II-VI Inc (IIVI) 2008 Q3 法說會逐字稿

Good morning, I will be your conference operator today. At this time, I would like to welcome everyone to the II-VI Incorporated third quarter fiscal year 2008 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. I would now like to turn the call over to Mr. Craig Creaturo, Chief Financial Officer. Sir, you may begin your conference.

Thank you. And good morning, everyone. I am Craig Creaturo, Chief Financial Officer, and Treasurer of II-VI Incorporated. Welcome to the third quarter fiscal year 2008 II-VI incorporated investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, April 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. I'm Francis Kramer, President and CEO of II-VI incorporated. I'm very pleased to report record revenues and record bookings for the quarter ended March 31, 2008. Our bookings from continuing operations increased 44% compared to the third quarter of last fiscal year, and reached a record $93.7 million. Contributions toward these records occurred in the majority of our business segments.

The compound semiconductor group or CSG experienced 63% higher bookings as compared to last year's third quarter. The just-completed quarter was very strong one from for Marlow Industries. Bookings were up 58% year-over-year driven by strong demand in the industrial, defense, and medical segments. The Q3 bookings included the largest single industrial order in the history of the Marlow division. In addition to these large increases we continued to see a gradual increase in telecom demand. Revenues for the quarter were up 22% in the third quarter of FY '08, versus the third quarter of FY '07 for Marlow. This was a result of increased sales in the defense, space and photonics, industrial and medical markets.

We expect that industrial revenues, driven by new applications, will continue to increase during the fourth quarter. We further expanded our Vietnam manufacturing capacity to accommodate the increased demand in industrial products. Our largest medical customers next generation product was delayed during the just-completed quarter, due to customer program issues. But it is now expected to start in production during the fourth quarter.

The wide band gap materials business of the compound semiconductor group continues strong shipments of semi insulating silicon carbide substrates to RFIC applications market in North America. Progress continues to be made in wafer qualification at several potential customers in Asia with full qualification at one large customer expected by June. During the quarter we passed a major hurdle with one large Japanese customer by successfully completing a qualification system and manufacturing process audit at our New Jersey facility. To address crystal growth capacity challenges, we have finalized installation and qualification of several newly-constructed growth furnaces, increasing our capacity 30% to date this fiscal year.

On the technical front, our government partners have completed one stage of evaluation of our 100-millimeter semi insulating wafers, and report results on par with our more mature three-inch wafer product offering. We have the polishing tools in place in our New Jersey facility to lower costs of 100-millimeter fabrication and polishing process, and are on track to ship 100-millimeter semi insulating wafers to commercial customers in this fiscal year. We have historically included in the compound semiconductor group our EV products division, but our decision to sell this business has condensed the income statement results of EV into a single line item.

II-VI has made significant investments in capital equipment, research and development, and operations in this division over the last 15 years. This has enabled DV products to be the world leader in the radiation sensor business based on cadmium zinc telluride or CZT crystals. Our decision to sell this business was made after careful consideration of several factors most notably being one, creating sustained II-VI shareholder value and two, creating a path to unlocking the value of the technology that was developed at EV products over a long period of time. Following my comments, Craig will make some general remarks on the financials of EV as well as how our financials will look now that we have made the decision to divest of this business.

During the quarter, our VLOC near infrared business continued to meet or exceed the required schedule for deliveries of UV filter assemblies to our primary customer. This has been a very successful program. Based on our best information and the interactions with our customer, our current forecast expects that the delivery rate on the UV filter business will reduce in the first quarter FY '09 to a rate that is slightly below that we experienced in fiscal year '07. Over the next few months, we will determine the running rate needed by our customer and will adjust our production plans accordingly. We have included this expected slowdown in business, in our initial guidance for fiscal year 2009, that was included in today's press release.

In our VLOC near infrared business we continue to see increased demand for optics use for medical and cosmetic laser applications. We have been able to address this higher demand with our low cost capacity in our Vietnam facility. The example of this was our ability to quickly ramp capacity to meet a 40% demand increase for windows used in laser -- in Lasik eye surgery. Military materials group also had a very strong orders during the third quarter. The Exotic Electro-Optics military infrared business unit improved margins and exceeded forecasts due to improved manufacturing yields, reduced graphic expenses and improved productivity, especially in the sapphire business unit.

Bookings for the quarter increased slightly over the prior year's third quarter. But we were 1 million below forecast due to a delay of production orders for infrared components for the arrowhead targeting system on the Apache helicopter. These delayed orders are expected in the fourth quarter. We have received a request to increase the production rate of sapphire window shrouds for the advanced targeting pod, ATP, which has flown on the F-15 and F-16 fighter aircraft. Production orders and delivery rates are expected to nearly double over the next two years. The exotic team is working with its customer to define production tooling and capital equipment requirements to support this production ramp-up. The accelerated delivery rate will be included with this production order, which is now expected in late Q4 FY '08.

