II-VI Inc (IIVI) 2011 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the II-VI, Incorporated first-quarter FY '11 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. (Operator Instructions). As a reminder, today's conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. Craig Creaturo, Chief Financial Officer and Treasurer. Sir, you may begin.

Thank you, Devin, and good morning, everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI, Incorporated. Welcome to the first-quarter fiscal year 2011 II-VI, Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, October 26, 2010.

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, Incorporated, and my remarks today describe, first, the confluence of positive events that we have experienced in the first quarter that drove record revenues and significant earnings; and second, what is expected in future quarters.

The integration of Photop Technologies into the II-VI Near-Infrared segment continued to progress smoothly. Photop continued to exceed expectations, with bookings of $28 million and revenues of $27 million in the first quarter. This follows the fourth quarter of fiscal year '10 bookings of $33 million and revenues at $27 million.

Photop continued to support the strong demands from customers across all markets, including telecom, consumer, industrial and medical. Photop's increased demand in the telecom market segment is mainly driven by increased bandwidth demands that are resulting from increased Internet traffic worldwide, along with worldwide deployment of 40-gigabytes-per-second optical networks, as well as major infrastructure investments in Asia that are scaling in order to support mobile communications and computing applications.

We continue to invest in our workforce and capital equipment expansion, as well as in research and development needed to meet the future expectations of our Photop customers. Increases in raw material prices and lead times from some of our strategic suppliers and the resulting capacity constraints are being worked out by our Photop operation teams.

We're managing the capacity ramp-up internally in the supply chain by developing and qualifying alternate sources of supply to maintain delivery rates. Based on our backlog, holiday time, expected product mix, and our interactions with major customers and suppliers, we expect to achieve slightly lower revenues at Photop in the December-ending quarter as compared to the quarter we just completed. We continue to have limited visibility past one quarter.

In the VLOC portion of our Near-Infrared segment, bookings were down compared to the first quarter of fiscal year 2010. This was entirely due to the timing of orders for UV filter assemblies. Without this timing difference, VLOC bookings were up 25% compared to last year's first quarter.

On the non-UV military side, VLOC won orders this quarter across several product lines. Impacting the optical component product line was a production order for a complex optic used in a laser-based range-finding and target-designating system that are used by multiple branches of the military. This program, one of our customer's flagship products, has a lifecycle that is expected to extend over the next three to five years.

For our YAG product line, we qualified on several new programs and received production orders for complex YAG slab and raw geometries. These military programs support the build of laser-based range-finding, illuminating, designating equipment, with an expected program life of four to five years.

With respect to the commercial markets, VLOC experienced additional growth. In the US market, the growth was driven by increased demand across various medical and industrial applications. In the international markets, demand for low-, mid- and high-power industrial products supporting laser-based marking, welding and cutting applications continued to grow.

As mentioned last quarter, this growth is led by laser-based equipment that is utilized in Asia for flat-panel repair, measurement, laser welding and marking. These processes support the manufacture of consumer products such as iPhones, iPads, batteries and various MP3 devices. VLOC is addressing this increase in the commercial market with its lower manufacturing cost facilities in Vietnam and China.

In addition, during this quarter, the first qualification orders for commercial optics were shipped from our newly-established Advanced Optics Manufacturing group at our Photop facilities.

During the first quarter in our Infrared Optics segment, bookings, including HIGHYAG, of $41.3 million were up slightly quarter-over-quarter, but up 47% compared to the first quarter of fiscal year 2010. Historically, first-quarter bookings for Infrared Optics tend to be lower due to summer vacations and plant shutdowns throughout Europe. Orders for the first quarter just completed are within 7% of our peak that occurred during the third quarter of fiscal year 2008.

In the US, new orders from domestic OEMs for the first quarter decreased quarter over quarter, but increased 83% versus the first quarter of fiscal year 2010. This quarter-over-quarter softening was due to timing of blanket orders from our low-power OEM customers. High-power resonator and machine builds continue to improve, but they are still below pre-recession levels. Orders from high-power OEM customers more than doubled versus the first quarter of fiscal year 2010.

The North American aftermarket, which is a relative indicator of machine utilization, showed a 4% increase quarter-over-quarter and a 23% increase versus the first quarter of fiscal year 2010. We have seen a steady increase in volume from the diversified job shops that represent our largest customer base in the aftermarket.

