II-VI Inc (IIVI) 2011 Q2 法說會逐字稿

Good day, ladies and gentlemen. Welcome to the II-VI Incorporated fiscal year 2011 second-quarter earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session with instructions following at that time. (Operator Instructions). As a reminder, this call is being recorded. And now I would like to turn the call over to Craig Creaturo. Please begin, sir.

Thank you, Tyrone and good morning, everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI Incorporated. Welcome to the second-quarter fiscal year 2011 II-VI Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, January 25, 2011.

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. My remarks today describe the significant events that drove record bookings in revenues during the past 90 days. I will also present our expectations for the next few quarters.

First, I would like to congratulate the Photop team for completing a successful and historic first year as part of the II-VI family of companies. Also, I would like to take this time to thank all of our Asian employees and wish them success as they prepare to celebrate the new year in their respective countries and cultures.

In short, again, during the December quarter, like the previous three quarters, the Photop integration activities are proceeding smoothly and according to plan. The top management team's experience and excitement set the pace for Photop's growth. The December quarter exceeded expectations with bookings of $30 million, which was up 6% quarter-over-quarter and revenues of $31 million, which was up 16% from the first quarter.

During the quarter, Photop continued its growth trajectory in part as a result of stronger demand than forecasted, especially from the telecom and display segments of its business. Although all of its market segments experienced increased demand in activity. During the early part of the December quarter, industry analysts were quick to point out that the industries, such as telecom, which experienced increased demands during the prior three to four quarters, appeared to poise to take a breather. This led many pure play optical component OEMs to issue caution about their guidance and some to issue guidance that was flat to down sequentially while others believe that they had such limited visibility that they declined to give guidance.

These dynamics and the limited visibility of the December quarter for the telecom segment of Photop caused us to also be cautious about our outlook at that time. However, by the middle of the quarter, Photop received increased orders for delivery within 30 days or less. The unexpected demand came mostly for our 40G products that enable optical transmission, dispersion compensation management, coherent detection and reconfigurable optical add/drop multiplexing, more commonly known as ROADMs and also for our fiber-to-the-home, known as FTTH, and 3G wireless backhaul products that include thin-film filters, optical assemblies and related components.

Also, in the display segments, we experienced increased demand for our projection optics, as well as display glass panel that we manage as part of a manufacturing service relationship. We continue to invest in our workforce and capital equipment, as well as in research and development needed to meet the future expectations of our Photop customers. We experienced and therefore must manage raw material supply constraints to preserve our strong customer service and delivery results.

Now let me turn our attention to the next quarter. As of December 31, 2010 Photop had a backlog of $23 million. Our Photop operations are fully booked for January, but we still have less visibility beyond January than we would like. So we will rely on short interval orders to fill our current capacity. Therefore, we are guiding the March quarter to slightly lower revenues and margins due in part to the challenges with visibility and an anticipated change of product mix from some of our major customers toward products that are lower margin ones in our portfolio.

Next in our VLOC portion of our near-infrared segment, the second-quarter bookings were down year-over-year due to the $5 million Title III contract that was received last year for the development of ceramic laser gain materials. The team has met the challenging milestones required in the first year of this program. However, due to the political environment, especially some changes to the government budgeting process, this year, the funding of the next phase of this program did not continue. The team is working hard to develop alternate funding sources, as well as keeping the program active at a lower scale until future funding can be obtained. The second-quarter overall bookings for VLOC increased 10% quarter-over-quarter, driven by an increase in military business.

On the military side, VLOC won several key orders this quarter for both legacy-based products and for military platforms. One large order impacting the crystal component productline was an order for a VLOC grown material using a system that protects low and slow flying aircraft against surface-to-air and air-to-air missiles. This program currently expects to have a lifecycle that is extending over the next four to five years, which is beyond our previous expectations.

Other military orders we served during the quarter were for products going into systems for infrared countermeasures, long-range surveillance and next-generation laser designation. Expected life of the legacy programs in this area range from three to five years and for the next generation programs up to 10 years.

