II-VI Inc (IIVI) 2013 Q1 法說會逐字稿

Good day, ladies and gentleman, and welcome to the II-VI Incorporated fiscal year 2013 first quarter 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, this program is being recorded. I would now like to introduce your host for today's program, Mr. Craig Creaturo, CFO and Treasurer. Please go ahead, sir.

Thank you, Jonathan, and good morning, everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI Incorporated. Thank you for participating in the first quarter fiscal year 2013, II-VI Incorporated investor teleconference.

As a reminder, this teleconference is being recorded on Tuesday, October 23, 2012. 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 President and CEO of II-VI Incorporated.

My prepared remarks today will discuss operational results for each of our businesses. During the just completed quarter, we experienced softness in most of the markets we serve, and we are responding to orders for shorter time durations than normal. While our first fiscal quarter is normally one of our lighter bookings quarters of the year, the quarter we just completed was even lighter than we had projected. Resulting impact on our backlog drove the reductions to our outlook for the fiscal year.

In spite of these market conditions, our businesses did have some bright spots that I will highlight in these comments. During the first quarter, our infrared optics segment, which includes HIGHYAG, had bookings of $47.5 million, which is down 7% compared to the first quarter of fiscal year '12. Primarily due to reductions in new laser builds, especially in Japan. We did not see reductions in bookings from the after-market, especially in North America, which indicates steady laser utilization. However, military spending is down in the US, due to the proposed sequestration and budget cuts and the uncertainty related to the upcoming election.

For our Infrared Optics business, excluding HIGHYAG in the US, orders from domestic OEMs decreased 15% quarter-over-quarter. This was a result of timing of blanket orders from high powered OEMs. Despite the orders decrease, shipments to the high powers OEMs increased 17% quarter-over-quarter. Bookings from low power OEMs were flat quarter-over-quarter and shipments declined 32%. The low power market is expected to be weak into the third quarter due to inventory adjustments and global economic conditions.

European bookings for the first quarter were down 14% compared to the fourth quarter due to a delay in receiving a large diamond order that will be received in the second quarter. In addition to the typical seasonal effect of the summer holiday period in Europe, we are now hearing that several high powered OEMs are experiencing a softening in orders attributed to the unfavorable economic conditions resulting in a decrease in their current production rates.

Asian bookings were up 5% quarter-over-quarter; however, we continue to experience much lower demand from Japan with high powered OEM bookings dropping to a yearly low in September. Total Japan bookings in the first quarter were down 6% quarter-over-quarter and 33% year-over-year. The stagnant Japanese economy, in conjunction with the stronger Yen, has created a challenging environment. This trend is expected to continue for at least the next few quarters.

China bookings increased 8% quarter-over-quarter while the Chinese economy continues to grow at a slower pace. We have seen increased activity in the via hole drilling market and variable radius mirrors. In addition, we have seen favorable results in the after-market, due to our increased efforts to service this growing segment.

At HIGHYAG, bookings for the first quarter were up 7% quarter-over-quarter and revenues exceeded $8 million in the first quarter, which established a record for the quarter. We have increased capacity and streamed lined key processes to enable volume production. We continue to see growth opportunities in all addressable markets, including 1 Micron welding, beam delivery systems, laser light cables and 1 Micron laser cutting heads, mostly driven by the auto industry. In summary, our IR Optics business segment, including HIGHYAG, continues to see bookings pressure driven by the worldwide economic uncertainty.

During the first quarter at our Near-Infrared Optics segment, which now excludes our VLOC business, bookings compared to the same quarter last year were up 10% to $35.1 million, while segment revenues were up 31% to $40.6 million. The booking increase was mainly attributable to increased demand for Photop-related green laser devices and Aegis-related optical channel monitors. The revenue increase was driven by improvements across most of the Photop and Aegis product lines.

Compared to the fourth quarter FY '12, bookings were down sequentially by 21%. This was the result of order timing in three areas. Green laser devices, medical optics and certain China and North American telecom orders. Revenues were up 2% from the fourth quarter of FY '12, marking the fifth consecutive quarter of revenue growth for the new IR segment.

Now, at Photop, revenues grew 3% from the fourth quarter of FY '12 despite the continued broader market softening in the Optical Component business for telecommunications. The revenue increase was run by shipment of green laser devices, display products in our Contract Manufacturing business and optics for industrial and medical applications.

