II-VI Inc (IIVI) 2008 Q1 法說會逐字稿

Good morning. My name is Robin and I will be your conference operator today. At this time, I would like to welcome everyone to II-VI Incorporated FY '08 First Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. (OPERATOR INSTRUCTIONS) Thank you. Mr. Creaturo, you may begin your conference.

Thank you, Robin, and good morning to everyone. I'm Craig Creaturo, Chief Financial Officer and Treasurer of II-IV Incorporated. Welcome to the First Quarter Fiscal Year 2008 II-VI Incorporated Investor Teleconference. As a reminder, this teleconference is being recorded on Tuesday, October 23rd, 2007.

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.

Thank you, Craig, for the introduction. I am Francis Kramer, President and CEO of II-VI Incorporated. Today I will address a half dozen highlights that shaped our first quarter results.

First, in the Exotic Electro-Optics' portion of our Military & Materials segment we had very strong results. Orders were led by a $1.5 million letter contract to initiate long-lead materials to support an approximate order of 100 sapphire window shrouds for the Advanced Targeting Pod which is called ATP. This is flown on the F15 and F16 fighter aircraft.

The balance of this order is expected in the second quarter and should range from $5 to $6 million. We will record $1.8 million of that order in the second quarter due to our practice of not booking orders that exceed or that extend greater than 12 months.

In addition, for ATP, the production rate will increase from six shrouds per month on the current order to eight shrouds per month on this new order when the new order shipments start in August of 2008. Also during the just completed quarter, orders for infrared windows for targeting and surveillance applications increased significantly including a $1.1 million order for Apache [TAS] windows and a $1.1 million for [Paylinks] windows. Exotic Electro-Optics' results in the quarter exceeded forecast due to improved manufacturing yields, lower scrap expenses, and improved margins in our sapphire production process.

Secondary to highlight is our Pacific Rare Specialty Metals & Chemicals division called PRM, which is part of the Military & Materials segment. The unit had solid performance results during the first quarter and we are on track to meet our financial forecast of sales in excess of $20 million and accretive earnings in this fiscal year. Orders were unfavorably affected during the quarter due to delays in restarting the supply chain. However, late in the quarter, we secured long-term supply agreements with two major global copper producers. As these raw materials begin to arrive at our plant during the second quarter, we are confident our order book will improve. Additionally, we have launched our in-house material recycling program, which will help reduce the cost of selenium in our Infrared Optics business segment and add to the raw material supply at PRM.

The third highlight involves the Near-Infrared Optics business segment. UV filter production units in Florida and Pennsylvania continued to meet or exceed the required schedule for deliveries of UV filter assemblies to our primary customer. In addition during the quarter, VLOC received a $13.5 million follow-on order for these assemblies. In the optics area, VLOC received a $3 million order for the production of windows used in conjunction with LASIK eye surgery. The delivery of these windows manufacturing at our Vietnam facility helped drive the record 400,000 optics manufactured in Vietnam during the quarter and will help drive the unit to greater output in the third quarter and thereafter. At our VLOC Florida and Suzhou, China operations, YAG production progressed with the hardening of crystal growth processes and by transferring certain production steps to Asia. We will continue to aggressively focus on leveraging our Asian operations in order to achieve desired cost structure in the YAG business. In the Near- IR Optics manufacturing, the team is focused on improving the thin film coating production. To address this situation at the end of last quarter, VLOC put two new state-of-the-art coating chambers into production, adding coated engineering resources and is aggressively pursuing new market opportunities.

The fourth area to highlight is the over $500,000 improvement between quarter one of FY '08 and quarter one of FY '07 in segment earnings turned in by the Compound Semiconductor group. Q1 of FY '08 was a strong quarter for Marlow Industries. During the quarter, Marlow experienced continued increases in revenues and bookings from the defense and space and medical market segments. Inventories appear to be working down in the telecom segment and this segment is beginning to show signs of growth. Significant progress was made in the product development of several major new industrial applications. Our Vietnam factory had a strong quarter and exceeded revenue unit and profit plans. We completed our front end, Phase III transition from Dallas to Vietnam, installing wafer plating and [placing] capability in Vietnam. Our largest medical customer's next generation product introduction continued to experience delays and now is expected to launch during the second quarter. This delay had an impact on our Q1 bookings.