With respect to the commercial markets, VLOC experienced 10% bookings growth year-over-year with the medical laser market being the largest contributor. VLOC's aesthetic laser manufacturers are seeing growth, strong growth internationally and slower growth domestically. Leading this growth are lasers sold to plastic surgeons and dermatologists for such elective procedures as hair removal, tattoo removal, vascular reduction, skin rejuvenation and acne reduction.

During the second quarter, VLOC provided prototype optics for a new and exciting ophthalmic laser-based procedure being developed by a leading surgical OEM. VLOC continues to address this increase in the commercial market with its lower cost manufacturing facilities in Vietnam and China. During the quarter, VLOC made significant progress consolidating its near IR China manufacturing from the Suzhou site to the Photop site in Fuzhou with a completion of the transfer of the optics fabrication and coating operations and partnering with Photop to nucleate a new advanced optics productline at Photop as an outcome.

Now turning to the IR optics segment, during the second quarter, bookings, including HIGHYAG, reached $47 million and were up 14% quarter-over-quarter and 45% compared to the second quarter of fiscal year 2010. During the quarter, we continued to see strong demand from our OEM and aftermarket customers as machine utilizations readily, steadily improved. Orders for the quarter are 8% higher than our prior peak that occurred during the third quarter of fiscal year 2008.

Now in the US, new orders for domestic OEMs for the second quarter increased 14% over the second quarter of fiscal year 2010. This increase was the result of blanket orders from low-power OEMs driven primarily by Asia. High-power OEMs continue to see stronger demand for spare parts as machine utilization rates improve, but new machine builds are still 25% below peak levels here in North America.

In the aftermarket North America, which is a relative indicator of machine utilization, this showed a 2% decrease quarter-over-quarter, but a 22% increase versus the second quarter of fiscal year 2010. We have seen quote activity and part volume increase throughout the past six months, but we continue to face pricing pressure from the OEMs in laser service companies. The agriculture and automotive markets continue to improve while housing remains weak.

US military orders for Infrared Optics increased 30% quarter-over-quarter and were double the second quarter of fiscal year 2010 levels. We booked $1.5 million, which represents the first half of a key military order during the second quarter and the second half of that order should be received in the fourth quarter of this year.

Now in Europe, bookings for the second quarter were up 30% as compared to the second quarter of last year. New machine builds by high-power OEMs continue to increase and we are now approaching 70% to 75% of their peak production in fiscal year '08. As utilization rates continue to improve, price pressure in the aftermarket has also increased. Production rates for low-power OEMs in Europe are also increasing with a strong outlook for the remainder of calendar year '11.

Japan bookings in the second quarter were 66% higher than the same quarter last year. High-powered Japanese OEMs continue to gradually increase production while low-power manufacturers are [mainly] producing via hole drilling systems are growing at a much faster pace. The source of this increased demand is coming from China.

In China, our bookings in the second quarter doubled the same quarter of last year. Increase is being driven by strong demand for industrial applications in the low power and via hole markets, which show no signs of slowing. High demand from China has also had a positive impact on OEMs located in Japan, Europe and the United States.

At HIGHYAG, bookings during the second quarter were 50% higher quarter-over-quarter and more than double the second quarter of fiscal year 2010. The majority of the HIGHYAG activity continues to be one micron, beam delivery components, remote welding heads and 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 as evidenced by a substantial booking for multiple units this quarter.

I want to move to the Military and Materials segment, which consists of our Exotic Electro-Optics and Pacific Rare Metals subsidiary where we posted very strong results for the quarter. At EEO, quarterly revenues were up 25% from a year ago, representing significantly increased shipments of Sapphire Windows for the F-35 joint strike fighter program.

Bookings were also up 10% from a year ago, driven primarily by the JSF program where the balance of funding for LRIP 4 contract was received in the second quarter. The JSF program has received much press in the past few months. Defense Secretary Gates recently proposed to cut 125 JSF aircraft from the production requirements over a five-year period starting in fiscal year 2012 of the government calendar.

Based on our current backlog and the timing required to manufacture JSF Sapphire Windows ahead of final aircraft assembly, we do not expect the proposed cuts to have any significant impact on the fiscal year '11 or fiscal year '12 revenue projections for EEO.

