II-VI Inc (IIVI) 2009 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 Inc. fiscal year 2009 third quarter 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 call.

Thank you and good morning, everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI Inc. Welcome to the third quarter fiscal year 2009 II-VI Inc. investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, April 21, 2009. 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 am Francis Kramer, President and CEO of II-VI Inc. The continued caution of the worldwide consumers impacted II-VI Inc. in the third quarter almost in line with our guidance provided in January 2009. The largest business segment in II-VI is the infrared optics. The most prominent customers for this segment are those that operate high power CO2 laser systems to manufacture all types of products that consumers purchase and use. Laser system utilization at these manufacturers has decreased almost 50%. Therefore, our third quarter FY '09 bookings for the CO2 optics decreased 48% from the third quarter of fiscal year '08, and 33% from the prior quarter. The strengthening of the US dollar contributed $500,000 of year-to-date unfavorable adjustments to these bookings.

We served a higher -- high power CO2 laser optics markets through the OEMs, and also directly to the laser system operators that we call the aftermarket. The OEMs also provide spare parts to the aftermarket and carry substantial inventories of optics throughout their service networks. The amount of destocking of the supply chains or inventory correction that will be needed to get our Infrared Optics business growing could take two to three additional quarters. However in the high-power CO2 optics business, we are not a capital goods provider, rather 90 to 95% of our high-power optics are routinely accounted for in the maintenance, repair and operating or MRO budgets of our customers. The capital budgets for most of our customers have been slashed for 2009, but their MRO budgets have hardly been affected. We expect that laser utilization will increase later this year and we are well-positioned with favorable inventory strategically located around the world to capture this business.

Currently including all of the second quarter and third quarter of fiscal year '09, we have not seen an increase in our order cancellation rate. We have been rescheduling what we refer to as call-off orders out into the future at the customers' request for deliveries 6 to 12 months from now. We have picked up 43 new aftermarket accounts in the third quarter, as value shopping laser users look to stretch their MRO budgets. The total number of line items on sales orders we receive in the high-power CO2 sector, has remained nearly steady, while the average quantity per line item has decreased from 22 to 12 reflecting the lower laser utilization.

Bookings for high power OEMs in Japan and Europe were down 75% and 65% respectively for the quarter. These same OEMs were down 35% for the nine-month period, as all our OEMs continue to consume inventory and battle lower demand due to lower laser utilization rates and lower new laser manufacturing plans because of their customers' difficulty financing new laser systems while facing weak demand for their products. We're actively involved with a number of OEMs as they intensify their product development efforts in anticipation of a rebound. Additionally, we are seeing hopeful signs of growth from China as their government's stimulus program improves the outlook for both high and low-power laser systems. New orders for our Infrared Optics materials increased more than 50% for the quarter, and 47% for the nine-month period. Our material production yields continue to improve, and are now approaching record high levels.

Our military optics orders increased 300% in the third quarter, and have risen 16% year-to-date, primarily from the light weight laser designator range finder, which is called the LLDR program and the next generation Guardian program. We expect to grow our business in the material and military areas more than 80% and 15% respectively this fiscal year. The demand for replacement optics for the global install base of 55,000 CO2 laser systems will have a large influence on our recovery and will be the result of increased laser utilization rates. We have seen initial signs that some of our OEMs, distributors and users have now corrected their inventory levels and have resumed buying but in smaller quantities. We do see less of a decline in sales direct to our aftermarket customers than to our OEMs and we expect a slight improvement in our OEM spare parts order rates to achieve the guidance we have given.

During the quarter, our VLOC near infrared business continued to expand its non-UV filter military opportunities. Year-over-year increases in military related bookings at VLOC and the revenues were 69% and 27% respectively. This helped offset further decline in the commercial side of the business caused by the worldwide economic conditions. We are on target to double our military bookings for fiscal year '09 versus '08. We qualified sub assemblies and received production orders totaling over $3 million for two major laser-based range finder and target designator systems during the quarter. The majority of our non-UV military business relates to directly protecting and supporting our troops, and we expect these to continue to be included in future military budgets. In the third quarter, VLOC continued to meet or exceed the required schedule for delivers of UV Filter assemblies to our primary customer. As we previously announced, we'll have a reduction in delivery rates for this product line during the fourth quarter. We continue to adjust our production capacity accordingly, and are taking appropriate cost-cutting measures.

During the fourth quarter, VLOC continued to experience a decline in its commercial-related business caused by the worldwide economic crisis. Fiscal year-to-date bookings were down over 35% and revenues for the same period were down over 20%. This decline was led by industrial and medical market declines of 43% and 31% respectively. In spite of the overall market conditions, there continues to be pockets of growth in the commercial area due to market share gains and/or technology shifts. One example of this was the receipt of a large follow-on order for windows used in conjunction with Lasik eye surgery.

