I would say the weakness is probably our own inability to address certain opportunities that we'd like to. I think our limitations on the Infrared Optics business are more self-inflicted than they are market-driven. I think we have seen some softening in the auto industry in particular, but remember that this Infrared Optics business is very broad based in different industrial and other markets that it services. So, I would say that, really, that our material capacity and our recent challenges in that business, those are really limiting the growth of that business to be even better than it has been, so.

Okay. So this quarter, were there material sales in the IR optics segment or?

I'm sorry, Ganti. Say your question one more time.

Okay. What I wanted to know was were there sales of high tech materials, zinc sulphide selenide? Could you devote capacity to the high tech materials this quarter?

We've really wanted to continue to work on and service our optics customers. Again, that's where we get to add the value-added processes and our fabrication and our coating, metrology, QA processes. So that's really where we have devoted our efforts in making sure that we're servicing our large OEM customers and also that large installed base of after market customers that need replacement optics. So that's why we've chosen to service that marketplace more so than selling out material.

Okay. The second question was on the segmental margin. It looks Near-Infrared and Military, both have contributed nicely there. Could you talk about any long-term targets that you have for these two segments? And then also, if you could, give us an overall operating margin target that you have going into 2008 or some things like that?

Yes. I would say that in our prepared remarks, both Carl and I mentioned that for those two business units that you spoke of - the Near-Infrared and the Military Infrared Optics - we are very pleased with the performance.

I think we, Carl and I, would both say and I'll maybe let Carl add a little bit to the end of this, but I would say that we both and the management as a whole has done a great job in both of those business segments, improving the operations. One, in the Near-Infrared, in the face of significantly needing to ramp up the UV filter business, the other in the Military Infrared Optics business in spite of a little bit lower revenues. So both have done a very good job.

I would say that we both, Carl and I both, think that there's still room for improvement in both of those businesses. In the IR optics it'll be a combination of continuing to build out and ramp up the UV filter business, as well as utilize our Viet Nam manufacturing facility.

And I think in the Military Infrared Optics it'll be doing a good job of not giving up ground in the areas that we've gained on, as far as reduction in scrap and some other process improvements. And I think we're now being a little bit more comfortable about going out and being active in taking orders and gaining orders for that business.

So, Carl, do you have anything you want to add to that?

Yes. I do want to recognize that out at EEO, the Exotic Electro-Optics/Military Infrared Optics business, this story goes back three or four years, when we really knew that we had under-developed the quality capability, under-developed the reliable manufacturing process capability in that division. And we were falling short on quality that were delivering to customers and also on delivery schedules.

So much so that one of our major aerospace prime defense contractors - and I think we mentioned this some years ago on a call, actually - pretty much put us on fix or delete status and that hit us like a ton of bricks. And we said we got to fix this and we've gone about working very hard on that, without being so concerned about growing the business to a larger size, but rather improving the performance.

And I think now we're seeing it demonstrated and it starts by making sure that the management team really understands their challenge. And then, by going out and working on the shop floor to make sure that the quality system is just what it needs to be and improving the business information system that's driving. I mean, it's just a very broad-based program that's taken a long time and I want to credit that whole group out there for three or four years of really hard work and now we're all seeing the benefits of that.

At VLOC it's a little bit more of a dichotomy, if you will. We've got the UV business there. That everything I just said about EEO, is extraordinary how the UV business is being set up and guided and run at VLOC. And as we've done this tremendous expansion over the past three years from whatever it was, 1200% larger capability today than then. We've striven to make sure that the quality going out the door is just absolutely as close to 100% as we can have it and the deliveries are all on time and we've done a great job in that UV area.

It's different in our core optics, where I think I said a couple of calls ago we've under-invested in quality and engineering. But we're fixing that. We're going very aggressively at fixing that and an example is during the last six months we've hired a young man who is very skilled and very educated in the real world on quality systems. And he has become our Global Quality Director at our VLOC division.

And then more recently, we've hired an Optic Operations Manager who has a lot of background in thin film coatings, thin film operations and he is focusing a vast majority - maybe 80% of his time - on the problems that we have in our thin film coating capabilities at VLOC.

