II-VI Inc (IIVI) 2008 Q2 法說會逐字稿

Good morning. My name is Shatina, and I will be your conference operator today. At this time I would like to welcome everyone to the II-VI Incorporated second quarter and fiscal year 2008 earnings conference call. All lines have been placed on mute prevent any background noise. After the speakers' remarks there will be a question-and-answer session. (OPERATOR INSTRUCTIONS). Thank you. At this time I would now like to turn the conference over to Mr. Craig Creaturo, Chief Financial Officer and Treasurer. Please go ahead, sir.

Thank you and good morning to everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI Incorporated. Welcome to the second quarter fiscal year 2008 II-VI Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Tuesday January 22, 2008. 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 second quarter results. First time, in our Compound Semiconductor Group, the Wide Bandgap materials group continues to make record shipments of semi insulating silicon carbide substrates to the RF applications market in North America. Potential customers in Asia are running multiple lots of our substrates through their manufacturing line with the expectation of successful wafer qualification during their current calendar year. We continue to transition more capability to our new production facility in Starkville, Mississippi, newly built furnaces in our recently expanded crystal growth facility in New Jersey have already started producing bulk crystals for commercial sales.

On the technical front we are making progress in large diameter crystal growth and wafer fabrication technology, and we continue to make deliveries of 100 milliliter semi insulating wafers to our government partners for evaluation. We are on track to release in volume 100 milliliter wafers to the industry this calendar year.

Second, the second quarter was positive from for Marlow Industries. During the quarter bookings in the defense, space and photonics market and the industrial markets increased significantly. While bookings for the telecom market was only slightly higher and the medical market was lower compared to the first quarter. Revenues increased significantly in the defense, space and photonics, telecom and medical markets and showed a significant decrease in the industrial markets when compared to Q1 as was expected.

Progress is being made by the product development and account management team. And as a result, we expect to see an increase in industrial revenues in the second half of this year. During the quarter Marlow received a follow-on order from Sandia National Labs for thermoelectric power generation generators based on Marlow's advanced technology. Also our largest medical customers next generation product introduction, which continue to experience delays in the second quarter is now expected to start production in our Vietnam facility during the third quarter.

Next, in our Military & Materials segment the Exotic Electro-Optics subsidiary completed negotiations during the quarter on a multiyear pricing agreement with this customer to produce sapphire window shrouds for the Advanced Targeting Pod which is flown on the F-15 and F-16 fighter aircraft. The five-year pricing agreement applies to new orders received through December 31, 2011 and solidifies Exotic's position as the sole source supplier of this high-performance product.

Consecutive with the execution of this agreement, Exotic Electro-Optics received a $5.9 million order for Advanced Targeting Pods which represents the balance of funding from initial long lead funding received in the first quarter. We recorded $2.3 million of this order in the second quarter due to our practice of not booking orders that extend greater than 12 months. With the Exotic business unit during the quarter profits exceeded forecast due to improved manufacturing yields, lower scrap expenses and improved margins in our sapphire business unit.

The Pacific Rare Specialty Metals & Chemicals, PRM subsidiary portion of our Military & Materials segment had measured success restarting the raw material supply lines during the quarter by securing our third major supply contract. The first significant selenium raw material shipment against that contract was sent to PRM during the quarter. A sizable order was secured for tellurium products, which added over $4 million to our bookings for the quarter. The pricing on this order is linked to published market prices plus a premium for our processing fees. We believe this pricing structure will help reduce our financial exposure related to market price fluctuations. The market price for tellurium products increased nearly 12% in the quarter.

At this time the raw material contracts in place support our fiscal year 2008 revenue projection of over $20 million. PRM has met our earnings projections for the first half of the year and is expected to continue on this trend for the entire year. Beyond the external revenue projections, PRM is starting to supply both selenium and tellurium products to other II-VI businesses, and we will start to see some sizable benefits for the in sourcing of these raw materials in later quarters.

At our near IR subsidiary, VLOC, the highlights include the continued meeting and exceeding the required schedule for deliveries of UV filter assemblies to our primary customer. On-time deliveries and quality has been 100% on this critical system that plays a key part in protecting helicopters deployed in Iraq and throughout the world. VLOC experienced increased bookings in each of the non UV filter productlines driven by strong military and medical laser market orders. The increased medical bookings led to a record half-million parts being manufactured this quarter in our Vietnam facility.