Independent laser service companies and the automotive sectors are still improving. The transportation and housing sectors are showing early signs of improvement. US military orders for our Infrared Optics segment increased 18% in the first quarter compared to the fourth quarter of fiscal year 2010. Military orders received in the first quarter were primarily follow-on orders for existing programs. One key program award expected in the first quarter was delayed, but we have received this order of over $1 million in October.

European bookings for the first quarter were up 9% quarter over quarter and 37% as compared to the first quarter of fiscal year 2010, which was our weakest quarter in Europe last year. High-power OEM production rates have started to slowly increase, reflecting improving economic conditions, and low-power OEMs remained steady, with an ongoing positive outlook. End-user demand for spare parts remains healthy as a result of increasing machine utilization in Europe.

Japan bookings in the first quarter more than doubled the same quarter last year. Production rates for the high-power OEMs have leveled off at a steady rate of 70% of their high point in fiscal year 2008, and are expected to continue at this level into the next quarter.

China continues to be the source of their demand. Low-power OEM production rates are reaching, if not exceeding, the fiscal year 2008 levels. The strong demand for products, especially from the electronics industry, is expected to continue through the third quarter.

Strengthening of the yen versus the US dollar had a slightly positive impact on our first-quarter financial results. China bookings in the first quarter were even with the first quarter of fiscal year 2010. We anticipate a slight increase in the second quarter.

Zinc Selenide and Zinc Sulfide external raw material bookings for the first quarter increased 6% quarter over quarter and increased 45% compared to the first quarter of fiscal year 2010. The increase versus the first quarter of fiscal year 2010 consisted primarily of orders for material used in passive thermal imaging systems for commercial and defense applications.

Our HIGHYAG bookings for the first quarter were 21% higher quarter over quarter and up 49% as compared to the first quarter of fiscal year 2010. The majority of the HIGHYAG activity continues to be geared toward 1-micron beam delivery components, remote welding heads and some components for cutting systems. The activity level continues to be strong, as the automobile industry is beginning to invest again in new technologies. Our RLSK remote welding head is gaining acceptance with key customers seeking improvement in existing manufacturing techniques.

The outlook remains strong in the Military & Materials segment, which consists of our Exotic Electro-Optics and Pacific Rare Metals subsidiaries. At Exotic, quarterly revenues were up 14% from a year ago, representing increased shipments of sapphire windows for the F-35 Joint Strike Fighter program and an expedited order for multispectral Zinc Sulfide windows for the targeting system on the Predator unmanned aircraft.

The expectations for these products remains strong. The sapphire product line is primarily supported by two programs, the Joint Strike Fighter and the Sniper Advanced Targeting Pod. At present, we are sole-source supplier of sapphire windows in both of these programs.

The JSF program, or Joint Strike Fighter, has received much press in the past few months. Discussions on potential cutbacks by the US Defense Department and foreign military sale -- on potential cutbacks by the US Defense Department and foreign military sales have been in the news often. As of today, we have confidence the JSF program will support the capacity we have put in place in our internal bookings and revenue projections for the next five years.

The Air Force has recently announced an indefinite delivery, indefinite quantity contract with our customer, Lockheed Martin, for 400 Sniper Targeting Pods through the year 2017. This demand, along with our current order backlog, should maintain a steady production flow through our factory. Additionally, Lockheed is selling this product internationally.

Finally, at EEO, we have completed the leasehold improvements necessary for our 22,000 square-foot sapphire production facility. This facility would be completely online by June 30, 2011. The facility has been designed in conjunction with our main sapphire customer, Lockheed Martin, using lean manufacturing principles, and we expect to improve our manufacturing and efficiency and throughput as we move into the facility.

At PRM, demand for our selenium and tellurium products remains high. Bookings were equal to last year's first quarter in spite of a $3.2 million debooking from an Asian customer that has encountered business issues. In addition to demand for higher quantities of product, we are also benefiting from higher index prices for both selenium and tellurium and sales of precious metals, which are a byproduct of our refining process. Although there has been some volatility in index prices during the quarter, the net increase for each metal was about 10%.

The largest demand for our products is from the photovoltaic market, where our tellurium is used to produce cadmium telluride, which is then purchased by solar panel producers, such as First Solar.

In the past year, the copper-indium-gallium-selenide, called CIGS, solar market has emerged, which is another thin-film-based technology used to produce solar cells that has shown a higher level of demand. We expect this higher demand to continue and will probably push the index price higher in the next several quarters for selenium.