Our Wideband Gap Materials group booked new business of more than $1.5 million with a major merchant (inaudible) supplier for 3-inch diameter, semi-insulating substrates to meet the needs of a growing RF integrated circuit market. This is a new record for WGB. The group's continuous improvement focus is a key to our goal of establishing the leadership position in the silicon carbide RF application segments in North America and Asia. We have made significant progress towards production qualification at several major device manufacturers in Asia. We continue to invest in transitioning more capability to our new production facility in Starkville, Mississippi. By the end of this calendar year, we'll have the capability to produce all production polishing in Mississippi for direct shipment to our customers. To keep up with the growing requirements for silicon carbide, we have increased our investments in infrastructure, capital equipment and top talent from the industry. We recently completed the expansion of our New Jersey facility by 50% to accommodate the addition of more crystal growth furnaces that will double our crystal growth capacity by the end of fiscal year 2008. Finally, on a technical front, we recently delivered 100 mm semi-insulating wafers to our government partners for evaluation. This is the first step in providing high-quality, large diameter substrates to the semiconductor industry. We plan to release 100 mm wafers to the industry early next calendar year.

eV Products is experiencing a continued unfavorable impact of the Deficit Reduction Act on our medical imaging business. This is consistent with recent reports from the large medical imaging OEMs. We expect the situation to take some time to stabilize. And during this period, inventories in the entire supply line need to be balanced to this new demand level. As it relates to the security market, eV Products has received notification of a $1 million, one-year development contract from Smith's Detection to supply prototype sensor subsystems to be employed in new instrumentation for a Department of Homeland Security application.

A fifth highlight area involves the marketplace for carbon dioxide laser optics. The order rate in the first quarter of fiscal year '08 remained at the rate of the fourth quarter of fiscal year 2007. Normally there's a slight European-driven decrease sequentially from Q4 to Q1. Year over year, Q1 experienced an 8% increase in spite of the delay in several large blanket orders that are now expected in the second quarter. The first quarter bookings in Germany exceeded those for the same period last year by 25% due to strong aftermarket and OEM activity. A healthy worldwide economy and the subsequent demand for durable goods drove orders for both new laser cutting machines in replacement optics. German OEM manufacturers of laser systems report that sales are very strong in Asia and Eastern Europe. Carbon dioxide laser business has continued to show strong growth worldwide while fiber lasers and other 1 micron laser light sources have been getting publicity for their growth mainly as a tool used in laser welding. The carbon dioxide laser is most versatile and used for engraving, marking, via hole drilling, and quality metal cutting. New carbon dioxide laser applications are constantly being developed. One such application is on passports for a patented laser-coating technique enables protection from illegal duplication with a technique called changeable laser imaging and multiple laser imaging. In this application, the top transparent layer of the passport is first structured. Then a CO2 laser is used to burn in partial images at variant angles of incidence. The resulting images have an optical tilt effect which is very difficult to reproduce, thus deterring passport counterfeiting.

The sixth area to highlight is also in our Infrared Optic segment. The IR segment earnings were off in the first quarter from expectations. Most of the shortfall was the result of high-cost selenium and lower zinc selenide yields as compared to Q1 of last fiscal year. However, I'm happy to report that both of these conditions are improving. Our selenium costs should fall around 25% for the next two quarters as the market price has stabilized in the mid $30 per pound range. Coming into Q2 and thereafter, we will benefit from the PRM acquisition and its effect on holding down our selenium costs. I'm also pleased to be able to report that the cause of the falloff in zinc selenide yields experienced during the last few quarters has been determined and will be substantially improved during the second quarter and back to normal in the third quarter. The stabilization of selenium costs at a lower level and the resolution of zinc selenide yield problems will favorably affect future quarter earnings. This will be coupled with the expanded zinc selenide production capacity, which will be coming on line this quarter. Our reentry into the market for the merchant sales of zinc selenide and zinc sulfide materials will help boost sales and profits the second half of our fiscal year.

Craig, would you now review the quarter from a financial perspective?

Thank you Fran. Here are the items I would like to highlight. First I would like to highlight the quarterly bookings at over $81.8 million. This level of bookings was over $9 million or 13% higher than the prior record quarter. Our backlog during the quarter increased by approximately $9 million and now stands at $116 million. The components of September 30th, 2007, backlog were Infrared Optics at $29 million, Near-Infrared optics at $30 million, Military & Materials at $34 million and the Compound Semiconductor group at $23 million. This level of backlog gives us good visibility as we move into the second quarter of fiscal year 2008 and beyond. As Fran mentioned in his prepared remarks, the quarterly bookings include the bookings of $13.5 million for the UV filter product line of our Near-Infrared Optics segment.