YAG operations improved again during the quarter while progress continued transferring additional YAG fabrication configurations to Asia. In the IR optics division bookings in the second quarter exceeded those in the same period of last year by 25%, breaking our previous quarterly bookings record by nearly 10%. First half totals for the current fiscal year surpassed last fiscal year's by 16%. Order levels for the quarter were boosted by large military component orders which spilled over from the previous quarter.

In Japan heightened demand for laser systems increased our bookings by 24% and 13% respectively compared to the same quarter and first half last fiscal year. Replacement optics order levels helped make the second quarter the highest ever for II-VI in Japan. Strength also in bookings from our China office which was up 29% over the first half of last year confirmed reports from OEMs in both Europe and Japan that laser system sales growth rates remain very high in Asia.

Despite worries about a slowing US economy and its effect on the world, the US aftermarket bookings remain strong. Indeed, US job shops spending increased in 2007 and is expected to remain high in 2008. According to the 2008 Gartner research's 40th annual capital spending survey aerospace and medical industries capped their spending, and work was largely outsourced to metal fabrication job shops. As expected for the quarter we had to forego material sales opportunities due to zinc selenide and zinc sulfide growth capacity limitations resulting in approximate 20% decline over the first six months of last fiscal year on these materials. However, with additional capacity now available this will allow us to reverse these results later in the fiscal year to take advantage of the many opportunities that still await suppliers of component blanks for several government security and surveillance programs.

Zinc selenide growth yields improved during the quarter as did the quantity of material produced. The first furnace output from our newly added capacity was qualified successfully in December. Concerns over the US economy have left many industry forecasted conflicted over CO2 laser system growth in 2008. Many economic indicators are raised as concerns. A downturn in the economy would affect II-VI first with a decline in our US aftermarket sales, which to date we have not observed.

According to the recent January 2008 market survey and forecast by Laser Focus World, the laser market grew 24% in 2007 versus a 7% forecast. On the non diode side, laser side, materials processing was the key driver, growing 31% in 2007. For 2008 Laser Focus World expects the rate of growth for non diode laser sales at about 10%. At II-VI we are prepared for a range of growth rates from that forecasted for last year to what actually happened last year.

We are currently positioned with a strong backlog of products for all business units which gives us solid footing as we head into the second half of fiscal year 2008. We expect our financial performance and cash generation to continue as we build our existing businesses and look for new opportunities that will grow the company for the benefit of the shareholders. Craig, this concludes my prepared comments.

Thank you, Fran. There are several items that I would like to draw your attention to from the just completed quarter. First, we described in the press release the gain that was recorded from our sale of our investment in 5NPlus. The pre-tax book gain on the sale was $26.5 million, and the after-tax book gain was $15.9 million. Once the book tax differences are taken into consideration the pre-tax gain that we will pay income taxes on was approximately $28.5 million. II-VI received a consideration from this sale in C$ and by December 31, 2007 had converted substantially all these funds to US$.

During the quarter we recognized our final equity earnings in 5NPlus as a component of other income of approximately $350,000. Because of this disposal the major item that appears in the investments line item of this December 31, 2007 balance sheet is the carrying value of the company's minority investment in Fuxin Electronics, which we made in March 2007. Second, we were able to use the funds from 5NPlus investment sale along with strong cash generated from operations during the quarter to significantly reduce our debt. As of December 31, 2007 the only component of debt that we have is a yen denominated loan that acts as a natural balance sheet hedge for our operations in Japan. It is currently our plan to maintain this yen debt instrument in addition to having access to our $60 million line of credit facility.

Third, during the third quarter we will be making a tax payment due from the sale of 5NPlus of approximately $10.6 million. We also used cash earlier this month in January to fund the initial payments required for the HIGHYAG transaction. Besides these two uses of cash we plan on making some further capital investments and completing our open stock repurchase program over the next few quarters.

Fourth, even when the impact of the 5NPlus investment sale is removed the just completed quarter was a record quarter for EBITDA at $19.3 million, topping the mark we set two quarters ago and resulting in a quarterly EBITDA margin of 26%. Our trailing twelve-month EBITDA of $72.6 million excluding the impact of the 5NPlus investment sale at December 31, 2007, increased by $9 million or 14% from one year ago.