One of the challenges we currently face is procuring the needed raw material supply. Although the supply line in production demand is tight, we have been successful in increasing our overall raw material procurement level to achieve our growth plan. We are planning to expand our tellurium production in the second half of this fiscal year. However, the expanded capacity may take time to come online because of raw material constraints.

In the Compound Semiconductor group, our wide bandgap unit's first-quarter product bookings of $4.2 million continue to be very strong, doubling the prior fourth-quarter FY 10 bookings and far exceeding our first-quarter forecast.

The first-quarter contract bookings, however, were significantly lower than forecasted due to continued delay in the award of a new large DoD contract focused on improvements in the manufacture of large-diameter substrates for both RF and power applications. The contract booking is now expected in the second quarter of this fiscal year.

The first-quarter product revenues of $2.4 million exceeded our internal forecast and were up 8% sequentially and 26% compared to the first quarter of fiscal year 2010. Contact revenues were lower than forecasted due to the impact of the delayed booking.

During the quarter, the demand for 100-millimeter-diameter semi-insulating substrates for RF applications increased 50% over the fourth quarter of FY 10. We expect the industry transition to 100-millimeter substrates to continue and to accelerate quarter by quarter this year. We are forecasting a doubling of 100-millimeter substrate shipments from the first quarter to the second quarter of this year.

In addition, we are on track to achieve qualification of our 100-millimeter 4H-conducting substrates for power switch applications at several large OEMs in Japan and Europe during the second half of our fiscal year. Once qualified at these large OEMs, we expect that substrate demand will continue to increase in anticipation of the increased demand for all of our silicon carbide products.

We have begun during the quarter to add significant infrastructure to accommodate increased crystal growth capacity. We anticipate completion of the infrastructure expansion during the second quarter and a 30% expansion of our crystal growth capacity by the end of our fiscal year.

At our Mississippi facility, we have been working with Mississippi State University to complete the design of a new 10,000-square-foot building which will accommodate a significant increase in polishing capability for wafer diameters up to 150 millimeters. The new facility will be located adjacent to the site of our current Advanced Polishing Center in the Thad Cochran Technology Park. We expect the completion of this new facility by the end of the first quarter of FY 12.

Turning now to Marlow Industries, our first-quarter bookings of $17.4 million were very strong and exceeded our internal forecast. In the first quarter, Marlow achieved record revenues of $19.1 million, significantly exceeding our forecast, and were up 33% sequentially, more than doubled year-over-year.

We continue to experience strong demand in our defense, medical and telecom markets, although some telecom equipment OEMs have indicated that the recent recovery in that market segment may be slowing. However, all three of these segments contributed to the higher-than-expected revenues in the first quarter.

The initial ramp-up in our Vietnam factory of our new high-volume gesture-recognition consumer application product resulted in the highest revenue quarter for a single market ever at Marlow. We are very pleased with production yields and product quality that our Vietnam factory has achieved.

The Vietnam plant is now producing most of our commercial products. That is encouraging, because we continue to see a steady stream of potential new development programs and opportunities in all of our markets. We have started the transition of additional processing capability to Vietnam for our telecom production, which will further improve our cost, quality and delivery in the highly competitive telecom market.

We are increasing both our ceramic processing and plating capabilities in Vietnam. We continue to develop our technologies to broaden our product and solution capabilities, enable new, emerging applications and to expand market share.

Companywide, our new product development efforts, combined with our investment in new technology, process yield improvements and capacity, are fueling solid organic growth. We continue to search for the right strategic acquisitions, and we expect to leverage our strong cash position to meet our long-term strategic growth objectives. We do not have any specific acquisition that we would like to discuss today, but we are prepared to move forward in the M&A arena when good opportunities arise.

In conclusion, the overview that I've just given highlighted what we experienced in the first quarter. All business segments exceeded our first-quarter forecast in revenues and segment earnings. We expect similar trends with a few exceptions to continue most of fiscal year 2011.

Craig will next give some more details on our projections and our first-quarter results. Craig?

Thank you, Fran. Here are the items I would like to highlight before we open up the question-and-answer portion of the call.

The updated outlook that was contained in today's press release reflects the current range of expectations for the collective performance of all the II-VI businesses. In an effort to keep the question-and-answer session focused on market, operational and business-related matters, and less of a dissection of the guidance, we offer the following background factors that were used for the updated guidance.