So I know that's a very long answer to your question, but I think it's really important, because it says to me we can look for continued improvements. And Craig, I got to say we're looking for, in the next year and in two years, we're looking for them to keep improving their margins. And we don't know where the limit is in either of those businesses, but we're going to keep working very hard to improve those margins/

Yes. That's correct and to answer your question about the overall operating margin last fiscal year, excluding the goodwill impairment charge that we had, operating margins around 16.6%. We're running YTD around 18%, so we've made some nice improvements in spite of some of the recent challenges that we've been talking about for this quarter.

But I think we would like to end the year at operating margin in that 18% or a little bit higher range and then, as Carl is saying, we're expecting a little bit better things in the future years as well.

Great. That was very useful and just a quick follow-up on the delayed orders at the Marlow subsidiary. Could you talk about whether that's back in now in your bookings, in the backlog?

The delayed orders that Carl mentioned, I think some of the -- I think maybe just let me make a little bit of a different comment on the backlog. We're fortunate we've got a very healthy backlog for all of our businesses.

Right now, overall Company backlog sitting at about $96 million; we have none of our four business units with less than a $20 million backlog. So we have pretty good visibility there and as Carl mentioned, we think that some of the orders that we're talking about, really, just have been pushed out, not so much order cancellation.

Okay. Thanks a lot. I'll jump back in if I have more questions. Thank you.

Dave Kang, Roth Capital Partners.

Thank you. Good morning, guys. Craig, first question is regarding tax rates. Do we use 25% for fiscal fourth quarter as FY08 going forward?

Yes. Our YTD is always what we expect for the rest of the fiscal year, just by rule. We had that around 27%, first quarter 28%, second quarter reported back to about 25%, in fact, a lot of different factors in there. But always, whatever our YTD effective tax rate is, that is what we expect for the rest of the fiscal year.

Okay and then in fiscal second quarter, regarding that $17 million UV filter order. Did you disclose how much of that was shipped during the quarter and when should we expect follow-on, perhaps by the end of this calendar year?

We would expect, Dave, some follow-on orders. Not in our fiscal year, but in the beginning first or second quarter of our fiscal year '08. That $17 million was for a period of time that was a little bit less than a year, so either toward the end of the first quarter or beginning of the second quarter in FY08. We should expect or we should be booking the next round or next year worth or release on that order.

And you think it'll kind of a comparable amount or maybe larger?

We think it'll be larger. As Carl mentioned, we are continuing to ramp up and we'll be ramping up business in the capacity that we have not only in Florida, but also here in Pennsylvania, that supports that business. And we think that the running rate of that business has been increasing, so we're expecting that to be a little bit higher.

Okay and regarding CSG's eV and silicon carbides, can you just talk about their performance and are they profitable and if not, I mean, I guess what are your plans on going forward?

Yes. I would say that specifically the Marlow business has done very well and has been consistently profitable over the two and a half years that we've owned them.

EV, as Carl mentioned in his prepared remarks, really did a nice job of solving this one particular customer challenge that we had and their profitability has improved. We talked that they had a several hundred-thousand-dollar loss in the first quarter when those challenges really hit us and they have climbed back and they've done very well, improved not only revenues but improved their operating performance pretty nicely. So they're right at a very decent level.

And our silicon carbide group continues to perform well. They also had a nice uptick in revenues and also an uptick in profitability as well. They have been throughout the whole FY07. They, our silicon carbide group, has been profitable, so.

Okay and then also I was hoping you can quantify incremental opportunity regarding the Marlow partnership with Fuxin.

I think probably the main and maybe -- well, in fact, maybe, Carl, I'll let you take a shot at this one. I think maybe Carl can give you some insight and then I'll try to close it up then.

Well, let me start by saying I think that one of the very quick synergies that we're already feeling is this joint purchasing, being able to combine our purchasing requirements and get parts and materials and pieces that we need at Marlow at substantially reduced costs from what we've had to face in the past. That is a very quick thing that can be done and its happening.