Additionally, we continue to monitor proposed spending cuts and changing priorities in the US defense budget and assess the potential impact to our military business. While some spending cuts will be realized through cancellation or schedule adjustments to poor performing programs, we expect spending increases for programs related to intelligence, surveillance and reconnaissance, which are called ISR applications. Exotic's core capabilities in Infrared Optics are applicable to ISR applications and we expect to benefit from increased spending in this area.

In December, we announced the acquisition of Max Levy Autograph, which we call MLA, a manufacturer of microfine conductive mesh patterns for optical, mechanical and ceramic component applications for defense and commercial industries. As previously reported, MLA will operate as part of our EEO subsidiary, which is consolidated into our Military and Materials business segment.

MLA is a strategic acquisition, which adds new products and technologies that are important to the military market as it provides protection for ISR systems on various aircraft and land vehicles. MLA's products and technologies are well matched with the products and markets served by EEO. For example, MLA is a qualified supplier to EEO for electromagnetic interference, EMI grids on JSF, Sapphire Windows and ATP sniper programs. We expect the combination of these groups to provide a stronger platform for continued growth in the defense industry and potentially enable market diversification over the longer term.

At Pacific Rare Metals, PRM, strong demand for selenium and tellurium products continues. A significant increase in the order rate for the quarter was highlighted by a $4 million order for high purity selenium from a supplier in the photovoltaic industry. This order represents the estimated first-year demand of a three-year contract. This demand is expected to increase in the second and third years.

Increased demand for our products has driven the market index price to higher levels, which is consistent with the current situation for many minor metals and other materials. The selenium index price ended the quarter at $42 per pound, over 10% up from the beginning of the quarter. For tellurium, the increase was about 8% ending the quarter at $270 per kilogram.

Although this results in higher product selling prices, it also increases the cost of our raw materials. However, in the short term, it does improve profitability. The main challenge at PRM is increasing our raw material supply line and despite the supply tightness and tough competition for raw materials containing selenium and tellurium, we have been successful in procuring raw material to meet our product demand needs.

We are on schedule to complete our tellurium production expansion project later this year, which should increase our output by over 30%. We have customers in the cadmium telluride thin-film voltaics market. We have quoted for this tellurium capacity as soon as it comes online.

Finally in our component and our compound semiconductor group, our wide bandgap units year-to-date bookings of $11 million increased 85% year-over-year. As anticipated, we recorded a $5.2 million award from AFRL for a new DoD contract focused on improving the manufacturing processes of large diameter substrates for both RF and power applications. Revenues for the second quarter of $3.4 million were up 14% year-over-year and 30% quarter-over-quarter representing increased shipments of substrates for both power and RF products and increased contract revenue from the new DoD contract.

The demand for 100 millimeter diameter semi-insulating substrates for RF applications increased 50% over the first quarter of FY '11. We expect the industry transition to 100 millimeter substrates to continue and we are forecasting a continuing increase in 100 millimeter substrate shipments for the remainder of this fiscal year.

In addition, we have qualified our 100 millimeter 4H conducting substrates for power switch applications at two large OEMs in the US and Europe and expect to qualify at a large OEM in Japan during the second half of this fiscal year. Once qualified at these large OEMs, we expect an even more rapid increase in substrate demand. In anticipation of this increase for all of our silicon carbide products, we began during the first quarter to add significant infrastructure to accommodate increased crystal growth capacity.

We have completed phase one of the infrastructure expansion in New Jersey. We began adding crystal growth furnaces during the third quarter and we expect to more than double our crystal growth capacity by the end of this fiscal year. At our Mississippi location, we have worked with Mississippi State University to complete the design of a new 10,000 square foot building that will accommodate a significant increase in our polishing capability with 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 with the expected completion by December of this year.

At Marlow Industries, year-to-date bookings of $32 million increased 38% year-over-year. Bookings increases were driven by the launch of the Gesture recognition products, along with strong demand from our core markets of defense, telecom, medical and industrial.