We are seeing an increased level of business from our highest-margin business, Infrared Optics, which is helping to increase the bottom line at a disproportionate pace. Photop continues to perform well, but visibility in the second half of the year is not clear. Our Military Infrared Optics business remains solid, and we are looking for revenue growth of over 10% for the year.

PRM benefited from some precious metal sales in the first quarter that are not expected to repeat again this year, but nonetheless, PRM should be able to have a year where sales exceed the prior year by one third or more.

Marlow has performed well in addressing their significant gesture-recognition consumer application, but the outlook for this product is clear only through the end of the current quarter, so lower revenues are projected for the second half of the fiscal year for the Marlow business as a whole.

Our full-year tax rate expectation is about 24%, and is trending lower because of a higher portion of non-US-based earnings.

When you put all this together, we are projecting a fiscal year that will be up between 29% and 32% in revenues and 60% to 68% in earnings per share compared to last year.

As described in the segment information in the press release, bookings for the quarter ended September 30, 2010 were $112 million. This is an increase of 53% over the same quarter last year including the bookings of Photop, and an increase of 15% excluding the bookings of Photop.

Total Company backlog at September 30, 2010 was $148.5 million. The components of the September 30, 2010 backlog were -- Infrared Optics at $31 million; Near-Infrared Optics at $45 million, which includes Photop's backlog of approximately $24.5 million; Military & Materials at $47 million; and Compound Semiconductor Group at $25.5 million.

The share-based competition expense for the just-completed quarter of $3.7 million included the following items. $2.6 million for ongoing stock-option, performance share and restricted stock expense, including updates to the forfeiture rates used for certain stock option grants. $0.5 million related to stock options that were granted during the quarter that were done so on a fully-vested basis, in accordance with the provisions of the applicable employment agreement. $0.3 million of share-based compensation needed for the Photop performance and retention programs. And $0.2 million for option and restricted share given to our long-term nonemployee directors.

When we exclude the items that are unique to the just-completed quarter, we are estimating that the share-based compensation expense for the second, third and fourth quarters should be approximately $2.3 million per quarter.

Capital spending for FY 10 was $13.8 million. Capital spending for the just-completed quarter was $5.3 million. As the outlook for revenues and financial results for FY 11 has increased, so has our forecast for capital spending needed to support this growth. We continue to work on capital spending in areas that were planned some time ago, like the new sapphire facility in our Military & Materials business and the additional silicon carbide growth furnaces in our Compound Semiconductor Group, both of which Fran mentioned in his prepared comments.

We have recently started increasing our capacity, working on throughput improvements and increasing our metrology capabilities in key areas of our Infrared Optics business to keep up with demand. Our updated outlook projects that we will spend about $30 million in capital spending in FY 11, with Photop making up about 25% of that amount and Infrared Optics about 20%.

The movements in foreign currencies caused some foreign-currency gains during the quarter. The net foreign currency gain for the quarter, which is included as part of other income expense net in the income statement, was $1.2 million pretax, or about $0.03 per share.

A majority of this gain is attributable to payables of our Netherlands holding company for future payments to the selling shareholders of Photop. Because these are US dollar obligations that reside in an entity whose functional currency is the euro, the euro strengthening against the US dollar in the September quarter caused the recognition of unrealized gains for these future payments. However, the US dollar amounts of these obligations, which is how they will be settled, remains unchanged. Most of the gains that were incurred during the quarter were recoveries of losses that were reported in the fourth quarter of the prior fiscal year, which was a quarter where the US dollar appreciated against the euro.

Fran, this concludes my prepared remarks for today.

Before we begin the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements which are based on current expectations. Actual results could differ materially. For information about factors that could cause the actual results to differ materially, please refer to the Risk Factors section of our Form 10-K for the fiscal year ended June 30, 2010.

Devin, we are now ready to begin the question-and-answer session.

(Operator Instructions) Avinash Kant, D.A. Davidson.

A few quick questions. The first one, in the fiscal year 2011 guidance, you did talk about some uncertainty in Photop's business for the second half. We were trying to understand how are you modeling the second half of Photop in the guidance?

I think we are -- I think to triangulate on Fran's comments, and mine as well, we definitely had a very -- and have had a very strong performance from Photop for the three quarters that we've owned them. We are expecting a little bit of lower sales in the December quarter as compared to September. And then really, that is where our visibility drops off from there.

So we are kind of modeling it out in that manner. I don't believe we are able to give you any further kind of specifics or details on that, but that is how we are modeling it out.