A little slower is this idea of us going out with our global marketing capability and identifying opportunities either at the low cost end of the market. Which we have not been in a position to address from our factories, or even the middle market point where we, again, would struggle to meet the cost point of the application. But if we can find the opportunity and then have a contract manufacturing argument with Fuxin in their Shunde facility, boy, that should work very well for both them and us.

So, using our global knowledge and our global market penetration and coverage and their low cost capability, I've said we're addressing at least nine of those opportunities. They're almost one a week, probably, that we're finding somewhere and I can't mention what they are, because they're in development. But some of them could be potentially pretty high volume and so that's a nice opportunity.

It's going to take longer to, say, develop some new products. I mean, these products I'm talking about so far are just taking what we're already making and applying them in a new environment where we don't have to redesign things very much at least. It's just incremental.

But to go out and say, develop a lower cost version of some industrial product that we might know about, that we might make today but we just can't really hit the cost point and to jointly develop a new product and then have them produce it in their factory in China, that's going to take a little longer. The gestation period or the development period on that could be nine to 15 months, something like that, or averaging around a year.

The effort to go in and develop a new industrial product is longer than we might have thought, when we kind of started looking harder at that market. So those are my comments, that it's some short-term, some longer-term. I think we are building some of the into our '08 budget and I would expect to start seeing some of those benefits certainly over the next 12 months.

Okay and I guess the final question is, Carl, when you and I talked about fiber lasers a couple of quarters ago. It kind of sounds like it could be both an opportunity as well as a threat. I was hoping maybe you can kind of focus more on the opportunity aspect of fiber lasers. It sounds like you could sell some parts into fiber lasers currently, but maybe acquisitions could enable you to address a bigger portion of the fiber laser market?

Yes. We agree that there's both an opportunity and a threat and we can't do a whole lot about the threat except just be our best. What's going to -- people are going to find the right solution for the problem they have and they're going to find the right laser to do whatever they're doing and that's just going to happen.

But what we are looking at, as you mentioned, the opportunities to potentially maybe do an acquisition. I can't talk about anything in that area. It would be inappropriate to do that, but we're looking for the right entry points over time. And we're also looking at our current capacity and saying, "What can we make", and there are couple of products that we're working on that are in development that will address not just the fiber laser but the high-power 1.06 laser. Because you cannot forget that there are alternatives out there, as we talked before.

I must say that the disc laser that is being put on the market by Trumpf, it needs high-power optics just like a fiber laser system does. You've still got to focus the energy in some way and so there's the disc, there's the fiber and then there's continuing development and this 1.06-micron solid state slab laser continues to be very interesting. It's longer-term.

But we're looking at all of those needs for people that want to deploy that kind of a 1.00 micron light source and you will be hearing in the future, maybe not every quarter, but you'll be hearing more about what we're doing, as time goes on. And I think that some of that will be in the next six months you'll start hearing more about that.

Thank you.

Jiwon Lee, Sidoti & Co.

Good morning, just a few, sort of clarification questions, if you will. Craig, first of all, what kind of shipment levels and following orders on the UV filters have built into your fourth quarter as well as FY08 primarily guidance you issued this morning?

Our shipment levels that we've anticipated for fourth quarter would be a little bit higher than we have experienced here in the third quarter and then as we look into FY08, we would be expecting continued growth in that business.

We're really not talking about or we're not able to give you some specifics on that, Jiwon, but we're anticipating that this continued ramp up is going to continue throughout the fourth quarter and into the early FY08. And again, one of the other questions that was asked, we're anticipating that the level of business will be up over that $17 million order that we took back in December. We'll have a run rate in that business that will be annualized in excess of that number for 12 months ahead of us.

So we anticipating continued ramp up and just our customer is really enjoying us providing the parts and components that we are providing for that product line. So it'll be just a continued ramp up.

Okay and on to the commercial IR optics. How much of your sequential margin decline in the third quarter was due to capacity and yield issues?

A fair portion of it was. There were some other things as well. We recognize, too, that from an overall segment reporting perspective that that's the business that bears the majority of our overhead and corporate and non-cash charges like stock options and expense and things like that. But a good portion of where we have been, margin-wise, as we talked and mentioned a few times, we did take a step back as far as the yields in that material growth area and that did have an impact on our business.