Fifth, while our gross margin for the quarter at 42.9% was lower than the second quarter of last fiscal year it did improve nicely from the 40.1% gross margin level from the first quarter and exceeded our fiscal year 2007 gross margin level. Our military and materials and compound semiconductor businesses both posted solid gross margin gains during the quarter. The infrared optics business also made some gross margin improvements during the quarter and further improvements are expected for the remainder of the fiscal year as our material growth yields improve and we utilize the capacity expansion of the zinc base materials portion of this business.

Six, the effective tax rate for the quarter was 35.5% which was significantly higher than the 27% rate for the first quarter. The rate increase is primarily due to the gain on the sale of the 5NPlus investment. Excluding the 5NPlus gain the rate would have been approximately 28% for the quarter. The projected full-year rate for fiscal 2008 is approximately 29.5% including the 5NPlus gain and approximately 25.5% when it is excluded. This represents an increase from the 24% rate of last fiscal year and reflects a higher level of US sourced income as well as an expected tax rate increase in China. We are awaiting final Chinese tax authority guidance that may lessen the impact of this new rate increase on our operations in China, and if any tax rate reduction were to occur then we will adjust the tax rate in the future period.

Seventh, and finally, I think it is important to highlight the fact that our year to date bookings are up 18% compared to the same period last year. Our backlog during the quarter increased by approximately $5.5 million and now stands at $122 million. The components of the December 31, 2007 backlog were Infrared Optics at $34 million, Near-Infrared Optics at $26 million, Military & Materials at $41 million and Compound Semiconductor Group at $21 million. This record level of backlog gives us good visibility and confidence that the third quarter of revenues will be a record for the company surpassing the record revenues we achieved in the just completed quarter. All of the II-VI businesses segments showed higher revenues in the just completed quarter when compared to the first quarter of the fiscal year.

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 contain forward-looking statements which are based on current expectation. 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, 2007. Shatina, we are now ready to begin the question-and-answer session.

(OPERATOR INSTRUCTIONS) Avinash Kant, Broadway Capital.

Good morning Fran and Craig. One or two questions actually. First, talking about the materials yield especially on the zinc selenide and the zinc sulfide side, you did say that yields improved by the end of the December quarter. Does that mean you will start to see material sales at the level that you had before the yields started going down from the March quarter onward?

In the third quarter we will pick up our sales of materials, but I think it will take us fourth quarter to get back to the rate of sales that we had about a year ago. The yield improvement we started to head toward last quarter, we maybe had improved from our low point to get back to where we want to be, probably covered about 15% of that distance in the first quarter. Here in the second quarter we picked up another 25% of the distance. Or about 40% of the way back, another 60% to come, most of which I think will happen here in the third quarter.

So somewhere close to 60% level by the end of third quarter and then the rest by the end of fourth quarter, is that a reasonable assumption?

Well, what I was commenting on is yield, getting the yield of our process back to the steady-state that we like; we're 40% of the way now there at the end of the second quarter. I really think at the end of the third quarter we will be more like 90, 95% back. And so our level of sales while we're making that improvement we will pick up our sales back toward the old level in the third quarter, maybe pick up half to two-thirds of that level, then in the fourth quarter our sales and our yields I think will be back.

And if you could give us some idea about your international exposure for the quarter and also how much of revenue that exposed to the industrial application.

Overall for the company, the international sales for the quarter was around 45%. And the majority of those international sales are going for industrial applications, specifically our operations in Japan. Fran had mentioned and highlighted that we are seeing very strong business there, and that is primarily going for industrial laser applications to OEMs and aftermarket users in Japan. So that is a big driver of our international operation.

From the industrial point of view -- and it does, each one of our divisions has some industrial component with the exception of our one group Exotic Electro-Optics. But when you weight that number I would say 50% is industrially driven, of which a bulk of that heads to the IR Optics division.

And what is the trend there given what has being talked about the economy in general? Have you seen any kind of slowdown or any weakness over there?

No, as I made a comment in my prepared remarks, we have not seen a falloff in our aftermarket order rate, which is the best indication of how people are running their lasers. Certainly there is the dialogue that things are slowing around. We have not felt it and we sure do not find it in our aftermarket in Japan this quarter. Europe's aftermarket is harder for us to see because we sell mostly to the aftermarket over there through the OEMs. We are hearing a little bit of concern by the European OEMs on their production rate here in the third and fourth quarter but that is not the aftermarket. So I have to say we have not felt it; the consumer driven slowing down and therefore the slowing down of how people run their lasers, we have not felt it in the aftermarket to this point.