In our compound semiconductor group, the Wide Bandgap Materials group was awarded $5.2 million in new DOD funding to continue the development of silicon carbide substrate technology and will focus on the cost effective manufacturing of high quality, state of the art, 100 millimeter diameter substrates of both 6H semi-insulating and 4-H end type and hence, bookings for this quarter were significantly higher than during the second quarter. Wafer shipments to US DOD customers are were on target for the quarter. Shipments to commercial OEM customers in the US and Japan were significantly lower than planned. The demand for 6H semi-insulating 100 millimeter wafers for RF applications continues at a level consistent with the second quarter with evaluation units shipped to both Japanese and US OEMs and US DOD customers. This quarter, we also began sampling 4H 100 millimeter wafers for power applications and are planning the availability of evaluation units during the fourth quarter.

We expect the demand of 100 millimeter substrates to continue to grow as our customers complete their line qualifications with our products. To prepare for this, we have completed the conversion of 90% of our existing growth stations to a new design that is capable of substantially increased output and larger diameter, in order to have the future capacity to address a projected demand of 100 millimeter wafers. Work is also being funded to accelerate the development of next generation substrates of 125 millimeter, and 150 millimeter diameter.

From Marlow Industries third quarter revenues and bookings were down while profits were up significantly due to operational efficiencies and a favorable product mix. Bookings were down 3% quarter over quarter. This was primarily due to the delay in orders from a major customer in both the defense and medical diagnostic markets and the continued decline in demand that we experienced for our products in the telecom market.

Revenues for the third quarter were down 12% quarter over quarter. This was due primarily to the soft demand from the telecom market and the delays in shipment of a product to a major industrial customer. We are projecting that sales to the defense market will continue to be strong for the remainder of the year, and will have the effect of offsetting the softened demand we are seeing and expecting from the other sectors. The medical diagnostic market remains stable and consistent with our expectations.

Qualification and development of new opportunities continues to be strong across all market segments. We are excited by our initial launch into the automotive market, which is now targeted for the fourth quarter. We also have made significant progress in the product solutions for the personal comfort market, which is expected to be a major opportunity for future growth for Marlow. Our Vietnam operation has slowed in response to the impact of the economic downturn, but is expected to reverse as these key programs go live in fiscal year 2010.

Finally, turning our attention to EV products. As we have first announced on April 4, 2008, we are involved in a process to sell our X-ray and Gamma-ray detector business. Our sale process continues to progress and is being led by Roth Capital Partners, based on our current expectations for the purchase price of the business. We have made appropriate adjustments to the carry on value of the eV Products assets we are holding for sale, and have accrued for our expected sale related expense, which is primarily comprised of employee retention, investment banking, and legal expenses. These expenses were reflected in the loss from discontinued operation net of income taxes for the just-completed third quarter. Aside for these sale related charges, the eV Products business performed well during the quarter with revenues for the just-completed quarter increasing 34% over the same quarter in the prior year.

Additionally, we have been awarded another government contract for approximately $1 million to develop an explosive detection system used in cadmium zinc telluride sensors. This contract is being managed by the Army's Research and Development and Engineering Center at Picatinny, New Jersey. This project has the potential of commercialization within three to five years, and EV has partnered on this contract with American Science and Engineering, an industry leader in X-ray inspection and explosive threat detection systems.

In the Military & Materials business segment, PRM revenues were below expectation for the quarter, driven by lower demand for industrial products such as glass and steel that utilize selenium, and automotives that contain tellurium as the global demand in these markets has slowed due to the economic downturn. Additionally, the market price for tellurium declined 17% from $180 per kilogram to $150 from December 31, to March 31. We expect orders for selenium to continue to be the largest challenge for the remainder of fiscal year '09 and the first half of fiscal year '10.

Meanwhile, the overall demand for tellurium is expected to decrease slightly through the next few months as consumer goods and manufacturing declines and customers adjust their inventories of raw materials accordingly. Tellurium demand for the photovoltaic's markets that we serve is stable, although increased competition and industry inventory in the channel is tending to drive down prices. PRM is adjusting production capacity as orders dictate, and is taking the appropriate cost cutting measures. PRM margins were lower than expected, due to lower sales volume, reduced manufacturing output and the market price decrease of tellurium during the quarter. The decrease in tellurium market price resulted in an inventory write-down of $450,000. We also continued to closely monitor advances in new applications for tellurium and selenium. Products with improved [antimicrobial] and antifungal characteristics based on selenium have been announced over the past year, targeting the ophthalmic, orthodontic, and coatings industries.

We are optimistic about the long term prospects of tellurium in the production of cadmium telluride based photovoltaic panels as demonstrated by the rapid commercial growth in this segment of the solar industry, as well as emerging solar companies that have based their technology on thin film science using selenium as an enabling compound.