Second, the just-completed quarter was a record revenue quarter for the company at nearly $72.7 million, which was 20% higher than the same quarter last year. Contributing to the revenues were the results of Pacific Rare Specialty Metals & Chemicals Inc. or PRM which had revenues of approximately $5 million. PRM is on its way toward achieving our previously announced revenue expectations for fiscal year 2008. The record revenue quarter marks the third consecutive record revenue quarter for II-VI and our guidance for the second quarter of fiscal year 2008 anticipates that this trend will continue. For fiscal year 2008, we are currently expecting revenues to grow between 18 and 22%.

Third, I want to highlight a few recent changes in the mix of gross margin for the just-completed quarter when compared to prior quarters. Our gross margin of 40.1% for manufactured products compares with 41.5% in the first quarter of FY '07 and 41.7% in the fourth quarter of FY '07. The addition of PRM during the just-completed quarter has changed the gross margin profile of the company slightly as the historical gross margins of the PRM product offering are less than the total company gross margin. Also, the continued positive contributions of our Near-Infrared Optics and Exotic Electro-Optics businesses have been a key in the overall financial improvement of the company. These improvements have helped to offset the short-term yield and capacity gross margin challenges of our Infrared Optics business. We are expecting the second quarter to be similar from a gross margin perspective to the just-completed quarter while the second half of the fiscal year should show good gross margin improvements specifically in the Infrared Optics business segment.

Fourth, our capital spending for the quarter was just under $5 million. This level of spending was lower than the spending we had for the last three quarters of the prior fiscal year. The majority of the capital spending is for our material growth capacity expansion in our Infrared Optics business which has been completed. This has been the single largest area of capital spending over the last several quarters and we have invested over $7 million in capital in this area since the beginning of fiscal year 2007. Capital spending for the remainder of fiscal year 2008 will focus on expansion-- and expansion of our corporate research and development facilities, additional crystal growth capacity for our Compound Semiconductor group, purchases of fabrication equipment, and enhancements to our thin-film coating operations. Planned spending for the rest of the fiscal year is approximately $15 million and would bring the full year capital spending to around $20 million. Please remember that the capital intensity of certain of our businesses especially our Infrared Optics business provides a significant barrier to entry by competitors.

Fifth, the effective tax rate for the quarter was approximately 27% and is expected to remain in this general range for the remainder of the fiscal year based on our current projections. The effective tax rate increased from the 24% rate of last fiscal year and reflects a higher level of U.S.-sourced income as well as an expected tax rate increase in China effective January 1st, 2008.

Sixth and finally, as a follow-up to our press release dated October 2nd, 2007, the company has signed a definitive stock purchase agreement to acquire 74.9% of HIGHYAG based in Germany. HIGHYAG is a leading manufacturer of automated equipment to enable the delivery of 1 micron laser light for a variety of laser processing applications. The transaction is expected to close during the quarter ended March 31st, 2008, and guidance will be updated at that time. We have not disclosed any financial details of the transaction as part of today's press release and we will not be able to address that aspect of the HIGHYAG transaction during the question and answer session.

Fran, this concludes my prepared remarks.

Before we begin the question and answer session, I would like to mention that these comments and answers to certain questions contact 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 30th, 2007. Robin, we are ready to begin the question and answer session.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Dave Kang.

Good morning gentlemen. The first question is regarding bookings of $81.8 million. Does that include all of $13.5 million of UV filter follow-on?

Yes it does Dave.

Okay. And on the gross margin situation, I guess if you can just provide additional color as far as the yield situation versus selenium? How much of those two segments or those factors contributed to the gross margin drop sequentially? And how much of that will be in a function of PRM going forward? I guess that's my question.

I'm not sure I can wrap all those together for you Dave but let me try on a couple things. Certainly is the selenium cost issue, a 25% improvement in the cost will help us if you look quarter one to quarter one, about a $1.4 million lower earnings for the segment. Maybe a third of that was due to the selenium cost issue. Another 50% of that delta is really due to the zinc selenide yield issue. And the remaining percentage due to equity compensation and a handful of other issues. So the main driver is yield. Second is selenium and followed thereafter.

So PRM is-- go ahead sorry.

The comment that I made that I think in the second half we'll have much better results mainly driven by the $30 pound selenium in the market place, our acquisition of PRM, and how that will help our cost structure will come in, in the latter part of the second half. We do right now obviously purchase a lot of selenium not from PRM. And as we move that business by way of recycling some of the waste we have to PRM we will get a nice lift out of it. I cannot quantify that for you.

Okay, if I recall, I thought there was sort of a lapse after perhaps about a year as far as the selenium ties in, how that impacts your business. Isn't it true?