We did see some softening in the telecom market in the second quarter. Revenues for the second quarter of $16 million were up 75% year-over-year. These increases were primarily driven by Gesture recognition -- by the Gesture recognition and telecom markets.

We were also recently selected as the primary supplier on a high-volume automotive seat cooling application scheduled to go into production in the fourth quarter of this fiscal year. There continues to be a strong flow of new customer-driven product development programs in all of our markets. The Gesture recognition bookings and revenue levels are expected to follow the post-holiday consumer electronics cycle during the next two quarters.

The ramp-up of our Vietnam factory continued well into the second quarter. Vietnam production productivity and quality improved in the quarter consistent with our Asian value-added and low-cost manufacturing strategy. Vietnam facility improvements and equipment installations were on schedule to support the third quarter of fiscal year '11 startup of Phase 4 ceramic processing for telecom products in Vietnam. This represents the next major step in our manufacturing cost reduction strategy. The full transition will be coordinated with our customers' qualification requirements. Product development continued on two major emerging markets -- power generation and personal comfort.

I will speak a moment about M&A activities. We expect to continue to leverage our strong cash position to seek acquisitions that increase the value of our existing businesses, as well as help us gain access to new market sectors that meet our long-term strategic growth objectives. We do not have any additional acquisitions that we would like to discuss today, but we are prepared to move rapidly when good opportunities arise.

In conclusion, we are pleased with our strong performance in the first half of the fiscal year. With the continued improving worldwide economic news and projections, we have increased our outlook for the remainder of the fiscal year and included that information in today's press release. Craig, that concludes my comments.

Thank you, Fran. Here are the items I would like to highlight before we open up the question-and-answer portion of the call. As described in the segment information in the press release, bookings for the quarter ended December 31, 2010 were $134.1 million. This was an increase of 71% over the same quarter last year, including the bookings of Photop and an increase of 33% excluding the bookings of Photop. Bookings for the December 2010 quarter increased 20% from the September 2010 quarter.

Total Company backlog at December 31, 2010 increased to $163.5 million. The components in the December 31, 2010 backlog were Infrared Optics at $37.5 million, near Infrared Optics at $39 million, which includes Photop's backlog of approximately $23 million, Military and Materials at $59.5 million, which includes the opening backlog of Max Levy of $1.5 million and the compound semiconductor group at $27.5 million.

As we first announced on December 7, 2010, II-VI acquired Max Levy Autograph. Max Levy is now part of our Exotic Electro-Optics business and our Military and Materials segments. The total consideration that was paid for this business was approximately $12.8 million net of cash acquired and the form of the consideration was cash.

During the remainder of FY '11, we plan on completing the valuation work that is needed to fair value Max Levy's fixed and intangible assets. Until that work is complete, the excess purchase price will remain as part of II-VI's goodwill. The amount of the Max Levy goodwill as of December 31, 2010 was approximately $9.7 million and will be adjusted from there based on the valuation work over the next two quarters.

The financial results of Max Levy during the just completed quarter were not material to the overall II-VI business nor did the addition of Max Levy have a significant impact on our updated guidance that was included in today's press release.

The effective income tax rate for the quarter was 20.4% and brought the year-to-date effective rate down to 23%. This is a decrease from our prior estimates for FY '11. The effective tax rate represents a benefit from the extension in December 2010 of the US Research and Development Credit for calendar year 2010. This reduced income tax expense during the quarter by $550,000, or about $0.02 per share and will lower our quarterly income tax rate for Q3 and Q4 of FY '11 by about $150,000 each quarter.

In addition, we are forecasting a higher mix of international sourced earnings than our prior forecast. PRM and Photop, which enjoy a lower tax rate than US tax rate, had stronger-than-expected earnings. Our current forecast for the fiscal year 2011 tax rate is to range between 23% and 24%.

We have been very pleased with our cash generation during the first half of FY '11. As noted in the press release, cash flow from operating activities for the six months ended December 31, 2010 exceeded $33 million. This is accomplished despite the working capital needed to build our inventories to meet our rising level of sales.