The strongest performing division during our third quarter was Exotic Electro-Optics, which we call EEO. Third quarter bookings were strong with half of the quarters orders being for the ATM sniper shrouds. We recorded approximately 55 to 60% of this ATP order in the third quarter, and we will book the remainder in future periods based on the 12-month rule. Revenues at EEO were also on plan, and we continue to forecast fiscal year 2009 growth to exceed 18%. The shipment of ATP shrouds, Arrowhead assemblies and work on the Joint Strike Fighter, which we call JSF development were highlights of the quarter.

The new administration -- with the new administration there has been speculation on defense spending and changes that might be expected. Defense Secretary Gates unveiled his priorities in April, and in this plan, the Joint Strike Fighter budget was increased for 2010 to include enough funds to now buy 30 jets, up from 17. The key focus for EEO now related to JSF is to ramp up the number of sapphire window sets produced per month. Many industry observers believe the US military spending may have peaked and that new administration will redefine defense spending investment priorities. The share of II-VI Military and Defense business has increased from 30% of total sales in the first quarter of fiscal year 2009 to almost 40% now. We will continue to be flexible and opportunistic in the military markets. Our defense products M&A focus will be on acquiring small divisions of large companies and with product lines that leverage our competencies in engineered materials, custom optics, coatings, components, and subassemblies.

We believe that our industrial laser business will begin to experience a slow recovery later this calendar year. We are targeting M&A opportunities that would enable us to grow market share, as well as diversify our technology and product portfolios. These could enable us to participate in new markets, for example, in providing materials to the IR security markets. We plan to continue to position ourselves to build down our one micron and fiber laser platform at our HIGHYAG subsidiary. We are exploring opportunities to enhance the face and footprint of the Company by targeting businesses in our related markets that have been established in Asia, and that have been successful at penetrating markets in Europe and North America, and especially material-centered businesses in Asia, which we -- which are expected to be long term drivers of economic growth.

In the area of renewable energy, we'll be very selective and target those opportunities that enable us to derive synergies with existing businesses. For example, we would be interested in thermal electric power generation to the extent that there are synergies with our Marlow Industries subsidiary. We are targeting acquisitions of companies with nanotechnology and engineered materials that are expected to have broad-based applications long term. With the strong balance sheet, cash position, and attractive currency in II-VI stock, with our solid leadership and management in all business segments that are prepared for a considerably slower pace to the economy we are poised to work aggressively in the M&A arena to add to our business portfolios with good value acquisitions. 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 described in the segment information from continuing operations in the earnings release, bookings from continuing operations for the quarter ended March 31, 2009, were $62.3 million. This is a decrease of 34% when compared to the prior year quarter, and a decrease of 8% when compared to the quarter ended December 31, 2008. Our bookings continue to reflect the softness in the nonmilitary markets that we serve, and have given us less visibility into the future than we have enjoyed in the past. This level of bookings combined with the revenues generated for the quarter reduced the overall backlog from continuing operations at March 31, 2009, to $112 million. The components of the March 31, 2009, backlog from continuing operations were Infrared Optics at $30 million, Near-Infrared Optics at $20 million, Military & Materials at $40.5 million, and Compound Semiconductor Group at $21.5 million.

As described in the press release, during the quarter, the Company wrote off certain long lived assets of our UV Filter product line which is part of our Near-Infrared Optic segment. This write-off was the result of an evaluation of the assets needed to produce the UV Filter materials that we grow in relation to the current and expected demand levels of our customer. Based upon this analysis, certain assets that were deemed to be more than temporarily idle were written off. This write-off amounted to approximately $800,000 pretax and was included as part of cost of goods sold in the condensed consolidated statements of earnings for the three and nine months ended March 31, 2009.

I would also draw your attention to the UV Filter comment we made in the outlook section of our press release. We expect to end fiscal year 2009 with around $16 million in UV Filter revenues based on current expectations of our customer, we believe that fiscal year 2010 will result in approximately $6 million in revenues. We have made and will continue to make adjustments to our cost structure for the UV Filter business and even at these lower revenue levels expect that business line to remain profitable.

The earnings release described the fact that during the just-completed quarter, the Company recognized certain costs associated with its X-ray and Gamma-Ray sensor business UV products which has been treated as a discontinued operation for accounting purposes. The estimated loss on disposal of $1.810 million after tax was recognized in connection with the planned disposal of the business. These included employee retention costs, transaction costs including investment banking and legal expenses and write-down of the net assets of this business to their expected realizable value. These actions were appropriate given where we were at in the UV sale process. We anticipate having further updates on the sale process in the near future.

One of the significant items that impacted our earnings in an unfavorable manner in the quarter ended December 31, 2008, was foreign currency losses of approximately $2.9 million pretax. During the quarter ended March 31, 2009, the foreign currency fluctuations were not nearly as severe as we saw in the December quarter, and we actually had foreign currency gains of approximately $1.5 million pretax. All of the other income and expense components offset each other for the quarter, leaving the foreign currency gain as the largest component. In spite of the favorable movement in the foreign currency for the quarter, our year-to-date foreign currency position is one of a foreign currency loss of approximately $2 million pretax.