Well, maybe I would say six months. So the negative impact we had in this quarter was due to the selenium we consumed back in the January, February and March when we put the selenium which was high-priced in the $50 range into our zinc selenide production process. Now the way we carry inventory to be sure we're well protected on having adequate zinc selenide and as that's flown out into production in Asia and back through cost of goods sold, it's probably a six-month trip.

Okay. And then how much will PRM provide I guess what you call it hedge, going forward on the selenium pricing?

That was one of the drivers Dave of the acquisition. Obviously the top line growth is what we've experienced here in the first quarter. And that $5 million is all external sales. We're not reporting any product sales from PRM to our other II-VI units within those numbers. But that definitely was one of the drivers for it. I think it'll do really two things. One is give us access to a supply that we didn't have access to before at a lower cost. And the second is it should enable us to as we were just talking on how the inventory-- how much inventory we've had to keep on hand because of really being-- using one qualified vendor, we're able to use or enable us to basically have less on hand because we'll have a sister company that has access to those-- to that material. So, that was definitely one of the main drivers for the PRM transaction for us.

Okay and moving on--

Sorry.

Sorry, go ahead.

Just on the selenium issue, market price in the mid 30's. Certainly it'll cost us a little less to produce it at PRM. But we will not be into supplying ourselves much selenium even in the third and fourth quarter of this year because we do have supply contracts from other suppliers that run out into next year. So we'll gradually bring in our shift over to PRM.

Got it, got it. And then moving onto UV situation, can you provide additional color or perhaps quantify the situation as far as what you meant by the medical imaging situation?

At one of the prime accounts that we've had has been for bone mineral densitometry measurement and that price that the doctors are getting for the BMD scans is reduced from $140 to where maybe by the year 2010 it's scheduled to get down closer to $50. So that reimbursement rate has caused our customer to really find a drop-off in their order book. They expect it to recover here in the next year or so as doctors get used to not having a one-year payback in their system prices but maybe having a 2.5 to 3 three payback. So it's the float of parts that we're producing for the customer. It works down. Inventory stabilizes. The new demand level probably is going to drop. That's what I was referring to. And getting through that whole issue might take us 6 months to 24 months. We're not really sure and our major OEMs are really saying the same thing. They've been through this before. When new reimbursement rates come out, everything dries up. And then it returns to a nice business. So we're treading water on that particular medical product. That's what I was referring to.

Okay and lastly it sounded like you do expect some fairly large blanket orders in this current quarter, second quarter. So with that assumption, should we expect this quarter bookings, second quarter bookings, to be up sequentially from first quarter?

Dave, we've really shied away from trying to give guidance on the bookings. It is because we don't have a-- we don't really have control. But I think the comment Fran was making was specifically in the infrared optics area where even in spite of some normal seasonality we had similar bookings as we did in Q4. And that Q4 of last year and that's a very good sign for our business and the health of the Infrared Optics business. And that is in spite of not having a few of these large blanket orders come through. So we're unable to give you any specific numbers as far as specific guidance for bookings. But I think just the trend of what we're seeing especially in infrared optics is pretty strong.

Okay, lastly I promise on the $13-- going back to the $13.5 million UV filter follow-on, most certainly those are for helicopters correct? Any update on the fixed wing opportunities?

No still only on the helicopters but the next and some portion of this $13 looks like it's to put a fifth sensor on the helicopters. They had been at four. They're going to five on some of them. And then some more of this $13 million is to outfit more of them. And yes we booked the whole order because it all will be delivered within 12 months.

Okay, all right. Thank you.

Your next question comes from the line of Mark Douglas.

Morning, Craig and Fran.

Good morning.

How are you?

Good.

Alright, for the IR portion of the business, are you still waiting to resume some of your sales to your material customers? And if so, how much money do you think is being left on the table? And when might you expect some more orders? I assume the back half of '08 once capacity is expanded and you're up and running.

Yes, just what you indicated is true. Here in this first quarter, we did take one order for materials that we really had not been even willing to look at. So obviously we're feeling better. And we are resuming the quoting process here in the second. We'll get some shipments on materials but the second half of the year, the third and fourth quarter, yes we'll be active in the marketplace. I think I made that comment in my quote that I just presented. We're getting better yields, which is so important. And then our other-- our new capacity expansion comes on line with the first furnace starting this month, getting good output out of it I think maybe by December. So yes we'll be back active in the market. The amount of sales that this is going to generate for us, I don't think we made that comment to this point.