And one final question in the same vein basically. In terms of visibility, Fran, typically how far out do you see, and how much clarity do you get in terms of from your customers about the future business?

Well the aftermarket is not visible. We really run that business more on the statistics. It is running solid right now, I would say from the way it is running we could project 90 days out that we're going to get our order rate for the aftermarket around the world. Going further than that is very far for us to do. The OEMs on the other hand we probably have 90 to 180 days. So Craig made the comment that our backlog is really solid for the third quarter and will have record revenues in the third quarter. That is solid; we're working into the fourth quarter right now on what we expect. So 90 to 130, 140 days is where we are pretty solid.

Thank you so much.

Pierre Maccagno, Needham.

Congratulations on the quarter Frances and Craig. Can you tell us again how much business zinc selenide business did you forego during the quarter, and do you believe you might have lost share there or is there something you can recover?

Yes, I made the comment in my prepared remarks that we were 20% off in a quarter over last year similar quarter because we didn't have the capacity to quote. So we really don't breakout what our total material sales are, so I am unable to give you a relative. We were down 20%, but it is a really profitable product so when we resume our shipments in that area, third quarter and for sure in the fourth quarter it does have a nice gross margin help.

You will continue growing capacity for several more quarters or are you mostly done?

No, we agreed we are going to grow more, certainly this return to the yields that we've had in the past that will help us here in the third quarter, and we are bringing on capacity expansion that we outlined in prior calls. We have a facility and we are putting in quite a bit of capacity. We started to see the first of that capacity late in the quarter in December, qualifying the material out of these new furnaces takes some time, very important to have everything safe and properly operating. And we're on our way there. We will get more of that new capacity in the third and fourth quarter.

So basically have you tweaked the process now? You're getting more capacity out of your existing furnaces?

That would be one portion of where we are getting the capacity from. We had a gradual deterioration in our yields a year, year and a half ago. We've been working on getting that back in order and we've picked up getting back to the yield level we want in our older furnaces, 40% of the way there in the first and second quarter combined. I think we will get the rest of the way back to where we've been here in the third quarter so that is a big help on our capacity. The second big help is the new furnaces we are bringing online. We've been a year building them, and now it is starting to produce product.

Can you remind us what is the CapEx for the year?

The year, we are anticipating somewhere between 18 and $20 million; through the six months that we just ended back in December, capital spending had run about right in the middle of that range, and just right over $9 million.

And finally, how can you expect depreciation of the dollar to affect the business?

For II-VI it is an interesting question for us, Pierre. In some ways that does help us. For instance in our international sales operation specifically in Japan, to a lesser extent in Germany, that depreciation of the US dollar actually does help us a little bit. But on the flip side we do have the manufacturing operations in our Asian operations which are mostly tied closely related to the dollar. So our operations in Singapore, China, Vietnam and even in the Philippines, those, that goes the other way for us. So roughly speaking I think it is kind of a mixed bag for us. We are fortunate that it is, we are fairly balanced. There is not a hard and fast rule for II-VI that if the dollar appreciates it is bad or good, it is a little bit of both for us. And because some of the functional currency in our Asian manufacturing is a functional currency as a US dollar, when we do have some deterioration in the US dollar some of that offset does come back to us through foreign currency gain. It is a little bit of a mixed bag overall. I think the highlights that we've reached in the last couple quarters have been, the strengthening of the yen for us has been good because Japan is one of the top two or three markets that we service into.

I don't know -- and I make this comment and we might have to defend it at a later stage but a 10% weakening in the US dollar against Singapore dollar and so on, I think it hurts us a half to one gross margin point. And that has been going down over the last two years maybe as much as 20% now.

That's right.

Okay, great. Thanks.

Ian Fleischer, FBR Capital Markets.

Good morning. Could you comment on -- you laid out your guidance for the rest of the year, what are the swing factors that get you to or the most significant swing factors that get you to the high end of that guidance versus the low-end?