Okay. And in your prepared remarks, you did talk about some contract bookings that may come back in the next quarter. This is for Q2. Now, based on those contract bookings, would you expect the bookings in the fiscal Q2 to be higher than fiscal Q1 levels at this point?

We really don't try to get into forecasting the bookings. It is so based on the customer, timing of orders and things of that nature. And that is one of the reasons we put out the just-completed quarter bookings, so people can see where things are trending.

But I think we tried to mention at least one that was kind of close to coming in in the quarter, that came in here in early October that Fran mentioned for about $1 million of bookings. But beyond that, we are probably not in a -- we probably don't have enough information to give you a good guesstimate of the bookings.

If I could add to what Craig said, we will have to be up a little in the next few quarters to make the numbers we've guided to in revenue. So we did have the first quarter just a little less than what we -- for a while, we were getting quite optimistic, but one delay of a big order that pushes into the second quarter happened.

Right. So I'm thinking when that order comes back in the second quarter, that should take bookings up from current levels or not?

Yes, that is what I was saying. Yes, I think it will.

Okay. And the final question was that acquisition strategy. Historically, other than Photop, you had done most of the bolt-on or smaller acquisitions. It looks like your inclination to do some larger acquisitions has been shown up actually lately. So should we expect some small or larger acquisitions going forward?

I think we will work on both. As we continue to look in the areas we want to be investing in, we look for the small and we look for the large. And you have to have a willing seller and we are working hard on both sides of it. We don't have anything we can talk more definitive about.

But it looks like there is something coming up soon.

No, like I said, I didn't have anything we could talk about today, but I can just tell you we're active. We are working it, and that is as far as we can go.

Perfect. Thank you so much. Thanks, Fran. Thanks, Craig.

Jim Ricchiuti, Needham & Co.

If we just look at the upside that you have provided to your fiscal 2011 guidance, and we think maybe in terms of your end markets, is it fair to say that more of the upside is coming from commercial versus military in terms of the major markets? Or maybe you could just comment on that.

That would be fair to say.

And is that increase in commercial, would you say that from a geographic standpoint is fairly well balanced? Certainly, you are seeing nice activity in Asia, but it sounds like you are also seeing a good uptick in the US, as well as Europe.

I think it's well-balanced, but I think the heart of what is stimulating the balance worldwide expansion is the China spending. So the Japanese and the Germans are building lasers and systems that are helping -- some going into China directly.

Then you have quite a bit of the semiconductor, whether it's iPad, all that business, that is expanding, being built in China. The via hole drilling systems -- laser based out of Japan. We have -- there's quite a bit of China expansion with their own stimulus money in every sector, whether its telecom to road-building or bridging or steel. And so when steel production is up, we do better as a company, and China is right now one of the big steel guys, if you know what I mean.

I do. And just one -- as an aside, you commented, I believe, on the Infrared Optics business. Perhaps I caught that right. I'm not sure. But you referenced the Predator. And I know you are sole-sourced on a number of projects. Is that one that you are also sole-sourced on?

No, that would be in the Exotic Electro-Optics.

I'm sorry, right. That's right.

But no, we are not sole on the Predator. For that particular part, we reference. It is a multispectral zinc sulfide window.

Okay. Thank you.

Mark Douglass, Longbow Research.

On the IR Optics front, Frank, could you provide some readthrough? What are you seeing from the laser OEMs as far as new laser shipments, both solid-state, really fiber, CO2, low, high power?

Okay. They are increasing their production down the assembly line a little bit in the high-power CO2. But I won't tack it to be much more than 2500 to 3000 units worldwide a month. But that is up from maybe 2200, 2500. So it is coming up slowly.

You go to the fiber side of it, in the 1-micron business -- you probably follow that closer than we do -- you know the people who are in that space. It is getting some more output volume, I think, and a lot of welding work. We see it through our HIGHYAG subsidiary, who is making more beam delivery systems. And I refer to it as RSLK head, which is our welding head. That one is getting pretty good speed, pretty good traction.

Go to the comments I made about our Near-Infrared business, where we do 1-micron system -- or 1-micron product, which is the YAG laser host material. And that business is seeing some nice pickup. And a lot of it heads into China, again, for -- the Chinese are making products and they are making them very cost-effectively. And a very cost-effective solution can be the traditional YAG laser on the lower powers. They are not high power at a kilowatt, but lower power.