I think Mark historically that materials-only portion of our business has been anywhere between and $2 and $3 million per quarter. Again for the last several quarters, we've-- that's the business that Fran's talking about that we've really been unable to address even from a quoting perspective. Now the quoting we're-- starting to let that free up and hopefully we'll get back to that run rate in the latter half of the year. I think that the signs that we're seeing though is the demand for that materials-only business is still strong. So we think that once our capacity comes online and we're able to address that that the demand for that product line is still going to be out there.

Okay. Thanks.

The next question comes from the line of Ian Fleischer.

Hi good morning. It's Ian Fleischer.

Morning, Ian.

Just a quick question on the PRM acquisition. Were there any asset step-up costs in the quarter related to that acquisition?

Not during the quarter Ian. The-- we did that transaction-- we completed that transaction on June 26th of '07, so that-- all the purchase accounting was done in our FY '07, the June 30th, 2007 had all of those-- all of our purchase accounting in there.

Okay. So it had all the P&L related step-ups?

Yes it was all the allocation of the purchase price was done in Q4 of FY '07, so that was the-- there was-- actually we had some of that transaction, we had no goodwill. We went through the process of valuing the assets and that was all completed as of June 30th.

Okay, just going back to the selenium raw material, you say that you have supply contracts in place through the third and fourth quarter. So once those run off, what percentage of selenium can you get from PRM?

Ian really I can't-- I'm not sure I quoted it exactly, but the end-- at the end of the fourth quarter. I think they do run into next fiscal year, but at a lower and lower rate. So we'll bring our own PRM work on 20% of our needs, 30, 40, 50. Probably we'd like to get it stabilized a year and a half from now where we produce for ourselves at PRM 60 to 80% range in there cause we always like two suppliers. And ourself we'll prefer to be the number one position.

Right, okay. So it's a year and half out, you'll be in the 60 to 80% area do you think?

Yes I think that's probable. The scrap that we generate in there are little clippings for zinc selenide and scrubber waste and so on, we'll-- we are routing that back to the Philippines now. So as we develop the process to reclaim the selenium, we'll blend that into even-- to what we are processing. So over a nice period of time, we'll get quite a nice help on this recycling of a waste.

Okay and on the-- in the CO2 optic side, did I understand you right that the end demand you think is coming a lot from Eastern Europe and Asia even though you're shipping a lot into I guess Germany?

I made that comment for the quarter. The German OEMs, which their OEMs are a nice part of our business, those German OEMs are saying their sales are heavy into Eastern Europe and Asia. Ourselves, we're well positioned in China. So we can see the China demand is very strong. And we have a couple nice OEMs in China that we're doing very good business for. So if you look at the quarter around the world, Europe strong on order taking and so on, driven mostly by aftermarket but OEM good; China, very, very strong; the U.S. was good to fair; and Japan was weak. So our net average year over year Q1 increase of 8% could have been stronger if Japan had been hitting hard. I think the Europeans, the Germans were stronger than what we usually see them to be.

And just finally maybe touch on-- in your Near-Infrared Optics business, the business away from the UV filter business? How that's doing?

Yes, I made some comments on that. Certainly there are a couple products that we're doing very well in our Vietnam factory. The windows for LASIK eye surgery, very strong; windows for 1 micron laser debris field for Volkswagen, very strong; products for another customer or two that are-- we call them debris shields. They protect the black splatter from a patient for example if it's in a medical application. Produce all those out of Vietnam. That business is going very nicely. Our YAG business where we've been struggling and working hard to improve our yields and our growth process and transition, a good portion of that fabrication to China, we're doing okay. Our transition to Suzhou is helping us reduce our costs. We're not where we want to be. Then our final portion of the business where we produce optics for 1 micron, beam delivery and other applications around near infrared, we're doing fair. It's been a challenge for us to get our coating yields to where they need to be and that's-- we're not happy where we are. But we are working hard at that.

Okay, thank you very much.

Your next question comes from the line of Jiwon Lee.

Good morning. First one housekeeping item. What was the international sales for the quarter?

They were 42%, Jiwon.

Okay great. And I just got slightly confused. Back to your military IR optics, I recall there was $7.2 million multi-year order that I think you were expecting on the Arrowhead. Now was that all in the first quarter booking or how was that split, if it was split at all?

Yes, did not end up coming to us as a multi-year order. I think we've received a good portion and then the portion that we have booked would be only that that we'd ship in 12 months. So I'm sorry I'm not able to tell you of our-- the segment we had about total of $12 million in bookings, EEO was a good portion of that. And then a portion of that was the 12 months of that.

Okay, any indication from the customer as to how that may sort of kind of track on a go-to basis?

I'm sorry I don't understand your question, Jiwon.

I know you're a little vague about this but any indication one way or the other as to how that may progress?