I think -- Frances kind of touched on a couple of them -- one is getting back into the and seeing the continued improvement of the zinc selenide yields and how that sets us up for not only getting back into further material sales but also allows us to participate in the overall optics growth. I think that is one key factor. The second factor will be kind of the continued improvement segment earnings wise or bottom line wise from our Military & Materials group. They have just done a tremendous job over last several quarters, and we are really anticipating that they will continue on along that track. I think a third factor would be PRM and continuing to ramp that business up and as Fran mentioned in his comments really right now the benefits for PRM have been pretty much external to the company.

Now in the back half of the year as far as sourcing tellurium and selenium from PRM for a couple of our businesses, we are going to get some cost savings from gross margin improvement because of that. I would say those are the key factors and the only other item I would put in there would be integrating HIGHYAG into the business mix. We didn't include that in the forecast. We're expecting the revenues of HIGHYAG for the second half of fiscal year '08 to be roughly 4 to $5 million or so with a little bit of improvement, with a little bit of help on the bottom line. So that is a factor that will get them ingrained and get them in the II-VI family businesses here and have them start reporting earnings as soon as this quarter that we are about ready to end here in March.

And I would add the important thing also to hit that high end of the earnings guidance we have is we need to be near the high end of our revenues and bookings, and right now we have a strong backlog for the third quarter. But to make the high-end number we need good bookings that would come in late February and March. So that last 2, $3 million of shipments that we are projecting, we are projecting the bookings and everything looks like it will happen, but in late third quarter if something would change might take a little bit of the top off from our top end of our earnings. We need those bookings and revenues to do it.

Okay, and with respect to your capacity, your additions to capacity, when do you expect to have that fully up?

End of this fiscal year. We've got the two features, the recovery on yields, another part of our current furnace production is we're expanding the amount of output we try to get in each furnace. That development continues and it will probably go past the fiscal year. But the second feature of adding these new furnaces in our other facility, that will happen. And I think we will get them all online by end of June.

Okay, and then on the PRM benefits with respect to sourcing, when do you think you will fully feel that benefit from PRM?

I think we've kind of targeted Ian, to get -- we are starting to see a little bit of that benefit. We are getting through some of the older contracts that we have, I think in, we will start to see some more significant benefits this quarter in Q3, definitely in Q4 and I think as we lean into FY '09. I think for us calendar '08 we should start to really realize the full benefits of that lower-cost selenium and tellurium. There has been a lot of work in the last six months, the first six months, I should say of the PRM ownership as far as qualification and as far as coordination, etc. And now we are really starting to -- calendar '08 we will actually start to use them as a primary supplier for a couple of our businesses.

And just finally, on the demand-side, would you see a change in demand earlier in your OEM business or your aftermarket business?

It will happen earlier I think in the OEM business. The OEMs are out there trying to sell capital machines and they will be able to see the auto turn down or any of those things that are capital related. The diversity that we have in the aftermarket is extraordinary. The amount of laser applications that are out there across all different fields is unbelievable, and if a few those turn down there and so opposed to running their lasers say five days a week, 12 hours a day and if they go to 5 days, eight hours we feel it a little bit. But at that same time there are some new applications that go out there so somebody else starts to buy for the aftermarket. There is an installed base of people using high-powered CO2 lasers of about 50, 55,000 units around the world. So they are constantly trading out their optics to get better performance. So it is a diverse mix. So we feel it soonest in the OEMs.

Great. Thanks very much.

(OPERATOR INSTRUCTIONS). Dave Kang, Roth Capital.

Fran, can you remind us what the mix is between OEM versus aftermarket?

Yes, OEM orders to us probably 35 to 40%, maybe 30 to 35%. That means aftermarket straight to us, the 65, 70. The OEM business, though, that they buy from us is split. They are buying for their assembly line, and they are often the primary suppliers into the aftermarket. So you would break that 30% of their business, is 35% that they buy from us -- that are our orders from them, you are probably seeing not much more than 10 points out of the 30 going to their assembly line. So you end up being about 90% is aftermarket driven.

I noticed that on your international business went up by about five percentage points. I think last quarter it was about 40%, now it is 45%. Should we expect that mix to continue to increase going forward, especially with this US going into recession or possibly going to recession?

I think we're seeing a little bit of shift there, Dave. Maybe not. I don't think we believe it is going to go to 50% or 55%. I think we are seeing some slight shifts there. If you look kind of back over a longer period of time over last, say 10 quarters or so, we've been bouncing around that 40, 42% range, touching up to 45%, a little bit of a higher mark for us but I don't think we are anticipating any other drastic changes there.