So overall, pretty good on most of our fronts in terms of pickup from OEMs. I made one comment that at least in Japan, where it is 70% of the pre-recession peak for lasers coming down the assembly line, I think that might be a little low compared to the rest of the world. But it's not much more than 75% of the pre-peak level.

Thank you. On bookings, your book-to-bill is below one. Is that something that kind of leads you to some cautious back-half guidance then, and is some of that seasonality?

I think we'll be right back. Our book-to-bill will be in good shape in the next couple quarters. We see it coming pretty well. The quarter, I cannot give you all the reasons for the book-to-bill being the way it was.

We did talk about an order or two that slipped into the second quarter from the first that we expected. We did have our UV filter product line that we are shipping well on here in the first, second and third quarter. But it was against orders that were received in the fourth quarter. So that might -- and we might get another order of that nature in the fourth quarter of this year or it might slip into the first quarter of FY 12. So UV filter comes in big hunks, and that was a bit of a factor.

And Mark, we had one more factor that Fran mentioned as well. For PRM, we had one customer that has experienced some business-related issues, and they may -- or their business may or may not come back. And we unbooked or showed as a reduction in bookings this quarter over $3 million. So that was also in the quarterly bookings this quarter as well. That is reflected that way, so --.

And all of that -- a lot of that is military material. So is it fair to say that the bookings particularly like in military materials is probably going to be more lumpy than sales?

Yes, definitely so.

And final question, on Kepong Semiconductor Group. With the additional capacity that is going on for the 100-millimeter silicon carbide, will this -- is this going to drag the CSG margins a little bit going forward, until you can really build and produce into the capacity that you are adding?

I think we've been very pleased with the progress that group has made, especially over the last couple years. They really have done a good job kind of managing not only the kind of increase in commercial business, but maintaining a decent level of contract business as well. It is definitely giving them some margin.

I think what we are adding as far as furnace capacity is more incremental type of additions. It is not that we're going to need to shut down certain areas of the operations or do additions in that manner. So we are expecting it to be fairly neutral to the margin profile.

Again, we are talking about WBG is our smallest -- one of our smallest businesses. But -- and we are not anticipating any significant falloff in margins, significant changes for that matter at all in margins, because of that capacity expansion.

Okay. Thank you.

Dave Kang, B. Riley.

Good morning. First, regarding your guidance, what kind of gross margin assumptions are you making as far as on your EPS guidance is concerned? Should we use Q1 as the baseline?

Dave, we're thinking that with kind of the way we've modeled it out, it should be somewhat close to the gross margin we experienced. Maybe a little bit lower in some of the outer quarters, again, just because of -- again, because of the volume that we've expected; not so much for the second quarter, but for the third and fourth quarters, really, back to the prepared comments, because the visibility in a couple of our businesses is not as good, because the backlog kind of ends in December/January timeframe. So we should see a little bit of -- gross margin will come down a little bit in those outer quarters, but not too drastically.

Got it.

Dave, I would add to that, just so it is clear, that we might have, what Craig says, a half point down or something like that. We've been running awfully large amount of overtime in two or three of our businesses, maybe 18%, 20%, way more -- and we've sustained it now for six to eight months because we've tried to hold off adding the people. Although we've added -- we're working to add; we just can't get them quick enough. But we want to replace a lot of that overtime with people.

So that will have a tendency to bring down the margin a little; the untrained people coming into our business usually affect us a little bit. So we really are modeling that in the next three quarters. And we are taking the belief and we are seeing enough steadiness in all our leading indicators that through the rest of the year, we should put on those people.

Got it. And then you certainly spoke of seasonality, but in the past, Q1s tend to be seasonally soft, followed by stronger Q2s. So is this year more of an anomaly or is this more of a new II-VI seasonality?

I think it is an anomaly. The knockdown with the economy and how that came back and it just carried over a pretty strong -- a reasonably strong July/August/September. And I think there is still a seasonality in this business, especially the IR CO2 optics business. Our M&M business, maybe a little due to PRM. But then when we go to CSG, not so much. They are quite nice, steady products that they have. So it will have a little bit more seasonal effect in the next few years, but this year, it was an anomaly that didn't happen.

Got it. I may have missed this, but did you break out China in terms of total sales?

We did not, Dave. We usually report that -- or we do report that in our 10-Ks each year, when we go through in the segment information and break that out.