The effective income tax rate from continuing operations for the quarter ended March 31, 2009, was 24.4%, and includes the impact of certain favorable return to provision items relating to the Company's June 30, 2008, federal tax return. This was mainly driven by the benefit the Company receives from the research and development credit that was enacted by Congress prior to the filing of our federal tax return. In the prior year third quarter ended March 31, 2008, the effective tax rate was 17.7%, which was the result of certain FIN 48 tax reserves being released due to statutes of limitations expiring. Our current expectation for the quarter ending June 30, 2009, is an effective tax rate of around 29%, which would bring the full year effective tax rate up to approximately 16.5%. One of the drivers of the expected effective tax rate increase at the end of the fiscal year is the expectation of less foreign sourced income, which is taxed at lower rates.

Included in today's press release is a condensed consolidated statement of cash flow for the nine months ended March 31, 2009, and 2008. The inclusion of this statement reflects the result of much planning, analysis and execution to deliver this consolidated information from our worldwide entities within the time frame of our regularly scheduled earnings release. I want to thank those who have been involved in this project. We believe that this will continue to enhance the usability of the financial information that we incorporate into the earnings release. Our ability to generate cash flow from operations during the current fiscal year is prominent in today's press release.

We also continue to slow down our capital spending, as evidenced by our capital spending decline from $4.5 million in the December 31, 2008, quarter, to $3 million in the March 31, 2009, quarter. During the current quarter, we paid down over $3 million in debt, and saw our cash balance rise to over $83 million the highest in the history of the Company. At the bottom of the cash flow statement you will note the disclosure of some noncash transactions that occurred during the current year. These transactions relate to the establishment of our new II-VI Italia sales office -- sales and marketing entity in Italy during the just-completed quarter. These transactions show that we were able to acquire inventory and an intangible asset by reducing accounts receivable due from our former distributor in Italy.

The updated guidance contained in today's press release gives our current view of the expected financial performance for the quarter ending June 30, 2009, and the fiscal year ending June 30, 2009. I would say that the single most influential factor that we considered from the current guidance when compared to our prior guidance was the lack of visibility in the orders from our laser OEM and aftermarket customers in the infrared optic segment. This is the main reason that we are delaying providing guidance for the fiscal year ending June 30, 2010. 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 question 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, 2009. We are ready to begin the question-and-answer session.

(Operator Instructions) Your first question comes from Mark Douglas from Longbow Research. Your line is open.

Good morning, gentlemen.

Mark.

Good morning.

I have -- just real quickly, Craig, you said fourth quarter tax rate, you are guiding at 29%?

That is correct.

Okay. And then 16.5 for the full year?

That is correct.

Right. Okay. On the -- in the press release, you talked about the $15 million yield in annual labor and benefit cost. Is that the current run rate, or is that what you are expecting in this fiscal year '09?

That was the annualized savings, Mark, of the actions that we had taken as of March 31, so the annualized savings, we started that really at the time when we saw the industrial business slow down. Those go back to really, toward the end of November, 2008, but all of the actions that we've taken as of March 31, on an annualized basis will yield us about $15 million in savings.

And is that predominantly in the IR optics and [probably] near IR?

Yes, that's correct, just exactly as you said, 80% IR, 20% maybe near IR.

Okay. Okay. So with your outlook for the OEMs, what do you see as far as any commentary on high-power versus low power, and specifically, flat sheet cutting, I assume that flat sheet cutting is probably dominating what you're seeing as far as reduced sales, and then even laser utilization, but can you give some more insight into maybe high versus low power and solid state versus CO2?

Starting out with low power. That segment was the first to really show weakening back November/December, came quickly. You remember in the low-power side of it, we do not have an aftermarket. Most of those lasers with the complement of optics that they're sold, that's how they operate, so that business really has to do with what quantity of new lasers are coming down the assembly line. And that has really turned off. There is just not the capital budget for engraving or marking or identifying and labeling foodstuffs, for example, or [via hole] drilling for circuit boards. That market is just stopped. I think the capital budgeting has stopped that pretty strongly.

On the other side of it, if you look at the high-power business, as I said earlier, that 90% of our business comes in the aftermarket. That business has some -- the repair and maintenance component is what's very important to us and always has been, and that continues on as people are operating those laser systems as opposed to 6, 7 days a week, 24 hours, they might be operating 5 days a week, 16 hours. So it's really throttled back, but it continues to have this aftermarket sales activity for us in the CO2 business. But the -- the business is mainly cutting, as you said, a slight bit of welding, but 95% cutting, 5% welding. The activity in the new laser installed base coming with the fiber laser, or the disk laser, or even YAG lasers for cutting, activity is modest, if any fiber laser and disk laser, big in welding. And since we're not so close to the welding market, I cannot tell you how badly that's been hurt, but I assume it will be equal to proportion to the cutting market. All the capital goods, durable goods, brown goods, all of those activities right now are just weak, so capital budgets are not deploying new machines.