This level of cash production was sufficient to allow for the payment of the Max Levy acquisition and to fund nearly $15 million of capital spending year-to-date and still increase cash by over $11 million. Our year-to-date capital spending in FY '11 has already exceeded our capital spending for full-year FY '10. Capital spending for the just completed quarter was $9.4 million. Our current capital projection is that we should spend between $8 million and $9 million for each of the two remaining quarters in FY '11, for a projected capital spending of around $32 million for the full fiscal year.

The two largest areas of planned spending will be in our Infrared Optics and Photop businesses and there will be capacity throughput and facility improvements in many of our other businesses.

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. The following comments should help you better understand the factors that were used for the updated guidance.

Our strong Q2 bookings have increased our outlook for revenues from our Infrared Optics segment in the second half of the fiscal year. Photop continues its strong performance in spite of their limited visibility. We are anticipating some market softening at Photop in Q3 and into Q4.

Our VLOC business is continuing to forecast top-line growth for FY '11 at a slightly lower pace than previously expected due to the timing of certain military orders. Our military and threat optics business remains solid and with the addition of Max Levy, we are looking for revenue growth in excess of 15% this year. PRM is forecasting a strong year in FY '11 and based on the current market pricing of selenium and tellurium, it should increase sales by 40% or more over the prior year.

Marlow is expecting in Q3 a slowing of revenues due to the timing of expected shipments of their Gesture recognition consumer application. Our WBG business is seeing continued acceptance of its carbide-based products and is expecting its revenues to continue to increase during the second half of fiscal year. When you put all this together, we are projecting a fiscal year that will be up between 38% and 41% in revenues and 76% to 83% in earnings per share compared to last year.

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

(Operator Instructions). Mark Douglass, Longbow Research.

Good morning, gentlemen. So Craig, on just the -- on the last bit of your outlook there, see if I can kind of summarize it, so IR Optics you expect to continue to be up in the second half?

That is correct. That is correct, Mark.

Okay. Near IR kind of flat to slightly down, Military and Materials kind of flat to slightly down and I mean half-over-half and then (inaudible) Group I guess up a little bit? (inaudible) by segment.

Yes, I think, Mark, I think everything you said is right on. Maybe just one exception. Both the Military -- both pieces of the Military and Materials business we are looking for continued growth from both of those businesses. And so our comments were that, in Military Infrared Optics, we are looking for a year where they are going to be up about 15%, PRM should be up more than 40% and we are expecting strong second halves from both of those organizations.

Okay, you ran through this quickly. Now looking at 3Q EPS guidance and (inaudible) rest of the half EPS guidance, you are looking at a sequential drop in EPS, but revenues are kind of flattish. Is that to be read that it's a lot -- mostly due to your uptick in investment spending across the board or just kind of what is going on there and then what segment do you think we will primarily see the implied margin hit?

I think those will -- I think when we looked at our guidance, Mark, and put it all together for Q3, I think the one that was showing the largest difference between Q2 and Q3 would be at Photop. Again, especially some of the incremental revenue that they have gained on the higher levels of sales, we do think that will impact the bottom line. We do not anticipate having this extra couple cents of help that we had this quarter from the Research and Development tax extension. So that is something that was factored into our guidance as well.

And you are correct in saying that our capital spending is -- it started to increase. That is going to start to add some extra depreciation into Q3 and Q4 and so that is something that factored in as well.

I think, Mark, maybe another fact, Craig hit it right on the head about 60%, 70% of our slight tickdown might be due to Photop. But the other 20%, 30% might be on our CSG with our Marlow product. This toy cycle, which happens after the Christmas holiday, I think that is going to hurt us just a little bit in the third quarter. So mostly Photop down a hair, Marlow CSG down a hair, offset by IR up a hair and about normal performance at M&M.

Okay, so the Gesture recognition (inaudible) the Xbox was particularly profitable?

I would say we have done a good job I think with -- just kind of broadly speaking, we have done a good job with products that we have been able to manufacture over in Vietnam and that would be really pretty much most of all of our products that are not of military nature. So I think broadly we can say that Vietnam has worked exactly the way we anticipated it being a very efficient manufacturing site for us.