I think from -- based on the prepared comments from Fran, he mentioned that is one of the higher regions that we are selling into. And even a lot of what we are seeing the strength in Japan, especially in the Infrared Optics business, our intelligence is saying that a lot of that demand is flowing into China. So we didn't break it out specifically. We don't do that, other than at the end of each fiscal year.

What about in terms of trajectory as far as your guidance? I mean what kind of trajectory should we expect from China going forward?

I think in Fran's comments, he mentioned that, especially in the Infrared Optics business, we're expecting Q2 orders and Q2 revenues directly in China to be up. I think that is a good indicator for us, for Photop, which has a significant concentration of customers within China, within the China telecom area.

Again, we are going to pattern that similar to what we patterned for Photop, which is it has been very strong for the last three quarters. We're expecting it to tail off here a little bit over the next few quarters.

So overall, our international sales is really, as a whole, starting to -- it is really starting to be a different makeup for II-VI as a whole. This quarter, we did -- 60% of our sales, excluding contract sales, were outside of the US. That is the highest level that has ever been in the company.

Got it. Then I guess you sort of answered my question, but just a little -- trying to drill down a little bit more. In terms of Photop, how much is China? Is it like maybe 60%, 70%, 80%?

It is a big portion, Dave. We would probably say roughly half of the business is in their own backyard within China, and roughly half is outside. That is probably a good rule of thumb.

There is a lot of -- a lot of what they sell into China finds its way out to the US and Europe, and a lot of what they sell into the US finds its way other places. Obviously, they have a very strong global footprint, strong customer relationships in China and also outside of China as well.

Right. Because I'm trying to figure out -- because one of Photop's competitors in the optical component sector, their sales were up 10% sequentially in the September quarter, and yet you guys were basically flat. So I was just trying to figure out whether it is a market share issue or the fact that you have a much bigger exposure to China, because that is what I'm hearing, is that the slowdown as far as optical is concerned is coming from China.

Okay.

All right. Thank you.

Jiwon Lee, Sidoti & Co.

Just a few quick questions, if I will. Just wanted to go back to the international sales. Craig, could you help us kind of how you rank the size of your international sales among Europe, Japan and China?

Definitely, it is probably two different comments, Jiwon. Prior to the Photop acquisition, we would say that Japan and Germany were the two largest non-US markets that we sold into. Now, with the acquisition of Photop, that has changed that metric quite a bit.

If you look back to our FY 10 non-US sales, almost a third of that was in China. And that is definitely picking up. As we get a full year worth of Photop within the FY 11 financials, that number should increase. It will push it up to 40%, maybe 45% of our non-US sales coming from China. But right behind them would definitely be sales into Germany and also into Japan as well.

In Japan, as Fran mentioned a little bit in his comments, we are benefiting a little bit from the strengthening of the yen. We're selling into yen in that country. As we translate those sales back to dollars, that is giving us a little bit benefit. And again, the Japanese recovery, Asian recovery has happened faster than what has happened in Europe.

So if you rank them as far as what our expectations would be for FY 11, as far as non-US sales, China would definitely be a very large market for us, followed by Japan and Germany.

How would that ranking change if we looked at specifically the CO2, the IR optics business?

As far as the recovery, Jiwon, is your question? As far as what we're expecting for FY 11, how will that change. Is that what you're asking?

No, no, the question was how would you rank among those three geographies if we looked specifically at the CO2 laser optics now?

Okay. I would say it would be -- and I'll ask maybe Fran to give you his thoughts as well -- I think those geographies, you would probably rank them Japan first. Again, very closely behind that, though, Germany and then China. And again, it is also not only where the lasers are deployed, I think as you understand, but also where the laser manufacturers are, as well.

Fran, do you want to add (multiple speakers).

I would do about the same, probably. Japan and Germany flip-flop between first and second. One time, one is ahead, one is the other. North America, US is in third spot. And then China is down in fourth on the CO2 side. And it is down a ways. They are coming fast. It is still down a ways compared to those other three, which have been -- they've shared the globe at 1/3 each for a number of years.

Okay. That's very helpful. And the second question, what was sort of the big factor for the margin swing in the September quarter? Would you attribute that mostly to the CO2 laser optics sale that went up almost 7% sequentially?

That is definitely a contributor. We would also point to kind of some very high-margin precious metals sales that we had within the PRM business. And I think the third area that we would point to would be this much higher, much improved performance from Marlow as well. I think those are three of the -- kind of the brighter spots that impacted the margin during the quarter.

And thirdly, how is the pricing side playing out for your IR commercial optics?