The Arrowhead business?

Correct.

Yes, I think they have placed what they need right now. And it's always-- they like a multi-year quote from us. If they're not funded for multi-year, say two or three, they'll only place the order for what years they're funded. So my impression is funded for a year. They'll probably come back nine, ten months from now, put some more orders to the supply chain and go from there. So I feel like we've got our one year's worth of business on the Arrowhead right now. And maybe we got 85 to 90% of what we hoped for. There are five important parts on it for us and we received 100% on a number of them. Maybe one of them we didn't receive 100% and that's why we're a little bit may be down 10% with what we'd expected to book for the whole order.

Okay fair enough. Thank you. And it looks like you're gearing up for a little high R&D spending and that I guess goes with a few areas that you are expanding on our CapEx as well. Can you give us a little more idea as to where you plan to focus R&D over the next several quarters?

We have been ramping up a little bit more, especially at our corporate R&D center here in Saxonburg, Pennsylvania. We-- that group has for the last probably two plus years been so busy with the UV filter product line that we have been directing efforts of that group onto production, onto UV filter. And now we're in the process of expanding the R&D facility that we have. We will be able to do really two things. One is to get onto some internal projects that we have been working on and some things that we have planned. And those are usually from a corporate perspective, those are really material-centered projects or things that we want to get into. And without naming any specific materials, Jiwon those would be things that we might be able to use in one or more of our existing businesses.

And the second is that we may be able to go ahead and do some-- get some external contract funding for our research here. Most of our external contract funding flows through our near infrared optics. The biggest area that we've talked about in the past has been on our ceramic YAG program and that is progressing nicely. And then we also have research and development that's funded at our Marlow facility as well. So those will be-- those projects and programs will continue but we expect with our expanded capacity here in Pennsylvania we should be able to get some external projects directly for our corporate R&D center.

And Marlow meaning on the defense side, yes?

Some-- Marlow's a lot of theirs-- if not really most of our contract R&D development is some type of military or military application. Fran you want to add?

If it's contract work, yes it may-- it probably flows through something like a plus up or a VAA to work on material improvement. But right now certainly at our Marlow group, we're doing a lot of work to penetrate the industrial market. We're working really aggressively on two or three different applications. And I did not make this in my prepared comments, but our industrial thermoelectric cooler business for the quarter was up 236%. So that's Q1 '07 over Q1 '08. I know it's a detail down lower than what we report but we've always targeted to work to penetrate the industrial market at Marlow. In this quarter we did well.

Okay, that's good. And I also sense some, I guess if I may, optimism on the high power sort of a CO2 laser optics on the commercial side. Could you just kind of tell us a little more about what your customers are projecting or telling you, sort of kind of looking out '08?

Yes, I would agree with you. We're quite bullish on that. And I think the improvement in the swing in zinc selenide yield situation will go a long way. At the same time, the customers, OEMs are-- they're sure important for us. And they're-- most of them are adding more capacity to their assembly lines. And that's in Japan and Germany. So that capacity is starting to come on. Remember for us, 85, 90% of the CO2 laser optics we sell are either directly to the aftermarket or through the OEM to the aftermarket. So the people that we're talking to are talking of running their lasers a good length of time. Divide by 24/7-- we're getting good response and I would say the strongest at the moment, Europe, Eastern Europe, Asia including China, modest in the U.S. and light right now in Japan. But Japan the two big OEMs there are building more lasers. They've built and expanded their factories. So this is due to hit pretty soon now.

Okay.

So we see everybody expecting more and I keep trying each quarter to talk about a new CO2 laser application. Because in order to get why there are more optics sold, you have to understand that there are more applications are constantly being developed.

Okay and finally, is there any sort of an operating expense growth for (inaudible) way that you guys can share?

As far as operating margins run?

Well I was more focusing on the expense line in conjunction with your options expense? In conjunction with build-- almost the expansion thing you may undertake in Asia as well as here? It's about 22%, 21% sort of you were kind of going back and forth.

Yes we-- I think kind of just the broader without giving any specifics, I think the broader theme of the rest of the fiscal year will be continued. I think once we get past Q2, what we're saying that we're anticipating the gross margin Q2 being similar. I think we're looking for a lot of lift on incremental sales that we'll be having. And that's really around the company. We're definitely expecting incremental sales in Infrared Optics business. PRM should be picking up as well. And we want to continue the good trends, operating improvement trends that we've made at the Near-Infrared Optics business and also EEO. So sorry to not give you any specifics there, Jiwon, but I think the overall trend is kind of a steady upward lift. Again, specifically with the IR, we'll still get through this second quarter but I think the third and fourth quarter are looking very good for us.