The other part of the military and materials segment is our Pacific rare specialty metals and chemicals subsidiary called PRM which was acquired in June of 2007. PRM supply lines have continued to improve nicely, in the third quarter for both selenium and tellurium raw materials. Third quarter bookings of PRM were strong due to the significant increase in the price of tellurium. As a point of reference, tellurium was priced at $115 per kilogram on December 31, 2007, and on March 31, 2008, had climbed to $250 per kilogram. Revenues for the quarter continued at the rate needed to achieve our FY '08 revenue projections of in excess of $20 million for the year. After three quarters of operating as a II-VI entity, PRM has met our profit projection and has been accretive to earnings.

We have successfully recruited a general manager, Mike Carpenter to run our PRM business. Mike has an extensive background in the chemical industry and will be full time on-site at PRM in the Philippines. We now have a program in place to send all selenium containing material waste streams from our optics manufacturing operations around the world to PRM for recycling. This program should benefit both entities going forward.

We're starting a capital investment plan to upgrade the PRM facility to increase capacity and capabilities. This investment plan of nearly $1 million will be executed over the next 18 months, and will include upgrades to our laboratory and R&D facilities.

The final segment today is the IR Optics division. I'm pleased to announce the hiring of [Gene Yosbeck] as the President of the business. His addition culminates successfully a lengthy search by bringing to the business an experienced general manager with a background in managing profitable manufacturing and sales organizations. For the IR Optics division, bookings in the third quarter of $41.4 million, excluding HIGHYAG, exceeded those in this same period last year by 19%, this is the second consecutive quarterly booking record for the IR Optics division. The nine months total bookings of $116 million surpassed the same period last fiscal year by 17%.

Order levels for the quarter were boosted by strong OEM bookings in the U.S., Asia, and Europe. Stong production of lasers and laser machine tools in Germany, Switzerland, and the U.K., contributed to a record-breaking quarter for Europe. Meanwhile, Japan bookings also set a new quarterly record with continued strength from laser machine builders and from laser via hold drilling machine manufacturers, and were assisted by the strength of the Japanese yen. Blanket orders for U.S. OEMs resulted in bookings increase of 21%, compared to the same quarter of last fiscal year.

We continue to closely monitor U.S. after-market orders, for signs of a weakening economy. While certain market segments tied to the housing and automotive market have been weaker, our overall direct after-market sales for this fiscal year are forecasted to be 8% higher than last fiscal year. This growth is made possible by the very diverse markets addressed by the laser machine tool industry. Our zinc selenoid and zinc sulfide capacity expansion has resulted in a significant increase in material production.

We will finish our capacity expansion during the next quarter. Bookings for zinc materials of $1.2 million in the third quarter were significantly higher than the $120,000 in the same quarter last fiscal year. Material bookings of $4.2 million for nine months of this fiscal year exceeded last fiscal year by 20%. In March, we realized the impact of the new capacity by increasing our output by 25% compared to the year to date monthly average. We expect this increased output to continue in the months ahead, and will aggressively pursue material sales opportunities in the rapidly growing infrared imaging market.

Our new HIGHYAG subsidiary is being integrating in the II-VI infrared segment. Significant opportunities exist for the one micron laser well beam of assemblies and components including many automobile, truck, agricultural, materials handling and moving equipment. Demand is being driven by higher fuel costs which promote light-weighted vehicles for better fuel efficiency.

We are currently positioned with a strong backlog of products for all of our business units. We have good visibility for the remainder of the fiscal year 2008. While we recognize there are global economic challenges and uncertainties, we expect to make our growth projections and continually look for new opportunities that will accrue to the benefit of our shareholders during fiscal year 2009. Craig, that concludes my comments.

Thank you, Fran. Here are the items I would like to highlight before we move into the question and answer portion of the call. As we noted in our press release on April 4, and as further described in today's press release, our decision to sell the EV products division has led to our accounting treatment of this business as a discontinued operation, in accordance with FAS 144, accounting for the impairment or disposal of long lived assets. Historical and current financials and related data in today's press release have been presented on this basis.

We disclosed the prior year revenues of EV at approximately $8.5 million, and the current year to date revenues at approximately $5.1 million, in the April 4, press release. Further, we have detailed the after-tax losses from this business, for the three and nine months ended March 31, 2008, and 2007, in today's release. This is the financial information regarding EV that we were able to discuss at this time. And we would entertain discussion during the question and answer portion of this call that focuses on any additional business-related matters that we may be able to address, excluding of course, any particulars on the sale process and its status. Please also note that our guidance reflects the continuing operations of the Company, excluding the discontinued operations.