But assuming if it does is that going to change your business model as far as currency situation and all that?

I don't think it will have a big impact, Dave. Again the one that is going to have some impact would be in Japan. Again, we're getting a little bit of a pickup there, topline sales wise because of the strength of the Japanese yen. But overall I don't think -- that is not going to change our business model that much.

Got it. And then I was wondering if you can comment little bit more on the gross margin situation. Fran, you talked about 60% still to come. So what does it mean in terms of gross margin? Can we expect another point or so in terms of a gross margin improvement when you capture the 60%?

I think overall, Dave, we are expecting the margins to continue to improve; to give you kind of a specific number would be a little bit difficult. Fran's comments were more specific to the infrared optics business. We are seeing the segment earnings of that business improve second quarter earnings were up as a percentage of revenue and total dollars wise versus the first quarter. We definitely expect that to happen in the third and fourth quarters. To give you a specific percentage is a little bit difficult, but we are very encouraged by the gross margin improvement that we had picking up almost 3 percentage points, 300 basis points second quarter over first quarter.

We are targeting to kind of get back in the toward the mid-40s for gross margin. We've been kind of hovering for the last three to four quarters down in the lower 40% range. And if we target over the next two to four quarters to get back up into the mid-40s, I think that is overall our kind of longer-term plan. I hope that answers your question. I was trying to give you more specific numbers, but it is definitely -- there definitely is improvement there, both on the improved yields, selling out the capacity, getting back into the material only business and the infrared optics business. Those are all things that are positive for the gross margin of that business.

And lastly, actually a couple more. Regarding the UV filter you booked about $13.5 million last quarter. How much of that was shipped in the December quarter, and when should we expect another follow on, probably another couple more quarters or?

Yes, maybe a quarter and a half. And we probably of that 13.5 maybe we are shipping 40, 50% of it. And I think we are due to get an add on to that in the fourth quarter.

Dave, maybe to answer your questions a little longer-term, last year our FY '07 revenues from the UV filter business was right around $20 million. We are expecting that to go up around 20% or so this year. And so we are at a run rate that is closer to 24 or $25 million in sales for that business. So not as high or not as large a growth rate as we've seen in the past but definitely a nice, solid and profitable business for us.

And still for helicopters, no fixed wing aircraft at this point, correct?

Not yet, no.

Any update on the fixed wing opportunities?

I think right it is now kind of just out on the debating platform. The change in politics is kind of coming into the discussion or there could be a change and where the war is in Iraq, and good news that no fixed wing commercial plane has been struck. So I think it is in the debating mode. There continues to be development activity on the commercial platform that has been funded for two different primes to work on. But that is as far as it has gone commercially and I know of no fixed wing military plane that there is a plan to put it on. Maybe our guys who are closer might know. I know some of the slow low-flying cargo planes have some but it is not a major deployment.

Craig, just last question on the -- can you talk about the repurchase program, how much was bought back last quarter and what the plans are going forward?

Yes, we had no activity in that program, Dave, in the December ended quarter. We did have some activity in the first quarter Q1 of FY '08. It is our intent; we have about on the open repurchase program, we have about 165,000 shares that are still on the program that we have open. And we do anticipate completing that over the next few quarters or so.

Chris McDonald, Kennedy Capital.

Nice results. If I look back into the '05, '06, even early '07 timeframe at the margin performance in the infrared optics business, within a run rate in the upper 20s to low 30s. And I know we've had an increase -- a meaningful increase in selenium costs between then and now -- but I am just wondering if anything structurally has changed in that business that would prevent you from getting back to those kind of margin level.

I think, Chris, it's a good question; we definitely are targeting to get back at those levels. Again I think this yield challenge that we've been dealing with for the last three, four quarters or so really has pushed us down to the lower 20%, as we kind of ramp that business up part of the growth that we are expecting for Q3 and the rest of the fiscal year is coming from the infrared optics businesses. As Fran and I touched on, we have a nice backlog of products. We've taken a record level of bookings this quarter. We definitely are expecting higher revenues levels of revenue and doing that with the current operations that we have.

So I think we have the capability and capacity to do a lot more revenue but not without adding a lot of cost structure to the infrared optics business. The other point that you touched on was as we transition the selenium purchases away from our current supplier and get more on supply from PRM that will definitely help the gross margin as well. So I think there is nothing that is fundamentally changed about the infrared optics business that wouldn't be able to put us back over the next several quarters. It will take a little while to get there but we should be able to get back up in the high 20%, so maybe up into the low 30s at some point.