Okay, but if I may, could I say is it fair to say that you have the proper infrastructure under way. And obviously with the top line help in the second half of 2008, we could expect some leverage? Is that a fair statement to say?

Yes. That's a fair statement to say. And I think it's also a reflection of--in some of the units where we're expecting sales expansion and improvements, specifically on the SG&A line, we will not be adding a lot to that. For instance, the SG&A costs for the extra $5 million in sales we got from PRM, that's definitely much lower than the overall metric of the company. So we're starting to get some leverage from that. And to the extent we can do more and expand the PRM product offering, that will help as well. But I think that's a good-- that is a good summary. We are expecting some leverage on those future sales.

And great, thank you.

Your next question comes from the line of Avinash Kant.

Good morning Fran and Craig.

(inaudible)

Yes, question on actually CO2 laser front. You talked about this one earlier and you seem to be seeing some (inaudible) here. Now what I was trying to understand is that the customers that have been using this, how is their loading looking? Like what I'm thinking is that of course you talked about growing application, but from the applications that are already there, how are you seeing demand? And what's the forecast from your customers at this point?

I think we would give you the same as what I described. That these people who are running their lasers, certainly some are having slower times and some are having stronger times. But example-- so Detroit, the traditional big three, their lasers are not operating the hours per day that they were so they're not consuming optics at the rate. But the guys who moved into Mississippi and Alabama and Tennessee, the Japanese automakers are consuming optics very, very strong. So worldwide if you just took automobiles, worldwide look at worldwide automobile production, it's coming up in many of the non-U.S., non-German, non-Japanese auto producers are saying, wow whenever we build the line, we're going to put lasers all over the place. So just a simple thing like autos is, in spite of America, thinking the big three are down, our automobile CO2 laser optic sales worldwide would be up.

And would you think or would you say that the lines that are going up now do have a relatively higher laser content in it than there were a few years ago?

No, no, not-- I'm not able to say. I can't make a qualified judgment. But the people who out of our sales group who call on these factories are very impressed by-- the ones down in Alabama and Mississippi, the amount of automation and certainly CO2 laser processing that's put in.

I think, Avinash, that we are as we-- we tend to play into the strengths of our customers. And as they are producing more, higher power laser systems, that's really playing into the strengths that we have especially in our diamond turning and our interim coating operations. And I would say as those systems become more complex and higher power, that's definitely playing into a couple of the strengths of II-VI. So I don't know if the content to answer your answer, I like Fran don't know if the content per say has changed, but I would say that our concentration as far as us providing more and more of those higher power, specifically reflective optics that-- we definitely believe we are gaining a very large share of the high power CO2 laser market.

And you may not have broken it down, but would you give us what percentage of sales were from Asia?

The sales from Asia-- we just broadly said that there's 42% international sales and that's-- we have not given any specific further details, Avinash, on the concentration there so.

And just some clarification on the military and for in optics of course, that business has been very strong for you. You've booked orders, but how would that revenue trend go from now over the next maybe one or two-- or talking about just give me '08 at least?

Specifically for our military infrared optics business, Avinash?

I think they are very strongly like from something $7.5 or so to $12 million this quarter.

Yes, that's-- and again remember too in our-- in that Military & Materials segment are both the military business and also the PRM business. But specifically for our military infrared optics business, again with a lot-- like a lot of our businesses we're expecting a pretty steady increase during-- throughout the year. We are expecting them to be up in revenues. That was the only business unit last fiscal year, FY '07, it was down in revenues. They were down about 8%. But on the positive side, the bookings last year were up 10%. And that's kind of pushing us in. We have a nice healthy backlog in front of us. And you know we're really encouraged by the great operational improvements that have been made there and how that's translating into much better financial results. Our group in Exotics and the leadership there really deserve a lot of credit for, really making a lot of improvements over the last four to six quarters. Fran, do you want to add anything to--?

No I think it's right on. And we've had a similar nice improvement in our Marlow Industries that it gets-- it's included in the Compound Semiconductor group. But had nice improvement and certainly the transition of some of our cost operations from Dallas to Vietnam are paying off for us there.

Just to confirm, Craig, the-- all of the $5 million of the PRM is in the segment military right?

That is correct. It's a component of the Military & Materials segment.

All of it, right?

That is correct.

Perfect. That's it for now. Thank you.

And you do have a follow-up question from the line of Ian Fleischer.

Hi, Craig, in the income statement, can you explain what went through the other income line?