The record levels of bookings for the quarter from continuing operations at $93.7 million has added to the Company's backlog. When the beginning backlog from HIGHYAG is included, which was approximately $1.6 million, and the backlog of EV products is excluded, the current backlog from continuing operations now stands at $134 million. The components of the March 31, 2008, backlog from continuing operations were infrared optics at $38 million, near infrared optics at $19.5 million, military and materials at $44.5 million, and compound semiconductor group at $32 million. This backlog is giving us confidence that our fourth quarter will be a record revenue quarter.

The quarterly gross margin from continuing operations for the quarter came in at 41.7%, and was lower than third quarter of last fiscal year, in the second quarter of the current fiscal year. The addition of our recent acquisitions, including HIGHYAG for the first time in this quarter, we just completed, has changed the mix of revenues for the Company. This along with other revenue mix changes is a significant contributor to the decrease on a percentage basis despite the $10.8 million increase on a dollar basis from the same quarter last year.

Our military and materials and compound semiconductor group businesses both posted solid gross margin gains during the quarter. The infrared optics business, excluding HIGHYAG posted its second straight quarter of gross margin improvement. As we continue our efforts on yield improvement, and crystal growth capacity expansion, we believe there is upside for gross margin improvement in this business. The effective tax rate for the quarter from continuing operations was 17.7%, and brought the year to date rate to 30.1% including the gain on the sale of the equity investment from the second quarter and 24.5% when this transaction is excluded.

During the quarter, the Company benefited from the expiration of the Statute of Limitation of certain tax exposure items, that were previously reserved in accordance with FIN 48, accounting for uncertainty in income taxes. Our current forecast projects that the year to date effective tax rate from continuing operations of 24.5% will be consistent with the rate we will use for the fourth quarter.

During the third quarter, we made the tax payment that was due from our sale of our equity investment from the prior quarter of approximately $10.6 million. In addition, we spent about $6.2 million for the initial investment in HIGHYAG, and $5.3 million to complete our open stock repurchase program. In spite of these uses our consolidated cash balance only went down by approximately $6 million during the quarter which is a reflection of the strong operational performance of the business. Because none of the three specific uses of cash in Q3 that I just mentioned will occur in the current quarter, we are expecting a build in cash during the current quarter as we close out the current fiscal year. Fran, this concludes my prepared remarks.

Before we move into the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements which are based on current expectations. Actual results could differ materially. For information about factors that could cause the actual results to differ materially, please refer to the risk factor section of our Form 10-K for the fiscal year ended June 30, 2007. We are ready to begin the question-and-answer session.

(OPERATOR INSTRUCTIONS) Your first question is from Avinash Kant of Broadpoint Capital.

Good morning, Craig and Fran.

Hello, Avinash.

A few questions. In the guidance for fiscal year '09 you are guiding to I believe roughly 11% revenue growth and historically you have been able to add 4 to 5% at the top line through acquisitions. Is that still the strategy and should we be thinking about that for the longer term?

Well, it is certainly always our strategy to be out there opportunistically, looking for an acquisition that fits our model, and we're constantly trying to make that happen. So we're on the same strategy. Can it happen? And will we find the right acquisition? It is a little unpredictable. At the same time, we have had maybe a little larger top line growth organically, and so maybe 11 might have been a few percentage points more in the past. But certainly as I made comments in my prepared remarks, we have a little bit of a downwind on the UV filter business. So I think our growth rate on the top is adjusted a little bit based on that. And whether we're going to be opportunistic enough to find the right acquisition. It is hard for us to predict at this moment. But we're trying.

Okay. And then based on what you see at this point, do you expect overall backlog to continue to grow in the June quarter? Is that what you have in your guidance?

Avinash, we gave the specific guidance for the revenue growth. Because of bookings, we don't control that. Or we don't obviously have as much control over the customer orders. We don't try to make projections on the bookings quarters so we've put into the guidance what we think is going to flow out in the fourth quarter, and again, it gives us the good visibility and why we're able to come out with preliminary FY '09 guidance as well, but we're probably not in a position to make any specific guidance on the bookings.

And also, the yield improvement, a question on that, I believe you had talked about 30% growth in capacity. Now, how much of that is coming from yield improvement and how much of that is just from the new install in capacity that you had?