The only thing I would add to what Craig says is there might be two gross margin points that are tied to this foreign exchange, the weaker US dollar. Until that changes we might not get two of them back so if Craig is saying we are headed for 30, we are not headed for 32 because of [rap]. If you look a year ago at this time we are at the 28% operating segment margin for optics and we just did 23; I do think we will get back to the 28 plus.

Great. Thank you.

Pierre Maccagno, Needham & Co.

Even this 1% of your business you outsource now to external distributors and any further plans for more distributors in that area?

The portion of our business that is using distributors is fairly low. We have done some acquisitions over the last several years in Germany and Switzerland overall and the distributors selling our products if you look -- let's just look at the infrared optics business, it is probably less than 5% is what I would assume would be through distributors. And then if you look at II-VI as a whole, some groups we do use distributors a little bit more frequently. I would say it is probably less than 10%. So by and large we are using our own subsidiaries and sales and marketing locations to do those transactions. We don't really have that many I think areas targeted to in source.

I think one of the things we've done recently is set up our own sales and marketing organization and trading company in China and that obviously in anticipation of future growth in that area. But that was a start from scratch. That was not an acquisition of a distributor per se. That was actually just starting a brand new facility. So I don't think we have any burning needs right now. I think some of the things we've done over the last several years addressing Germany and Switzerland specifically have definitely got a couple of key areas to be serviced by II-VI entities rather than a distributor.

Thanks.

Jim Hollister, private investor.

One quick one. Have you seen any benefits from your Philippine operation yet?

Yes. In the comments I made, Jim, throughout the dialogue that PRM, which is our Philippine subsidiary, made our sales projections and our earnings expectations for the first half. So that is very, very good. We expect them to finish the year at around north of $20 million in sales and to be certainly accretive to us during the year. And the comment I made which is really an important one is that we have gotten some raw material supply contracts, and we think that our pace on how we can grow that business will be geared to the pace at which we can get these raw material supply arrangements set up.

Very good, thank you very much.

Ian Fleischer, FBR Capital Markets.

Just quickly in your infrared optics business, can you touch on geographic areas of strength or weakness in the context of both sales and orders?

Let's go orders first; really, really strong in Japan; really strong in China; good strength in Europe and good strength in the US. And when I say that I am referring to the OEMs and the aftermarket on all four of those continents or those four geographic areas. So not one that I can point a weakness to and I know we are all looking for that because of what is going on in the economy but at this moment we have not had it. It could happen any moment or it might go on and not happen. We are tuned up to the one that is talking maybe a let up would be the OEMs in Europe. They are saying their order rate, they built a lot of factory, high-powered lasers are running worldwide right around 5500 units per year. That is what the capacity, and that is what everybody has been tuning up for or headed up to 6000 from 5500. And I think the Europeans on their part of it are saying no, we're not going to go on up from 5500 to 6000 for our portion. We are seeing this starting to level off. So that is the segment where we get a little bit of likeness. On the shipment side for our revenues it is equal about across all three, four major areas. We are shipping to every place pretty much equally according to our order book.

Okay, and just to stay on the European orders, is there a difference between Western and Eastern Europe?

Yes, I'm really referring to Western Europe. That is where the big high-power OEM builders are, and they are sending their machines into Eastern Europe, into the brick countries, and some of their strength in the last six months has probably been heading into China, India and so on. And I cannot tell -- they are only telling us that they are not going to go on up much further right at the moment. That is the start of slow of the growth rate that we are wondering about. And more driven and we cannot see into their order book whether it is driven by letting up in the brick countries or is it due to a letup or just a slight, not as rapid growth in main Europe right now. We do not know that but they are just signaling a little bit slowing in the growth rate.

(OPERATOR INSTRUCTIONS) At this time there are no further questions. Will there be any closing remarks?

If there are no more questions I would like to thank everyone for participating today. Our next earnings release for the quarter ending March 31, 2008 is tentatively scheduled for before the market opens on Tuesday, April 22, with a conference call to follow that same day at 9 AM Eastern time. Thank you for participating in today's conference call.

Thank you. This now concludes today's II-VI Incorporated second-quarter and fiscal year 2008 earnings conference call. You may now disconnect.