During the first quarter, the telecom component business experienced a slowdown in legacy products and 40G components due to the government delay of broadband network deployment in China and softening of orders in North America. This partially offset by increased demand for high end components in Asia and Europe for 4GLTE and 100G networks.

Photop continues to invest in R&D for high end components and module products for customers in their next generation high speed network requirements. Also during the first quarter, Photop continued the integration with Aegis Lightwave, with the pursuit of joint R&D programs, which will allow us to optimize our global resources and better service our customers, further manufacturing consolidation and joint sales and marketing efforts that should result in greater sales to the China market.

The Photop laser business shipments surged again in the first quarter due to the volume delivery of green laser diode devices for several key contract wins. These contract wins covered various applications in the biomedical law enforcement and government contracting areas. We expect to see continued growth in this area over the next couple of quarters.

The Photop Optics business also continued growth in the first quarter, which was up 8% sequentially from the fourth quarter of FY '12. Photop continues to see key design wins in areas such as optical instrumentation and industrial optics as a result of investing in new product initiatives and new capabilities such as opto-mechanical assemblies. We anticipate moderate growth in the optics product line in the near term.

Overall, for the second quarter of FY '13, we expect Photop revenues will be flat as compared to the first quarter given the overall market dynamics and product mix. Photop will continue to put new resources on new product developments such as laser modules, optical mechanical assemblies and 100G components.

At Aegis, the first quarter revenues were down 6% related to the fourth quarter of FY '12, were up 13% over the same quarter one year ago. Aegis has seen some reduced demand within its core optical communications markets as a result of the broader market softening, but continues to see strong growth in its industrial market segments that are addressing the high powered fibrolaser markets.

To meet customer demand, Aegis is expanding its manufacturing capacity at Photop for optical channel monitors for the ROADM market and high power fiber laser combiners for the industrial fiber laser market. Aegis also continues to invest in research and development of next generation products including high performance flexible bandwidth, optical channel monitors for transmission networks with high rates of 100 gigabyte per second, 400 gigabyte per second and beyond.

Similarly, AOFR is expanding its portfolio of high power fiber laser combiners for use in fiber laser applications. Based on recent work with customers in Asia, North America and Europe, we expect to gain design wins in market share from our line of fiber laser combiner products. We believe these products will be synergistic with a broader fiber laser optics portfolio that the near-IR team is developing. In the first quarter, we achieved optical channel monitor and fiber laser combiner wins with major customers in North America.

For the first quarter, our Military and Materials business segment, which now includes our VLOC business, bookings of $17.7 million were off 33%, as compared to a year ago, and sequentially lower by 17%. The drivers for these reductions were the timing of orders related to Military business, lack of market demand for selenium products and the delay of our new rare earth metal production line start-up. Revenue for the first quarter of $23.9 million decreased 11% from the fourth quarter of FY '12. This reduction is attributable to both the Military business and the Materials business.

Our Military business is comprised of exotic of electro-optics, VLOC, which was recently transferred from the near-IR segment and Max Leavy Autograph. The primary driver of the lower order rate on the quarter as compared to a year ago is attributable to a follow-on order for the current generation of UV filter assemblies, which is used in the missile warning system on helicopters. We now expect this follow-on order in the second quarter. Generally, we continue to see softness in our military business attributable to federal budget uncertainty and threat of sequestration, and the political climate gyrations.

While we have some insulation from the overall US defense budget, since our products are primarily used in ISR defense applications, which continue to receive favorable funding, we are experiencing longer contract negotiations, slower order awards and increased competition. The bottom line is our current market environment is challenging, and we remain focused on improving productivity, cost control and winning market share and introducing new products.

During the past quarter, we have had several significant design wins. These include opto-mechanical assemblies; an intricate prism assembly for a multi-spectral targeting system for manned and unmanned platforms; small diameter optical components for [paleer] applications; next generation laser slab assemblies and optical components for foreign military customers. And additionally, we have seen orders for continued R&D funding for our Sapphire product line, orders for certain legacy programs and strong orders for our Heritage products at MLA.

Now our materials business, which is our PRM [Snd rig] experienced lower tellurium product demand in the photovoltaic market this quarter. However, this was more than offset by increased demand in the thermal electric cooling market in China, which helped to stabilize the tellurium index price after 12 months of erosion.