Well, in my comments, my prepared comments, I indicated we're up 25% in our output in March, compared to the prior year, or the prior months of the year. So that is really where we're up 25% as opposed to 30, and it is going to be more like 20 of those 25 points is really from the new capacity. Five on yield, I think and the last time I spoke about yield, I said we had a problem, and we're off let's call it 100 index points and we've recovered 40 of those index points on the yield. The best I can say is we've recovered maybe a 45, 50% of those. We're not all the way back, and therefore, I would say the capacity gain, mainly 80% from the new equipment, of which we will finish the other newer equipment coming online here, during the fourth quarter. So I think we're going to be out of the bottleneck on not having enough capacity to take advantage of all of the sales that are out there, and that is just now starting to be felt. So that is the mix of the improvement.

So Fran, the $1.2 million in revenue that you received this quarter, how big could that be? Going forward I'm talking.

That was $1.2 million of bookings that we took in the quarter. We could -- it is hard for me to predict that number. It depends upon the programs that come forward to us where people want materials, and want to procure it from us, we usually supply more of those materials to fabricators of military defense systems. If it is commercial military work, we tend not to see those RFQ's, we're making those optics ourselves, but in a nutshell, we will easily -- I mean it might not be in the fourth quarter but other quarters we can double, maybe more than double that rate.

You see enough opportunity that this could be doubled, if you had all of the capacity?

Yes, and it is just as I said, it is kind of opportunistic when the orders, the RFQs are out there for these larger military or surveillance program systems, that's when we're active in the sales side of the market for materials.

Thank you. I will let others ask a question and then get back in line later. Thank you.

Okay.

Your next question is from Ian Fleischer of FBR Capital Management.

Hi, good morning. Can you comment, obviously the military segment was very strong orders-wise. Can you drill down a bit on what specific -- what specific areas you're seeing the strength? In your military segment?

Let me give a little bit of a discussion, certainly our business at exotic is all military. And the order bookings were, as I stated, a little better than the prior year's quarter. The Arrowhead program is certainly the one that goes on the Apache helicopter, which is doing very, very well. We expect more future orders on ATP, as I mentioned, and another one JSF. If you go to another one of our businesses where we have military and that would be at our near infrared VLOC, they did have bookings on the UV filter business here in the third quarter and that was good. And the final group I'd comment on certainly the Marlow Industries business is very strong and we call it defense space and protonics, their business was strong. And they're well positioned for most of these thermal electric cooler order opportunities that come out in the military. Last one, the infrared group here in the Saxonburg location, does do military business, and I think they were stronger than usual in this quarter, in the military, also.

And maybe also provide a little bit of granularity on the margin, and how you think about that going forward?

I think we've got some upswing in certain of the businesses, as we mentioned, we had a couple of quarters of improvement now in the infrared optics business, as Fran mentioned, finish can out the capacity expansion and getting even further capacity definitely will help the margins of that business specifically. Fran mentioned some of the other opportunities that we are working on, and say the Marlow business or the near infrared optics business. We are making a little bit of a shift with the mix of the product, again the HIGHYAG mix has changed the gross margin profile a little bit. Some of the opportunities we're going at are a little bit lower margin businesses than we have historically gone at but I would say roughly where we ended this quarter with the gross margins around the 41.5%, 41.7% range, we do think there is kind of overall upside from that mark. That is fairly consistent with where we are at year to date, as well. But again, it is going to be kind of business unit segment by segment specific. We definitely think there is upside again in the IR business, and a couple of the other businesses. But overall, we should kind of trend or see that gross margin trend up on a gradual basis.

Okay. And just finally, just touching on, your infrared optic segment, that continues to see very strong, it looks like end demand, with orders up 19%, ex HIGHYAG, can you provide a little bit more granularity on where you're seeing the strength there?

I tried to make a couple of those comments in my prepared remarks, Ian, but certainly, Europe, the OEMs in Europe are strong, they're continuing to have good outlets for the new systems that they're building, the replacement systems, and a lot of that heads into Eastern Europe, and Asia, and China. So they set a record. The Europeans set a record. And the Japanese also set a record, I'm talking record by OEMs, asking for parts from us, and the Japanese strong at one or two or three of the major laserhead people, laser CO2 laserhead builders and laser system builders, especially the [VO hole] drilling people which would be people like Hitachi, Mitsubishi and so on. So that runs in a cycle and they're in a upswing right now for VO hole business. So Japan had a record. The U.S. market was not a record for OEMs but it was still -- it was up nicely year-over-year 21%.

And then the final segment which I did make a comment on is U.S. after market which we do try to monitor and report to you, we expect the full year to be up 8%. It is a little weaker and it is really probably our best thing to report on that gives the general health of the economy, because this really relates to everything that is manufactured, where these lasers are being run, and at what rates of consumption of optics, their hours of operation dictate. And in the past, we've probably seen 12, 13, 14% growth year-over-year, from U.S. OEMs, or I mean U.S. after-market, and now when we report, we think it is 8%. That tells you there is something a little less aggressive going on in the U.S. economy, as it relates to laser machine processing of materials.