Again, we're not really going to give specifics on those parts, but that was a component of it, as well as these higher overall corporate costs. And then the other piece that we didn't talk a lot about, but it is important, is that we're starting to spend a little bit more internal R&D in that business, in the IR optics business that has been a business that historically have not needed to spend a lot of internal R&D. But we are doing that as we see where the market's moving and where maybe we can advance our capabilities or work on other materials that may be needed for that marketplace.

Okay and both of you mentioned that North American auto business, especially the replacement optics, were a little bit softer and it looks like that's sort of your expectations in the near-term. So in terms of the commercial optics, where do you see this [trying]? Is that mainly on the low power that you see?

Well, I think we're seeing a lot of opportunities in the lower power. I think Carl mentioned some the marketing opportunities in some other areas that we're seeing. We're still doing -- still, the replacement component part of our business is what drives 85% to 90% of our optic sales into that marketplace, so for those installed base of laser systems. So it's still doing high power sheet metal cutting and welding and host of other applications.

So, I would say the one that we've pointed out that's starting to look a little softer to us is auto and the related processes that go around that industry. But there are a lot of other applications that are growing nicely, including a far amount of the marketing side.

Okay and could you disclose sequential backlog for the quarter, please?

As far as where our backlog is now, Jiwon, versus where it has been?

Yes, correct.

Yes. I would say that I can give you the components of where our backlog is, as of March 31st, of the $96 million backlog that we have. We have Infrared Optics at about $26.5 million, Near-Infrared Optics at about $27 million, Military Infrared Optics at $20 million and our Compound Semiconductor Group at about $22 million.

Okay, that's all for me. Thank you.

Pierre Maccagno, Needham & Co.

Craig, I see that your bookings for the Compound Semiconductors has significantly increased. Is that Marlow? Could you add some color to that?

Sure, yes. The one that took the biggest part of that bookings period, from our Marlow business and did have some very strong, a lot of good orders that were in there, but the Marlow is the largest driver of the $17 million-plus bookings that we took during this quarter.

Is this like a one spike or is this something that you'll see developing quite strongly going forward?

I would say that the Marlow bookings are probably our lumpiest business as far as bookings is our nearer threat. But Marlow also has a -- their business -- there are a lot of -- there's still a fair amount of military defense type of applications that orders that are being booked and so their booking can fluctuate from time to time. But I don't think it's anything out of the ordinary. I think its just part of that business. That's really just a testimony to the markets that they serve, which defense is still a pretty big market for them.

So that's what drove it, mostly defense?

I think Marlow, maybe more so than any of our individual businesses, is probably the most individually diverse. They have a nice piece that's military. They have a nice piece that's medical. The industrial and the relationship with Fuxin we're hoping will increase our industrial. Our Viet Nam operations has continued to allow us to diversify a little more into the commercial and industrial applications. There's a little bit of telecom. So Marlow's business is very broad. There are a lot of different markets that those techs go into.

Thanks.

Arthur Weiss, Bank of New York.

Yes, just a question from your customer standpoint. If you were not able to deliver the materials that they're requesting, what do they normally do? What is their course of action?

There are other suppliers in the market, primarily one other, and obviously they're going to have to go to our competitor and get that material. They also are probably going to have to wait a little longer for it than if there were two suppliers in the market. I really don't know exactly how that's going.

There are a couple of smaller suppliers, one in Japan, one in Israel. From time to time you hear a little bit about one in Europe. But they're very small by comparison. The zinc selenide and zinc sulfide, the bulk of that material is coming from one or two U.S. sources - ourselves and our major U.S. competitor.

So, unfortunately, our difficulty is good for our competitor and as Craig said, to a degree it's self-inflicted. So it's something that later on we'll have to go back and try to re-win some of that business we've lost. But clearly, that's the option that they have, Arthur.

Right and have you had these issues in the past and have you been able to get the business back fairly easily?

Well, yes we have had problems. It's been a few years. I'm reminded, oh, six-seven years ago, we had a period where we had a yield problem, very much deeper than what we're experiencing now. It really put us in the same kind of position, though, where we just had to back off of external material sales and take care of the internal needs that we had. So, yes, we've been here before.