Okay. And then final question, if I read your comments correctly, Fran, I mean you comment quite a bit on low-power CO2, low-power applications for via drilling really booming. Was it safe to say that high-power CO2 is still kind of slowly recovering and how to read that as far as OEM builds?

Yes, I think that is a good way to put it. Right. Slowly but nicely recovering.

Okay, thanks and nice quarter.

Avinash Kant, D.A. Davidson.

A few questions here. The first one, maybe if you could talk a little bit about you clearly had an upside in the quarter compared to your guidance and would you say that all of the upside to the guidance came primarily from Photop or there were some other components to that?

I think there were some other components to that. I think that was definitely probably the most significant component in the quarter we just completed, especially on the sales line. I think that is probably where we saw the biggest change from our forecast was from Photop. That was probably the biggest change as well from the bottom line. But I would say that really all of our segments, including Military and Materials and CSG, were able to perform just a little bit better than we anticipated. But definitely the performance, the overperformance versus forecast was led by Photop.

Right.

I think you could expand a little bit more. That maybe half to 60% was Photop, but we had some extra help out of PRM. The better pricing there gives a real uplift to our profitability at PRM while prices are going up. But obviously when they come down, it does the opposite. So right now, we are enjoying that and that was a nice help. And at CSG Marlow with Gesture recognition I think late in the second quarter, we had more business there than what we had guided. So that was a nice help also. So we had good help across the board.

Okay. And tax rate, you gave us some guidance about fiscal '11 being close to 23% to 24%. Is this how we should be modeling things going forward also?

I think so. We really are switching over. We have got really about 60% of our revenues are now generated outside of the US. A lot are being generated in countries where we have a noticeably lower tax rate than the US. It is really dependent upon the mix of earnings, but I think kind of blocking in what we expect for fiscal year '11, that 23% to 24%, that should be -- that is what we expect for this year. It should be around that range I think when you start to look a little bit longer term. Again, heavily dependent upon the mix of earnings between inside the US and outside.

In some of the new markets, could you give us some idea about the automotive seat cooling market, how big an opportunity is or could it be and how big it is for you right now? Or maybe combine this one with the Gesture recognition and give us some idea so that we can have a framework in terms of how to model this going forward.

I think that is going to be pretty tricky for us to do. We have really not gone to that depth to disclose, but the car seat cooling market will be our first real entry and we are in the backseat, we are supplying to another supplier of that marketplace. So our guidance and our ability to project that -- I think it is going to have to be a wait-and-see for the next few quarters. The auto industry, it is booming in China, it is slugging along here in the US and the parts that we are going to supply to this other supplier are going into US cars. So a lot depends on how the US car market behaves.

Really we cannot give good indications on the seat cooling market and Gesture recognition. All we have been able to guide you to is that the third and fourth quarter of our year will be the down portion for Gesture recognition and the first and second quarters seem to be (inaudible) ready, build a lot for the Christmas holiday and then third and fourth quarter, throttle way back. That would be the best we could give you.

Maybe in the automotive seat cooling, are you up against competition or you are the only provider, and if you could get us an idea in terms of you are supplying to these many customers right now and eventually working with these many customers, could you give us some idea?

You can just say that we are a second-tier supplier to a prime supplier to all the auto companies in the world. So we are teamed with somebody else and I think in seat heating and cooling, there is probably -- Toyota and people in Japan, they have their own product and there is a manufacturer who supplies some other people around the world on the cooling side.

So it is a newer industry and I think it has been out there a half a dozen years or so, but this partner that we have is coming into the market and they have a good foothold because they are very big in the car seat heating side of the business. So we are helping them do the cooling.

And a final question, on the Max Levy side, of course, you seem to be very excited about this acquisition. When should we start to expect some either products or some meaningful contribution from Max Levy in the future?

I think it can really -- figure it is going to take us one to three years as we gradually increase the production of our JSF shrouds. Volume will go up out of Exotic and we will continue to supply the EMI gridding from MLA and from our other vendor. We will have a mix of both. But over the next one to three years, as that ramps up, we will have better margins we expect at EEO because of it.