Okay. So I mean it sounds like the strength you're seeing is really international, in particular, China and Japan, and then also in Europe, East Europe and then the U.S. continues to still grow to decent rates, is that a fair assessment?

I think Ian, that's a very fair assessment. I think the other factor that we have as a corporation for the quarter, international sales were about 47%. So that is kind of reconfirming the facts that Fran were giving you, that the stronger areas we're seeing and the higher growth areas are outside of the U.S. U.S. still doing okay, but overall, some of the more higher opportunities are outside of the U.S. for us.

Thanks. That's very helpful. Thank you.

Your next question is from Dave Kang of Roth Capital.

Hi. Thank you. Good morning. Craig, what should we use as a tax rate for fiscal '09? You gave something for fiscal fourth quarter, but for fiscal '09, what should we use?

Dave, I think our expectation is that the tax rate will go up just slightly in FY '09. We do -- we are moving into a higher tax program in China, specifically, and some of the growth drivers that we will have will be U.S.-sourced income. That is going to push our rate up a little bit. I don't think it will be -- we will still get a nice benefit from the international operations that we have, but to expect that rate to be up a couple of percentages from where we're targeting right now, about, right around 25%, for this fiscal year, and to be up a couple of percentages from that, probably would be pretty reasonable. We haven't given any definite specific but I can tell you directionally, we're anticipating it going up a little bit.

And you gave international revenue. What was the mix between after-market versus OEM?

Well, we're still on the -- again, when -- what Fran was talking about was the U.S. direct after-market, and when you step back from our infrared optics business, still 85 to 90% of those components, optics, mirrors, lenses, whatever components we make, are going into the after market, so that is still holding true, and actually gaining a little bit, as that installed base grows. So again, 85, 90% of the parts we're manufacturing are going to after-market uses. Fran was reporting on the direct after-market sales data that we have.

We do, have and we try to present, or at least speak about the U.S. after-market when we have more visibility.

Right.

Europe and Asia visibility is much cloudier. In those markets the customers who operate lasers tend to buy from the OEMs, a high percent of the time, their replacement parts, so the numbers for those markets are really purchased by the OEMs. The bulk of them.

Okay. And it is really a strange thing, is it really driven by new adoption, or is that the primary driver right now? Because currently the economy shows otherwise.

Yes, it is both. It is the switch of people from one way of processing to another, and I always try to give some new examples of laser processing that has happened, came to our attention during the quarter. I do not have one this quarter, except to report that it also swings from one economic issue to another. And right now, the U.S. is going heavier, believe it or not, from what we're seeing, our agricultural people, people like John Deere, things like that, are buying more, because of the Midwest focus on ethanol, and the crop issues, and so on, so when auto turns down, which it is, up in Michigan and so on, it is up down in Alabama where we've got import cars being built but in general, auto is down, agriculture is up, material handling people like JLJ, they're up. I do not know the reason for that business being up. But it swings -- in the U.S., and the after-market, by sector, construction industry, people who are building windows, who need welded dessicant strips to put between glasses, that business is off right now. So when the economy changes like it is right now, one is down, one is up, sorry I don't have any new applications to report.

Well, you guys talk about like Sunkist, and speaking agriculture, you guys talked about Sunkist using lasers several years ago, but I don't think I've seen much of it in the supermarket. Can you just give us an update on that segment?

I think all of the food stuff continues to move forward. Some slower than others. It depends upon the producer and how they want to mark the product but it continues going forward. We usually highlight those marketing, graving applications once, twice maybe when it becomes new, and since they're not, the product line that consumes optics for us and the after-market, those are lower-power applications, we really wouldn't tend to report on them again, but it is moving forward, and I think it is a matter two of or three years, people who already mark by the little stickies that they put on fruit, or by ink, gradually phase that down, as their equipment gets worn out.

Got it. Thank you.

(OPERATOR INSTRUCTIONS) Your next question is from Jiwon Lee of Sidoti and Company.

Good morning. I have several questions. First of all, on the commercial IR front, at the beginning backlog, from HIGHYAG was about $1.6 million, correct?

That is correct.

So looking at the sales and the booking figure, roughly how much we build in for HIGHYAG contribution on that segment?

For during the quarter, just completed quarter?

Yes, please.

We did about, just right around $2 million in both bookings and sales for HIGHYAG. So, and that was pretty close to where we anticipated. We do anticipate some growth over the next several quarters, but roughly it was about $2 million in both bookings and revenues for the quarter.

Great. And then are you now taking all orders for your zinc-based material? In other words, when I look at your segment bookings there, are you booking everything that you could? Now that you're capable of expecting the materials capacity done by the June quarter?