And in general, customers who are buying material would surely much rather had a two-supplier situation than a one-supplier situation. So if we had the capacity, there's no doubt we could go out and win some of that business.

But then, on the other hand, some people we may have disappointed them to the extent that they won't buy from us, at least not for a while, but there's really an opportunity. It's just a good thing. If people have a chance to have a second source, two suppliers, a lot of them are going to say that's a good thing.

Right. Okay. Thank you.

Lakshminarayana Ganti, Thomas Weisel International.

Hi, a couple of quick follow-up questions. I thought your capital, a majority of that, was going to get over by second half and given the fact that you would need another $19 million for the next year, I was wondering where you would be spending that on. Is it going to be Viet Nam transition or what exactly is the CapEx for FY08?

Yes, it is pretty -- it cuts across a lot of different business units. A lot of that will be continuation of projects that have been started in FY07. The couple that we mentioned, as far as material capacity for our Infrared Optics business is one that we will continue to have some ramp up of a fair amount of spending in FY08.

I think the other area that we continue to spend on is in our coating technology and that cuts across a lot of different business units as well. I think there's also some facility improvements that we will do in our Pennsylvania facility as well.

I think the investments, as far as starting up and moving more and more production over to our Asian operations, those will happen mostly in equipment, not necessarily in facilities so much. But that is anticipated in our FY08 spending, is continued deployment of resources to build out our Viet Nam, our China, and our Singapore operations as well.

Okay. At a steady state, when you have transitioned most of the manufacturing to Asia, what do you think would be the level of manufacturing in the Asian region? Do you have some sense of that and what kind of timelines are we looking at, to be fair?

It's a good question and it differs by each business unit. I can probably be most specific, because we have the longest history in the Infrared Optics business where somewhere between 75% and 80% of the optics, based on number of optics that are fabricated in China. And based on number of optics coated, about 60% to 65% of those optics are coated in Singapore.

Now that is the business that we have the most international manufacturing. It has kind of set the standard for the rest of the businesses and Marlow continues to ramp up and push more production over to our Viet Nam facility and now complimented by the arrangements we have with Fuxin. And the same goes true with our Near-Infrared Optics facility who has utilized our China operation for a number of years and they're continuing to push more operations over to Viet Nam.

I'm unable to give you any specifics as far as hard count goes, just because there are different business units that are in there, but suffice it to say that we're going to continue to ramp up those businesses to address industrial, commercial, medical-type opportunities that fit with the skill sets we have in those locations.

I'd like to add to that, Craig. It's a very interesting question and it kind of speaks to the way that we look at our business and I know that we've learned over the last 10 years that every one of the businesses we're in is global in nature. So we've really grown to think about our business as global.

So our challenge becomes do the right thing at the right place at the right time at the right cost. And as we look at that, there are things that we need to do in North America. There are things that we need to do in some other place. And always, when we make a decision of where to do something, we ask ourselves is it the right thing, the right time, the right cost, the right place and so forth.

And then we do our planning and it turns out that when we make the decisions that way, our workforce is pretty much projected to grow in all 10 countries where we have operations. Now manufacturing is more about four or five countries. The rest are sales operations. But if you look at the manufacturing, it will grow overseas, as well as domestically, if we continue to do the R&D and low-volume, high end, high demand production here in the United States, as well as defense production, which we can't do overseas very easily.

So if we obey all the rules of business and international laws on exports and so forth, it turns out, then, that we end up with quite a balanced growth both in North America and in Asia. Of course we aren't manufacturing in Europe, so it's not an issue. But in other words, we're going to be growing at all of our manufacturing locations over the next two, three years.

Thank you. That was very useful.

[Operator Instructions] At this time there are no further questions. Gentlemen, do you have any closing remarks?

Yes, Miranda. If there are no more questions, I'd like to thank everyone for participating today. Our next earnings release for the quarter and year ending June 30, 2007 is tentatively scheduled for before the market opens on August 7th, with the conference call to follow that same day at 9:00 a.m. ET.

Thank you for participating in today's conference call.

This concludes today's conference call. You may now disconnect. 16