Perfect. Thank you so much.

Jim Ricchiuti, Needham & Co.

Hi, thanks, good morning. I have been seeing -- we have been seeing a lot more reports of expansion in the Gesture recognition market beyond the toy market. I wonder if you would comment on perhaps the opportunity that you see in some of these newer markets like the smartphone market and other areas of consumer electronics. And if you could talk a little bit about perhaps the expansion of your customer base, how you see that in that part of the business.

That is pretty tricky for us to talk about. We are doing our best to follow this opportunity wherever it leads. And I think our team at Marlow is right on top of it. They understand who is going to try to do other things with this product and I think we have got a good start.

Now how it will go and who will dominate, there is a move toward television with it and there is a move in many directions. All I can say is we are connected. We have NDAs, nondisclosure agreements, with these people, so we cannot say much, except we are playing very, very closely. The chip manufacturer out of Israel is very important in this whole situation and we stay real close to them.

So from a competitive standpoint, you feel you are well-positioned in the market? Is that fair to say?

For what we are doing here, that is certainly -- really we are using our know-how in chip cooling and laser cooling, building these thermoelectric coolers and we are using our knowledge and sometimes the application is a little tricky so you have to redesign a little bit in how to cool it and so far, we have done that well.

Okay, and maybe just to switch gears for a moment, if we were to look at the military business and perhaps across your business units, can you talk a little bit about the bookings for the quarter in total in military relative to your expectations going into the quarter?

I think, overall, I would say, just broadly say when you look across each of the businesses and kind of add up all the military pieces, to answer your question, I would say that kind of overall, it met expectations. I think we definitely were pleased, as Fran was pointing out in his comments, in our near Infrared segment some of the programs that we have been able to get on and either win awards or new awards or new bookings. That was very positive.

Also in our WBG, our silicon carbide group, getting this large contract as well that is government-related. That was also an important milestone for us as well. And I think just broadly speaking, Military Infrared Optics business, as Fran was touching on, even though a bit of noise in the marketplace regarding JSF, our program and our ramp-up for that product continues along very strong.

So I think broadly speaking, I will let Fran add to that, but I think broadly speaking, we are pleased with where things shook out for the quarter. So Fran, do you want to add to that?

Yes, I agree. And I think because of Secretary Gates' comments on the military, we are sensitized to watch out that something could slow down on us on the military and so far, we have done our homework to check our programs and we are feeling pretty good.

We do a five-year plan each year annually and we look through all our different programs at different sites and we have usually tried to discount military projects because they delay. And I think in this year's five-year plan that we have just been going through, we have tried to discount and we have really discounted our JSF program by more than 25% just because of how this 2400, 25 unit reduction will be.

In our thinking on other programs like that, we have used our thinking more out in maybe FY '14, '15, '16 to say how this downshift in military spending could affect our programs. I think all the math you do for all the defense and I think we have calibrated ourselves. There is going to be a surprise or two. Something won't show up that we were expecting, but we have tried to put that into our thinking to the best we could.

And I think across the board, all four of our major business segments has a military component and for this quarter, we were right on, maybe a hair short in one group, but we went long in another, so right on. We feel pretty good right now on military.

Okay, thanks very much. That's helpful.

(Operator Instructions). Greg Halter, Great Lakes Review.

Good morning. I don't know if you mentioned it or not, but could you elaborate on your international sales relative to the total, as well as earnings from international sources, if you can provide that?

Yes, the international revenues for the quarter were 60% of total -- I'm sorry -- 61% of total sales (inaudible) pulled up slightly our year-to-date number, which is 60%. As far as the mix of earnings, Greg, I think kind of our comments are just broadly speaking that we have got very efficient manufacturing operations in countries that are at a lower tax rate.

So those definitely are a couple of positive factors for us. We don't make any specific geographic comments about earnings in a particular country per se, but we are taking advantage of, again, some of the lower tax rates in countries that we have either acquired businesses or established businesses ourselves.

Okay. And has there been any significant change in the end markets, the military defense at 30%, industrial at 40% and so forth and so on?