Well, I would say we're not 100% taking everything we can bid. We like to hold the prices at a good healthy level. Since we've been out of the market for quite a while, one would think the only way to get back in is to drop the price and try to bring in a load of work. We're not doing that. We're managing our pricing at the level we think it should be. And at the same time, our inventory around our three plants that use this material real heavily is not, the raw material we want -- the amount we want on the shelf at all three places is not close to where we would like it to be. So we're trying to move smartly to take some more orders on the outside, but still build our inventory. And I think that will -- that is why we're not able to state a rate at which we think we will increase those orders. We are going to work pricing at the optimal level, let's say, over the next quarter so that our capacity gets built back up.

Okay. And then on the UV filter business, the '07, FY '07 level was about $20 million, right? So looking at FY '09, you threw a little caution there. How much lower revenue should we sort of kind of expect for that business next year?

Well, and I think, Jiwon, we tried to guide toward it. It is going to be around that level. Again, our intelligence is roughly -- it is as good as our customer's intelligence and right now, we're seeing and based on recent data from them, are planning that that portion of the business will be down, and right now, I think that is about the best guidance we can give and I think Fran said slightly below the rate that we ran in FY '07 and you're right that rate was right around $20 million.

So that is something we obviously are reacting to, and have been working with the customer to make sure that we understand that, and in the past, on this program, this product line, there had been numerous changes. There might be positive changes might be negative changes but we're giving our best information that we have at this time on that program but we do expect it to be down a little bit from that $20 million in FY '09.

And your expectation there, it excludes any potential spread outside the helicopter? And you have no increased visibility?

That is correct. We are talking about the current platform and the current products serviced by our customer, the current platform that they are retrofitting, that guidance does not anticipate branching off or going into some other similar or tangential branch.

And IR windows for Arrowhead programs, you said there was sort of an order delay, but you expect that to pick up in the fourth quarter? Is that in the guidance?

That is in the fourth quarter. We anticipate getting that order in the fourth quarter. I'm not sure that will end up translating into revenues in the fourth quarter. Probably be more like early FY '09 but that is definitely in our future guidance and I think that was just a slight delay from what we anticipated, there was growth as Fran mentioned in the military infrared optics business, it would have been more if we would have got this one order, but we expect it here now this quarter.

I will try to move fast. On the PRM side, obviously the tellurium price, quarter over quarter, the price increase is tremendous. You mentioned your target for that business is about North of $20 million, right? And obviously, you're using some of them for your Marlow business but you're on margin business so how absolute we look at that business on an annualized basis?

Maybe one thing, I'll make the first comment and then Craig can add to it. Certainly this margin improvement that could come to even to Marlow or the IR optics business in fiscal year '08 has not happened. We had supply arrangements with other suppliers that we're working through during '08. '09, maybe late '09, we will start to get a little at the IR optics group, and the same on Marlow. So we're working it in very gradually, because with such a tight supply on selenium and tellurium, we're not going to stop on the supply agreements we have. At the same time, the sales opportunities of selling these materials, the number of metric tons of both selenium and tellurium, for PRM, might be slightly less than what we had anticipated when we were building this first projection for the business. So the pricing has helped a little in that regard. Volume slightly off on outside sales. Just because the price is so high. We're holding our prices up. We've taken less volume. And I expect this volatility in the price of both of these to be a constant factor.

So whether we're expanding sales or decreasing sales, we're looking at managing the margin between what we pay for these raw materials and what we sell it at. That's where we're focused, knowing it is going to move around. And I think to have any significant impact on the II-VI business, this PRM recycling of the zinc selenide and of tellurium materials probably will, at the earliest, it will have a meaningful impact would be second half of '09. That's how much we're committed to other suppliers.

Okay. But because of the price strength, especially on the tellurium side, that helps your bottom line, no?

See, the problem goes that some of the -- you buy the tellurium raw materials, or slimes, at the higher price and we process it and sell it off at a higher price, so we're managing the margin between what we pay for these raw materials, and what we sell at. So we give you more dollar value of sales. But the dollar values of margin will be about the same.

Okay. I see. That's very helpful. Thank you. And then the Marlow Industries, the quarter over quarter booking increase was tremendous. Is most of the booking increase as a result of your single largest order from the industrial customer, or is there some other variable in there?

I think it is pretty broad-based, Jiwon. I think we wanted to highlight that large industrial order that was taken, but I think in the other market segments, I would say that we're seeing good acceptance. There was in some other more sizable orders in defense area, as Fran mentioned even, we're seeing a little bit come back on the telecom as well too, and that demand continues to be growing and at a slower growth and still growth nonetheless. So it is more -- it is mostly industrial driven, we have some interesting opportunities that we will be working on here in the next one to three quarters, that are mostly of an industrial nature, but there is also some defense, and other bookings that they have take that has helped that very large growth rate.