Not much more I can add to it on the solid state laser side of it, our business and our HIGHYAG subsidiary is doing very nicely. They're a little below plan, maybe 5 or 7% below plan for the year, but hanging in there, and mostly with selling one micron laser delivery heads to new applications.

With your guidance, when we look at that fourth quarter, it's implying, you know, just call it $0.15 on average -- well, first of all, your new guidance, that includes the $0.12 tax benefit from first quarter, yes?

That is correct. For the full year numbers Mark, yes, that's in there.

All right. As we look at the different segments, where is the weakness, in particular? Are you expecting sequential decline in margins for IR, as well as near infrared, or, near infrared had a pretty steep decline this quarter. Would you maybe expect it to see a slight uptick, or how are you thinking about that in the fourth quarter?

Sure. I think really the challenge, the biggest challenge that is facing us is kind of that expectation that the IR revenues are going to be lower in the fourth quarter. And as Fran said, a lot of the cost reduction and things we have done have been centric around the Infrared Optics business, but obviously we don't want to cut into certain core capabilities that we have, whether it be in crystal growth or some of the things that really set us apart as being the world leader in that market. So I think we have tried to manage the business down. Again, we're trying to adjust the business to this lower level of production. But that is, historically, has been our most profitable business, and so when the sales fall off, that obviously has the most bottom line impact.

In the Near-Infrared Optics business, remember, too, that included in this quarter's results are the write-off of that UV Filter business, so they're skewed a little bit because of that unique item. Again about $800,000 there, but as Fran kind of touched on, in the -- in the -- in his prepared comments, some of the brighter opportunities that we have to look at or can go toward in the Near-Infrared Optics arm in the military, that is helping, at least in the short term to raise our expectations a little bit, as far as how that business will perform in the fourth quarter versus the third quarter. And then I would say all of the other businesses continue to kind of track on, as Fran said, good results from our military Infrared Optics business, and, again, some -- [little bit] challenging times yet still probably ahead of us with our PRN business. But that's the lay of the land, as far as the thoughts, Mark, within our, as far as the different segments and how it rolls up into the consolidated guidance.

Okay. And just a final question. Clarification. Fran, you mentioned the destocking in the OEM supply chain.

Right.

Is that destocking of the replacement optics, or optics for new--?

No, it's really the spare parts destocking and the whole destocking of their supply chain is multifaceted. Not only are they consumer goods that were built ahead sitting out in front of their customers, who are the laser operators, and for the laser operators to turn their machines back on, they need that supply of so many extra cars, [out in] inventory built and consumed to turn themselves back on to the speed that they had been operating or some better speed. And then the consumptions of optics, which are maybe in two or three different [depots]. maybe one at their own factory, where they stage them, or they might stage them at their headquarters. Also, or their service technicians if they travel from one plant to the other might have them in their inventories that they carry with them. Ourselves with inventories staged around the world, I think the supply chain is just right. We've tried to rationalize our sales. We held our inventory constant for the last three, four months as a Company, so we think we've put a good lid on the inventory build, and we've now got it in the right spots for things to pick up. But we do not know how much is in the supply chain at every point related to the OEMs and how much they keep for their spare parts business.

The slowdown, they're -- the inventory destocking takes even longer, so. Okay, thank you.

You're welcome.

Your next question comes from Avinash Kant from D.A. Davidson. Your line is open.

Good morning, Fran and Craig.

Good morning.

Quick questions. In the guidance for June, could you talk a little bit about the margin of them? I believe the gross margins in the current quarter had that 800K impact, right? So excluding that, margins would have been roughly 36% or so?

That is correct.

So then in the June guidance, what kind of margin assumption do you have?

Well, we do have the assumption that it will continue to go down from there, again. The primary driver there is going to be the lower amount of Infrared Optics revenues in that proportion. Again, it's the highest margin business that we have in lowering those sales, that will continue to impact the margins. We're also continuing this ramp down in getting down to the lower levels within the UV Filter product line, as well, and that has an impact of pulling down our margins. So overall, the expectation is that those margins will continue to contract within the fourth quarter.

Okay. And I think that the broad commentary, Fran had about military projects, it looks like at this point, the projects that you have been on, none of them seem to be at risk, and you see, in fact, given the talk that you could see military business grow once again in fiscal year '10, right?

That's correct. With only one caveat, and we made that, which was our UV Filter business, which is a military product line, and that dropping from $16 million in '09 to about $6 million in '10.

Right. But given that you have -- I would expect in fiscal year '09, you would have more than -- close to 35% of business from military sources?

I think it will be that, and then trending upward there. Again, it's a mix of the brighter opportunities for us in the near term, being on the military, also with the continued pull back in the industrial, as well. So I think in Fran's comments, that was kind of trending more toward kind of the 40% range, and that's kind of where we think we're at.