I would say our end markets -- I think as we continue to get more -- as we have more content coming from the Photop business, we are tilting a little bit more toward telecom than we did in FY '10. If you look back at FY '10, probably about 15% of our business was focused on telecom. It will definitely be higher than that in FY '11, really primarily because of adding Photop in for the whole year, not just for half a year.

But I would say that we continued this year to see the industrial rebound be very strong. As Fran mentioned in his comments, especially with our Infrared Optics business and 85% of that business is going toward industrial applications. We are seeing those -- we are seeing that market grow. We are seeing the telecom grow. We are seeing the military grow, but not as fast a pace as those other two markets.

Okay. And looking at your SG&A expense, it was down on a sequential basis and just wondering if that is something that we should expect to see going forward or how you would frame that out?

A little bit of that, Greg, is that first quarter of fiscal year we usually take a bit more share-based compensation expense than we do in the latter quarters. That's really just the timing of certain grants and certain things that hit into that quarter. In the quarter we just completed, we did about $2.2 million of share-based compensation spend. That's for the December quarter. If you look back into the September quarter, that number was a higher number. That number, the comparable number from the September quarter was $3.7 million. So a lot of that gets allocated to G&A and I think that's probably the one single reason that you could point to to say that why you are seeing that slightly down quarter Q2 over Q1.

Okay, great. And you would expect that historical trend to continue into fiscal '12 and beyond?

That is correct. It is really just kind of the mechanics, Greg, of kind of some of the timing of our grants and there tends to be a bit more activity within that first fiscal quarter and that leads to more expense in that quarter.

Okay, thank you.

Rob Ammann, RK Capital.

Thank you. I was very surprised to see the strength of the CSG margin as high as it was. Is that a margin level that either is sustainable or that you could grow from off this 19% plus level?

I think it is a little seasonal. Certainly we are in our -- first and second quarters would be what I think will be our hot seasons as we produce for Gesture recognition. I think in the third and fourth quarter, we might have a tickdown as our volume for that product goes into hibernation waiting for the next toy cycle. So it had a very good run-up and there were two or three other features besides Gesture recognition. We had -- the telecom business was very, very good and our other Marlow businesses were good. On top of that, our WBG business was very good.

So we should have WBG continuing forward for the full four quarters at their run rate. Our other Marlow businesses should be pretty much on track. Gesture recognition will be soft in the second half, so I could see the CSG margin in the second being lighter than the first.

Okay, thank you. And you mentioned that you are booked through January at this point. Can you give us some sort of comparable in terms of maybe in prior quarters at this time how far booked out you were versus the amount of turns needed in the quarter?

This is not complete data, but it is an example. When we enter a quarter, at Photop, we might be 100% booked as we look into the quarter for the first month, 80% for the second and 60% for the third. When that second and third month fills up and sometimes it has not filled up in the past. The 80% on the second month might grow to 85% and it never fills up, but we get hit hard in the third month or fall short or like this month or this quarter where we really overdid it in terms of getting to 110% in the December month of the second quarter.

So it is a visibility issue and we are not able to get our customers to tell us when they will place orders or if they will place orders. They will just tell us we would like to run at this rate, but don't ship us anything until we tell you. And we have not been able to get a better arrangement on this -- on some of those products. So limited visibility and I think everybody in this industry reports that. I made it in my comments that when you listen to other people who are telecom component suppliers, they will make the same comment.

But it sounds like the bookings experience though in terms of how much you're booking in the quarter sounds relatively similar to what you've seen over the last several quarters.

Well, maybe for the last four, we have been staring at the quarter 100, 80,60 booked by month and then each one for the last three quarters has had reasonably good results filling up that second and third month. But now I am just concerned and we really believe that we are not able to tell you any more than what we have told you on how that pattern behaves.

Okay, thank you. I appreciate it.

Thank you. I am showing no further questions or comments at this time. I would like to turn the call over to management for any closing remarks.

Thank you, Tyrone. If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the quarter ending March 31, 2011 is currently scheduled for Tuesday, April 26, 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. This concludes the program. You may now disconnect. Have a wonderful day.