And final two questions, I sense that you guys are being a little bit conservative when you're throwing out the initial FY '09 guidance. What do you think you have to do to raise that number going forward?

Well, I think we've put out what we believe based on again what we are seeing in the marketplace. Obviously, as was talked on and highlighted, that guidance excludes any results of our discontinued operations. It obviously is only based on the existing businesses that we have. Obviously, acquisitions are a key to that growth. And I think again, with the number of businesses that we have, and the number of markets that we serve, there are a lot of opportunities out there. And again, we will continue to pursue them, and we will see how the year shakes out 15 months from now, but based on our guidance, we're seeing kind of double digit organic growth from our existing businesses, even in this tough environment, is very achievable for us. And so we're comfortable with that. But we're also not comfortable that that is going to be enough and that obviously acquisitions or other opportunities or other things that we can work on obviously, those are things that we will work on. Whether it will come to pass in FY '09, time will tell, but that's why we are kind of comfortable with the guidance we put out. Fran, do you want to add something?

I would just add to it Jiwon, that 11% sales growth, 12% earnings growth, we would hope to have greater than 12% earnings growth on that same sale. And that comes down to a yield. Every one of our businesses has processes that depend upon yield. We're constantly working on improving those yields. If we do make strides on -- you pick it, whether it is our assembly yields of the thermal electric coolers in Vietnam, or whether it is the assembly yields of the shrouds out at Exotic, any improvement in that pretty much falls to the bottom line. So we're focused on it. Certainly this selenium material yield issue that we've been having, we get get a few more points on yield there. It will fall to the bottom line. So I would say I think the top line number is probably where we have to stick and I'm hopeful that we can do the bottom line better based on yield improvements.

Conversely though, Fran, as you have more material sales in your booking, and doing strong business on the commercial IR optic, and to a degree, for right of military programs, do you feel that you have enough cost structure on your variety of different operations, even including Marlow?

I'm not quite following your question, Jiwon. Do we have enough capacity to?

I was thinking more about -- I'm sorry. I was thinking more about your operating expenditure, or your cost structure to grow that business.

Yes, I think we're just properly positioned. We've not had to layer in any more overhead to manage it. We've put in a little bit every year. And I think we're feeling -- in '09 we will put in some more overhead at each one of our two or three pieces that have a little bit more growth that needs more technical skills and so on. We have a little bit of that into our plan. That is no doubt true. And certainly, our biggest challenge might be right now coming at us from Exotic, where we know we're getting this doubling of production rate of ATP that is being requested. When that all plays out in the next 60 days, on what we know is going to be asked of us, I think we're going to be digging deep for more capital expenditures than what we have been expecting but it won't hit on earnings impact to our guidance in '09. I think it is is a longer term issue for the capacity cost increases, I'm thinking we are going to go through at Exotic.

And overall, Jiwon, I think you're seeing a little bit of, in the financials that we put out and the detail in the last page, it talks about the capital spending, you are seeing us kind of slow down the level of capital spending overall. One of the biggest projects as we've been talking about for quite a while, this capacity expansion here in Pennsylvania, is really kind of coming to an end, in fact we pretty much spent, as we said, we are going to finish out the expansion this quarter here, but all of the dollars are pretty much for all intents an purposes been spent, so we're kind of moving away from that. That has been the largest over the last couple of years and largest single project that we've been working on. As Fran mentioned now we're going to get into some smaller relatively smaller programs, that still are overall important to the Company.

That was my final question. How should we sort of look at the FY '09 capital spending level?

I think we are going to end up for FY '08, obviously for the year to date, we're right around the $12.5 million mark, down a little bit from last year, we're anticipating coming in, somewhere around the 13 -- I'm sorry, the 16 million to $17 million range, up from the -- like I say the 12.5 that we're at right now. I think that level of spending is probably similar in FY '09. We have obviously got, as Fran mentioned, some individual projects that are on the table, but nothing in the grand scale of what we have done here in Pennsylvania.

So I would say it is going to be close. There is definitely a possibility that some of those projects could slide out a little bit. I think, one of the things that we have going for us, is I would say 75, 80% of the capital spending that we do is discretionary, in other words, if we see the business not growing as fast or not needing to spend those capital items, we have a fair amount of discretion in that, and I think we have definitely exercised that in the past, and you should expect us to do that in the future. If in certain businesses, they don't grow as fast as we anticipate. So I would say that is some flexibility that we have, and -- but given that flexibility, I would say kind of probably at a similar rate, maybe with the potential to be a little bit less.

Great. Thank you very much for patiently answering all of my questions.

Sure.

Your next question is from Chris McDonald of Kennedy Capital.