Right. So at 40% range, I'm saying for the fiscal year, you could be roughly around, what, 90 mil -- almost $100 million in revenue. So the $10 million impact on the negative side that you will see from UV Filters, it still should be offset if this business grows. Given the signs of the business alone?

Well, again, what we're -- I think the broad comment is, if you throw out the UV filter, we definitely have expectations of continued growth for the military portions of the business. And to your earlier point, as far as the early signs, as far as where budget cuts may or may not impact certain programs, at least to date we have not identified anything that would have a significant impact on the programs that we work on.

And you would usually have very good visibility into that program, right?

Well, I think consistently our visibility is as good as our customers' visibility, but especially some of the longer-term programs that we're on, certainly we have very good visibility. If you look at kind of the proportion of our backlog, our biggest area that is now -- has backlog is within our military Infrared Optics business. Fran mentioned some of the orders that we took during this quarter. We actually got orders for longer than 12 months, but we tend to and have historically limited our ability to record as of booking something that's beyond 12 months. So we have got orders that we have received that we have not yet recorded or translated into bookings, but, yes, we're definitely getting the best visibility in the military, and usually that is much -- usually it's historically longer. Nowadays it's much, much longer than we're getting from our industrial customers.

Okay. And anything about the utilization rate of the installed base? Like you talk about 55,000 installed base of CO2 laser systems. Now, if you could comment in terms of how the utilization rates that your customers have tracked over the last three or four months, and how do you see it going forward?

People's utilization rate is not something they want to tell you, so we have to back into our own judgment of what the utilization rate has been out there. So maybe when they were running peak time, maybe last summer or last year at this time, let's give them an 80%, 75, 80% utilization rate. Everybody wants to talk 7 by 24, but maybe think that we were thinking maybe they were at 80% on 6 by 24, and to go down right now and to say they're less than 50% utilization on 5 by 18, 5 by 20, that's about what we would have to tell you. We have no explicit examples of that. We can go to some factories that might have an automotive parts supply and factory that might have 10, 12 laser systems operating, and find out they're running one shift 8 hours a day. That's a very, very low utilization point. But we have to average that with so many other ones, about of that installed base, 40 to 50% of it is in laser job shops, and these laser job shops spread all over the world do multiple different operations for a number of different real end part industries. So it's a collection of -- you name it. Suppliers that are doing cutting, parts for heart pacemakers, all the way to welding gear hubs on to sprockets. So it's a real mix, none of those laser chop shops will talk about where they are in utilization.

And to add to what Fran said, again, without being able to kind of quantify an answer for you, I think the feeling is, and again, it was reflected in the pattern of our Infrared Optics bookings within the quarter, that we saw a level of bookings in January and it was lower in February, and that level was lower in March, and so we're just continuing to see this -- this -- whether it's a true reflection of utilization, to Fran's point, we don't exactly know, but we can tell you what we've seen, and that is within our order pattern within the Infrared Optics business, that, our order pattern at the end of the quarter was noticeably lower than it was at the beginning of the quarter.

Okay. So the order in the IR optic segment has continued to decline through March, and given what you have seen so far, would you see a turn in that in April, or no?

I think we have kind of refused to make a comment on when we think this will turn, because that's the key feature why we're not able to give you some guidance for FY '10. We haven't the visibility to know when it's going to turn around, because of the two things we just talked about, laser utilization versus destocking of the supply lines.

But, Fran, what I'm trying to figure out is that if when you say you expect a turn sometime in the second half, but should we expect continued decline in revenues 'till the turn comes, or it should stabilize at these levels while we wait for the turn?

Yes, I think, Avinash, again, our short-term expectation is really what we can give you, and that is the short term is we will have lower revenues Infrared Optics Q4 versus Q3. Beyond that, in our outlook, we definitely think there should some turning within FY '10. Exactly when that will occur, we honestly don't know. That's the challenge of --.

Well, we're having to look at the worldwide economy there in order to do that. The stimulus by all of the governments to get people back buying these consumer goods that are causing the laser systems to operate is very difficult for us to get a handle on. Heading into a summer period where a handful of factories have announced two-week shutdowns and so on, whether they're -- and what's happening to the auto industry is very, very difficult to predict how that will turn around on laser utilization. So we don't want to miss an opportunity to tell you what we think, but on this one, we do not know when this is going to turn.

I totally understand that, Fran. Thank you so much for your answers.

Your next question comes from Jiwon Lee from Sidoti. Your line is open.

So kind of going back to the commentary on CO2 laser optics, Fran, when you were talking about, hopefully the maintenance and replacement side of the business coming back later in this year, does that mean that your low power is out of the business, as you see it, is a lot worse than the high power?

Yes, and I think we announced that earlier, maybe December, January, we said that the low-power business had just about stopped. So if it was -- if it was a index last year in September, or last year at this time of a hundred stopped, to me is an index of about 30 right now. How the low-power CO2 new assembly line builds are going around the world right now, at a rate of 30, and not -- there's no one talking about what will cause that to move to 40, and it has to do with marking, engraving, and semiconductor processing hole drilling so on the finer type things done by laser.