Yes, sure. Ian the main drivers or the main components in there, in the other income, really the two main drivers, one is a little bit of foreign currency gain during the quarter. And the second is a little bit more income from our minority ownership of [5M Plus Inc.], a company in Canada that we own 36% of. And both of those were-- and both of those the foreign currency and the-- our proportion of 5M Plus is net earnings, both of those were up from the prior-- from last year first quarter. Those are the two main components. There's a little bit more interest income in there. But the main drivers are foreign currency and our share of 5M Plus income.

And finally maybe just touch on what attracted you strategically to the HIGHYAG acquisition?

Yes certainly I talked about that the 1 micron laser light sources are getting a lot of publicity and certainly there's a lot of interest because of the features that they do offer. And HIGHYAG has been one of the leading companies in how to deliver 1 micron laser light. For example, the 1 micron sources that have been out there would be Neodymium doped YAG lasers, whether they are lamp pumped or diode pumped. So in the lamp pumped arena for example, one account has 1,000 high power YAG lasers doing welding. Of those 1,000 systems, 700 of the beam delivery, the actual take the laser energy from the output of the laser head and deliver it to the work piece and do the welding. All that has been constructed. 700 out of a 1,000 of these machines, the beam delivery was done by HIGHYAG. So they're-- they are one of the leaders in how to deliver 1 micron energy to the work piece. And they are also adapting-- not whether it's-- whether it's a YAG laser, they can deliver the same, whether it's a disc laser or whether it's a fiber laser. So it fits kind of with our competency to be a components and subsystem supplier to the industry. And it gives us a method cause we do provide a lot of the debris shields for 1 micron, high-power welding machines. So it gets us right close to the 1 micron world. We're not a fiber laser building company. But we understand issues of high power laser processing. And that's where a lot of work is going on right now. So we're going to be close to where the work is going on, on what will be the next applications for 1 micron lasers.

And what are the key applications for 1 micron lasers currently?

That's what I tried to say there. It's really welding so--

It's welding, okay.

You look at the world from-- and we're really high power oriented. There's a lot of lower power stuff that out there-- I give you this picture that if there are 50,000 high power CO2 lasers doing work in the world, maybe 2,000 of them would be doing welding. But on top of the 50,000 lasers, there's probably another 5,000 out there doing welding that are YAG lasers. So worldwide installed material, high power processing systems, 55,000, 7 of them are doing welding, 48,000 are doing cutting. The CO2 business is a cutting laser business. The 1 micron laser light source is really dominant in welding.

Perfect. Thanks very much.

Your next question comes from the line of Chris McDonald.

Hi, Fran and Craig.

Chris.

Chris.

Just curious, if you look at qualifying the new capacity that you're adding there in Pennsylvania, are there any significant expenses that you'll incur as part of ramping that capacity up, would you expect?

It's a good question, Chris. There-- I mean there has been some ongoing expenses that we have been incurring over the last several quarters. I don't think they're-- they have been that material that we will, you know would need it to disclose those or felt compelled to disclose those. As Fran mentioned, as we start to get into operating this first furnace, those first few runs there will be some expense related to that. We don't really think it's going to be that much. I'd say there's a little bit of cost that we've added ahead of that capacity. But it has not been a very significant amount. We're talking few hundred thousand per quarter I'd say not-- probably not more than that.

Okay, great. And it seems like you've had an acceleration in the activity just in the military infrared optics business. And I'm wondering is that a function of there's more opportunities popping up or is the margin profile has improved there? Has the company been more aggressive in pursuing some opportunities that maybe have been there for some time that you've just neglected to go after in the past because you were focusing on internal--

I think there are three parts to the answer. Number one, the group has done a very good job of getting into yield focus, getting the yields improved, scrap down, labor efficiency up. So the managing of the operation where we took last year to get our operation in better order, that's paid out. Secondly, the upside on orders, some of it is due to the war in the Gulf. Apache windows for example and systems on those are due to that. And the third has to do with longer term strategic work that we're doing. The ATP shrouds and the joint strike fighter shroud, the near-infrared shroud that we're building out of sapphire. Those longer-term strategic programs have probably 10 to 25 year life. So we're at the head end of those two strategic programs coupled with the war, along with our improved efficiency. So it gives us much better results.

Great. Thanks.

And at this time, there are no further questions.

Thank you, Robin. If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the quarter ending December 31st, 2007, is tentatively scheduled for-- before the market opens on Tuesday, January 22nd, with a conference call to follow that same day at 9:00 a.m. Eastern Time. Thank you for participating in today's conference call.

And this concludes today's conference call. You may now disconnect.