Hi, Fran and Craig.

Good morning, Chris.

Could you just walk through what you see are kind of big-moving pieces on improving margins in the near infrared -- I'm sorry, the red optics business?

Well, the near infrared optics business has -- had some uplift over the last couple of years with the UV filter business. So that has given it a good help pulling it uphill. So unfortunately, as we look into '09, we have in our guidance projected less of a margin at BLO senior infrared, as the UV business slows, the optics and crystals business and the YAG business at that unit are not as strong as what what UV has been able to generate. So our focus on the core, we call it core VLOC business is optics and crystals and YAG is always on yield improvement, reducing costs, moving more product to Vietnam or China to get our costs down, and that program continues under way, and it is going to be focused on even more as UV slows a little.

I'm sorry, Fran, I meant to ask about the infrared optics business, the zinc-based business.

And I think in that business, Chris, really, the biggest opportunity continues to be on the crystal growth yields. The other portions of the business obviously have our yield, the whole process is yield-driven, but I think the biggest opportunity right now is to continue to March forward to implement the kind of corrective and preventive measures that we've discovered that need to be put in place for our crystal growth yields. I think the other areas, the fabrication area, and the coating areas, again, always something that we're working on. Always something that we can address. But the biggest near-term opportunity for us is on the crystal growth.

And how do the capacity additions and the availability of supply through PRM factor into margins? When you look out over a longer-term period, maybe a 12 or 18-month period?

Yes, I think we are right now, I think in the near term, again, kind of in that in between period, winding down some of the contracts that we have, whether it be for selenium or tellurium, we are, as Fran mentioned, we're, I'd say highly optimized now on the scrap recycling programs around the world. That is not only giving us the opportunity to maybe pull selenium, for instance, back to our infrared optics business, but it is giving us one more source of supply to maybe make an opportunity for a selenium-based sale from PRM. So again, I think that's that smartly managing the kind of source of supply that we have, even in the internal source. We're also making the decision too to come back to the business that sent it there or should it be used for another maybe potentially higher margin or beneficial program.

Again, that was -- PRM, the underlying them there from us was obviously a business that we believe we can grow, and also a business that will serve as a long-term way to kind of insulate ourselves against certain of the raw material pricing. As Fran mentioned, with the example on tellurium, just because we have PRM, we're not going to be able to get away from a large tellurium price increase. Everybody is smart enough to exchange the source of supply over to market-based pricing. We've been smart enough to focus on market based pricing for the sales. Overall, we're seeing it as a positive, that's why we're investing in the business, in the capital, in the infrastructure, so that we can continue to address those opportunities.

Okay. And then clearly you have had nice improvement in the margin here over the last couple of quarters. If I look back a couple of years in that business, 30, 31% type segment margin, you did roughly 25% this quarter. Just wondering, you have had the raw material price increase that you had -- or the raw material cost increase that you have had to deal with, but, in an optimal situation, is it possible to get that segment back to that 30, 31% type segment margin level? Or is something fundamentally changed there?

Chris, I think obviously, our direction would be to get back to -- and again, the things that we talked about on this call that we can -- that we are working on and can improve, I think that is -- those are definitely things that will pull that operating margin or segment operating margin up. I would say though, that as we continue to not only focus on the percentage improvements, I think the dollar improvement is maybe more important right now. We're saying this is the first time we've ever put out more than $10 million of segment earnings, from that business line. So we, like you, are focused on the percentages, but also the shear dollars of it, and that's important to us as well. So we're proud of the fact that that business continues to grow. And is a profitable one, and very successful business, but again, we're relentless in our pursuit of trying to make that a little bit higher, a little bit better, again, now that we've got the HIGHYAG reported in with that segment, that is a little bit of a different mix. Their margins have historically been not at the levels of the infrared optics business. So that will change that up a little bit. But again, I think our focus is just that continuous improvement and working on the things that we talked about a couple -- at different points on this call.

Okay. Thanks, Craig. I didn't mean to downplay the success that you've had there by any means but it just seems like there continues to be a lot of opportunity in that business as you deal with some of these yield issues. I appreciate it.

I wasn't preaching to you, Chris. I was just reminding that we, sometimes we have a habit of it too, we get hung up on the percentages and we don't step back to say that that obviously, that segment, operating margin improvement has been very healthy. And percentagewise it is moving in the right direction but dollarwise, it definitely helps to have the successful quarter that we did this past quarter.

Appreciate it. Thanks, Craig.

At this time, there are no further questions.

If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the quarter and year-ending June 30, 2008, is scheduled for -- before the market opens on Tuesday, August 5. With conference call to follow that same day at 9:00 a.m. Eastern time. Thank you for participating in today's conference call.