Okay. So then even later this year, you're not expecting that low-power side of the business to come back, and that I guess, is primarily tied the to the new OEM, the systems side of the business. Is that how we should look -- think about that?

I think the low-power CO2, or even low-power YAG, low-power solid state business, is -- the function that is usually used with those type of machines is to engrave, to mark, to resist or trim in the electronics side of things, to drill via holes and circuit boards, those type of activities right now seem to be well down in their use. Therefore the capacity that's out there is more than adequate, and capital budgets to buy new that we've -- that have come through our customers, they're not at all optimistic on low power.

Okay. That's helpful. Thank you. And then I notice your commercial IR optics profit was down noticeably quarter over quarter. Is that just a function of low absorption, or is there some present pressure that you feel that you would like to communicate with us?

I'll make a few comments and then I think Craig will add to it. The pricing pressure is there, all the customers that we have are being squeezed and their margins being squeezed, and they're asking us to help them. So in certain OEM cases, we do our best to keep our share where it is, or grow it, so we've made a price move here or there, but not significantly. So the pricing pressure exists, and I think we're not having -- we're not having our own desires, which is hold prices constant, but we are making moves to keep ourselves well positioned with the OEMs,, and, at the same time, we're certainly using our pricing and the strength there and trying to gain aftermarket business. I made a comment we picked up 43 new accounts recently, and we're being very aggressive that way. So pricing is out there. The margin issue for the IR optics segment certainly has to do with fixed costs, as we have scaled back our manpower around the world, our fixed costs are -- they're kind of like the iceberg sticking out of the water, and the top of the iceberg is getting more and more exposed so our fixed cost is taking on a bigger share of our sales dollar.

And I would just add to that, Jiwon, and say that fixed cost is an important component there, especially within the Infrared Optics, that's a business that has had a lot of, over the last, three to five years especially, a lot of capital investment as we've done things to expand coating operations and crystal growth operations, et cetera. So, and again, living with some of those historical legacy costs, depreciation, et cetera, in that business, that is definitely -- there's definitely -- there has been a lot of adjustments we've made to the cost structure, to Fran's point, there are certain things that we will just be dealing with at these lower utilization rates. I don't think we're ashamed at the kind of where the profit level of Infrared Optics is. I think we're continuing to make adjustments to make sure that the costs are aligned there. I think, that we have been able to, and foresee that business even in spite of the significant downturn that we're seeing in both the revenues and the bookings, still allow that to be a very, very, nice return on sales type business.

So I think it's definitely a challenge. I think, that's really we're that much the better when things turn around and get better, because, again, to the extent that that happens and as soon as that happens in the Infrared Optics business, that will definitely have a nice lift, as much as it's having a drag on our business right now, so.

Understanding the dynamics of your weak commercial side of the business, but fairly strong defense side of the business, do you feel that you have a sufficient operating scale, or if the commercial side of the business continues to be weak throughout the summer, is there some room for an additional improvement in terms of your operations?

I think the operations for the military side of the business are well positioned. We are scaling up, as I mentioned earlier, for our Joint Strike Fighter JSF work at our exotic operation. We have a plan there to go up in our capacity. I think it's going to be a challenge for us. We've never produced the quantities of sapphire panels and windows that we're being asked to do as quickly as we'll need to do it. So that's going to be a risk in our military business side of it.

In our other unit down in Florida, VLOC, where we've won additional assemblies, we have kind of a similar case there, one program, the LLDR program, we have a difficult assembly to make there that a few other manufacturers were not able to do, and we took it on. We know it's going to very, very difficult. So ramping to a higher quantity is going to be tough. But on both of these that I just mentioned that are military driven, I think we can succeed and I think we can make our numbers. I would like to say there was more opportunity, but at the moment, I think we've counted on those two units doing what we've projected, and it's probable near what we'll do. I wish there was more upside. The upside opportunity probably in the situation as we're explaining it to you right now, will be maybe a little better news from our Marlow unit as we start up in the fourth quarter, early first quarter next year on the automotive -- and the comfort products. Those are both new, coming on, and then the wildcard that we cannot quantify is this MRO, maintenance repair and operating budgets of companies. Our models that we've run in the past on CO2 laser utilization, are so far off that the numbers are so far down that it could be a surprise when people start to order and could hit us a little faster. We just -- our model is so disconnected to what's happening right now, that I can't give you guidance on that.

Okay. And -- yes, thanks. And, lastly, can you share with us how many deals that you are looking at right now, and especially perhaps one of the deals that you're looking at, when can we expect the outcome one way or the other?