It is getting more aggressive. Certainly, the amount of competition for the aftermarket optics business is heated up. And we've always been aligned well with the OEMs; we continue to try to be aligned. They support their own aftermarket. We support wherever there are opportunities that they are not covering.

But right now, we have more third-party producers or marketers of CO2 optics that they would get from one or two or three other sources. So it is more aggressive, and the OEMs have kind of lost some of their aftermarket holding power. So we now have to be back in the aftermarket. Even though we've always been aggressive, now we have to be a little more aggressive to not allow any third party to take share. So it is more aggressive on price in the aftermarket than what we've seen.

Okay. That's helpful. And lastly, could you give us a rough dollar content on your 400 Sniper Pod orders through 2017?

No, we do not have that. We do book whatever orders we have that are shippable within 12 months, and that has been in the numbers we've been talking about. But past 12 months, we do not claim those as bookings.

Did you say past 12 months there was no bookings on the Sniper?

No, we do not claim them as part of our registered bookings, just because of how things go. Past 12 months, things disappear on you. So if you count them, maybe we shouldn't have counted them. So we have the practice of only recording what comes in and is going to ship in 12 months.

Then could you talk about how much revenue was attributable to this Sniper program in last year?

Boy, really, Jiwon, I don't think so. I really don't have the data. But at the same time, it is kind of going deeper into the details of Exotic than what we've ever gone before. So I would tend not to answer that.

You did give us a lot of detail. Thank you.

You're welcome.

(Operator Instructions) Jim Ricchiuti, Needham & Co.

The operating margins that you are seeing in the Military & Materials and the Compound Semiconductor area, very strong the last couple of quarters. Is your sense that the margins are sustainable at these levels, or would you possibly see some of that back off in those two areas?

I think overall, we are definitely very pleased with where both of those groups have gone. I think that -- again, I think as you are looking at the history of where it has been over the last three or four quarters, we are, again, very pleased with where that has been.

I think there is nothing kind of extraordinary, if you would as far, as the recent results, Q4 or Q1 -- Q4 of last year, Q1 this year. Our expectations have been kind of moved up to those levels. And we do think that that is very sustainable for those groups to achieve those.

Okay. And Craig, with respect to Infrared Optics, it sounds like, given the improvement you are seeing in that business, that we could see possibly a return to the operating margin levels going back to the June 2008 and September 2008 time period, as you generate more volume.

I think we are getting closer to those revenue peak levels. As Fran was mentioning, kind of getting close there on the revenue and the booking side of things. Our Infrared Optics segment reporting, it does capture the majority of a lot of kind of corporate allocations and share-based compensation and other things that two, three, four years ago were of a different proportion.

I would say throughout that period and even, honestly, throughout the downturns in the Infrared Optics business, we've been able to have that business produce at gross margins that are in excess of our corporate margins. And I think what we're expecting is as that business continues to recover -- and we expect it to continue to recover -- that will definitely help pull up the segment earnings of that business.

I think the size and scale is similar to what it was two, three years ago. I think the profile of 26, though, is maybe a little bit different, where you are getting a little bit more nonoperational type elements into the segment earnings. So I wouldn't try to make that exact comparison, but I would say that overall, we definitely expect that the incremental margin at the recovering Infrared Optics business, a lot of that will drop down to the segment earnings level.

Jim, I would just add a couple -- because you started asking about M&M and CSG. M&M did have a little help this quarter, as we talked about, with precious material sales that are byproduct. We do that once every two, three quarters, and then times we do not sell for a year and a half. So I just wouldn't want you to think that particular part of the margin lift we had in the quarter would continue.

Then in our -- the second one you asked about was CSG. Very, very good, solid performance. The one that I made a comment on, we do not have visibility into the calendar year 2011 on our new product that we are producing in Vietnam. If it goes about the way we think it will, it will turn down somewhat. So the CSG margin, which was really helped very nicely by this additional volume, it would be a little softer in the second half.

Got it. Thanks very much.

(Operator Instructions) I am showing no further questions at this time, sir.

Thank you, Devin. If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the quarter ending December 31, 2010 is currently scheduled for Tuesday, January 25, 2011 before the market opens, with a conference call to follow that same day at 9 a.m. Eastern time. Thank you for participating in today's conference call.

Ladies and gentlemen, thank you for your participation in today's conference call. This concludes the program. You may all now disconnect. Thank you, and have a nice day.