I think out of our four business segments, there's at least one very, very good opportunity to each one of the four, and to say which one of those will come out and when, that would be going too far. You have to have a willing seller in a couple of our cases maybe we do not have a willing seller at the price we're willing to pay right now. A couple of the other situations, there are people that are selling their business, and so the seller problem's not the issue. Our issue is not paying too much. And we have always been reluctant to overpay, knowing you could just set that number on our balance sheet and go to work, but we're not -- we're still not willing to overpay. So half a dozen things we're looking at, one in each business unit, at least four, two of them that are willing sellers is what I would say.

That sound likes a good philosophy. That's all for me. Thank you.

(Operator Instructions) Your next question comes from Richard Shannon from Northland Securities. Your line is open.

Hi, Fran and Craig, how are you?

Good.

Good morning.

Good morning. I guess my first question is, just on the fourth quarter guidance, specifically on operating expenses, Craig, you talked about some annualized cost reductions, and I guess I just wanted to get a little help in understanding kind of where you're thinking the OpEx will come in in the fourth quarter and maybe some thoughts on beyond that?

I think Richard some of the -- I would say the majority or let's say two-thirds or more of the adjustments, cost related adjustments, have been more on the manufacturing operation side. So I think where we're expecting, as a follow-up to what was in the press release, that $15 million of labor and benefits savings. That's a -- two-thirds of that, we are expecting longer term, you know, we get to that annualized number, we're expecting that to be coming from the operations or the cost of goods sold line items, and then probably the other third is really mostly driven by the overheads. So I think we're going to continue at least in the short term, again, it's the gross margin direction is facing downward, we will definitely get some relief, especially in the overhead area and we're expecting to continue to moderate that down as well, but overall, I think, where the main bulk of our actions have been -- has been focused on that -- focused within the operations and the gross margin line.

Okay. Fair enough. And then kind of a follow-up to that, specifically looking at your IR optics business, the segment earnings that you had for that business in the quarter, just reported, was around 16 or 17%, if I'm looking at my numbers correctly. Obviously historically low numbers as far as I can tell. Is that a number that you expect to continue to go downwards again in the June quarter? Is that kind of -- are we going to see the bottom here in that number?

Richard, I think again we're facing the challenge of, again, what we're expecting based on the order pattern that we've seen, especially here recently, is that that -- the revenue is just going to go down, and again, as much as we've made adjustments, we're also expecting the profitability level of that business to go down as well. And to your point, we are kind of breaking through some historical barriers here. We've really not experienced anything like that with any Infrared Optics business, but again we definitely are making adjustments as we can, but to a certainly extent, we won't be able to perfectly offset what we're expecting, and that's why we are expecting that profitability in that segment to be down, even a little bit further than what we experienced here this quarter.

Okay. Fair enough. Fran, a follow-up from one of the previous questions regarding the M&A environment. You talked about not being -- trying to be conservative on pricing. You also mentioned that you're targeting a lot of divisions of larger companies, obviously those companies might not necessarily be as distressed here as many smaller companies. Is that the source of not seeing the pricing you would like to see out there, or is there even more to come, you can see some of those pricings come down over time?

Yes, I would say my comment about small divisions of large companies, that might be worth one-third to one-half of our shopping effort, and within that group, I think you've got the ones that we're interested in. I would not yet categorize the people as willing sellers, and the problem seems to be that those companies' earnings and their cost structure is so distorted right now, they're having downward pressure on their sales, so they're not willing to sell any asset off that was absorbing some of their costs. So they're holding or at least trying to hold, know that ultimately some of these are not core assets for them, and they would -- they would sell them in normal business times, but right now they're holding, because that helps absorb some of their costs. So maybe out of the people that we're trying to get interested, we probably have that problem with two-thirds of them at the moment.

Okay. And then maybe my last question in your Marlow business, you talked about the automotive opportunity. Is this something that you've received bookings for, or is that a business you're still expecting to receive orders for?

That's -- I think we've booked the booking of it in the third quarter. I'm not sure it's the whole booking we expect to get for this job that we expect to run on in fourth quarter and into FY '10. Maybe 25, 30% of the booking we expect, ultimately.

Okay. And then also, is there anything you can mention about this -- opportunities you're seeing within Marlow for personal comfort? What exactly does that mean?

Okay. In that area, if -- I think I can describe it this way. In chairs you're sitting on in your office, if it's too hot or too cold, products will be coming out that would make that more manageable. If you're sleeping in a bed, if you're in a very hot climate, and you cannot afford air-conditioning, a product is coming out that will keep your body temperature much more comfortable and will save energy. So it goes toward personal comfort more, not in a moving vehicle, like a car, but in the things that we do everyday, mainly sit or lay down.

Okay. Great. Thank you very much.

You're welcome.

At this time, there are no more questions in the queue.

If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the quarter and fiscal year ending June 30, 2009, is tentatively scheduled for before the market opens on Tuesday, August 4, 2009. 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.

Thank you. This concludes today's II-VI Inc. fiscal year 2009 third quarter conference call. You may now disconnect your line.