Selenium product demand was slightly lower than expected due to lower usage in agriculture feed applications. Our new rare earth production line failed to come online as soon as expected during the quarter due to technical challenges related to the manufacturing process. Bookings for the quarter were lower due primarily to the rare earth metal production start-up delays, which prevented booking additional contract commitments based on our 12-month booking policy.

Selenium product demand was off, but this was offset by improved tellurium product demand. Revenue and profits were significantly off for the quarter due to the high cost of inventory, aggressive pricing on tellurium products and the delay in our rare earth production. The selenium index price was volatile during the quarter dropping 9% from $43 a pound to $39 per pound, and then rebounding to $43 per pound towards the end of the quarter. The tellurium index price was stable at $110 per pound for the majority of the quarter.

The changes in pricing, combined with the timing of supply deliveries, resulted in an inventory adjustment of $500,000 for the quarter, which negatively impacted earnings. The lower demand for tellurium products in the photovoltaic market, along with significant inventory and the overall supply chain has led to very aggressive product pricing for high purity tellurium metal. Premiums over the index price for our high purity tellurium metal product have declined as competition has increased. These lower premiums, coupled with high inventory costs, resulted in the significant loss for the quarter.

Since the end of the quarter, the tellurium index price has increased to $120 per KG. Although there are several factors that may impact this index price, we general feel an index price of $110 to $150 per KG will be the range for the next couple of quarters. Given the start-up challenges in our rare earth product line, we are revising in our fiscal year '13 annual revenue projection for this product to $5 million to $7 million for the year, down from the $8 million to $10 million annual rate in our previous projections. Over the past 30 days, we have begun to ship product and we believe the production volume will begin to ramp during this quarter through the end of the fiscal year.

In our advanced product group, Marlow Industries bookings for the first quarter were down 39% year-over-year primarily due to reductions in the gesture recognition market. Overall, bookings for the quarter were flat when compared to the fourth quarter of fiscal year '12 with the reductions in defense offsetting the increases in gesture recognition. Revenues for the first quarter were down 44% year-over-year. Again, primarily due to reductions in the gesture recognition market. Revenues decreased 1% in the first quarter over the fourth quarter of FY '12.

We have continued to develop our personal comfort market entry with a shipment of prototype product to two large customers. Our recently introduced Climatherm product line continues to sell well in Europe and we have achieved multiple design wins this quarter.

In the second quarter, we are introducing a third product line that is directed at the lower end -- lower power end of the industrial market. We continue to see an increase in activity and interest in our EverGen energy harvesting solutions introduced earlier in the calendar year.

We are harvesting energy from temperature differences that exist in a variety of different environments like air, liquid, steam, gas, et cetera, to pile our wireless sensors and actuators. Lastly, we continue to line our costs with our revenues to mitigate market uncertainties and to focus our efforts towards the most promising markets to better position Marlow Industries for increased future growth and efficiency in an increasingly competitive market.

The Wide Bandgap group year-over-year first quarter product bookings were up 78%. However, quarter-over-quarter bookings were down 50% largely as a result of timing of a large blanket order in the previous quarter. Quarter-over-quarter, total bookings were also down substantially due to the receipt of a large DOD contract in the previous quarter. Total revenues for the first quarter were down 7% compared to the previous quarter, down 6% year-over-year. The first quarter shipments of 100-millimeter diameter semi-insulating substrates for RF applications were down 18% from the prior quarter and were flat year-over-year.

Customer demand for product deliveries and the completion of qualification programs of their devices on our substrates for both the wireless infrastructure market and the defense sector continues to slow. We foresee slower demand in the second quarter and third quarter followed by increases in shipments late in fiscal year '13.

During the second quarter, at the 2012 European conference on silicon carbide and related materials, which was held September 2 in St. Petersburg, Russia. WBG was the first silicon carbide vendor in the world to introduce N-Type 150-millimeter substrates for the power device market, and was the first silicon carbide vendor in the world to announce 150-millimeter semi-insulating substrates for the gallium Nitride RF and power markets. We have begun low volume shipments of 150-millimeter N-Type silicon carbide substrates to a number of major OEMs, and expect to begin low volume shipments of 150-millimeter semi-insulating substrates through several major OEMs in January of 2013.

Growth in the power device market continues to be driven by high voltage diodes for power factor correction in industrial motor drives, and the promise of more energy efficient products and solutions. According to recent industry reports, silicon carbide power electronics are projected to take a 10% to 20% share of the $15 billion market over the next decade, which is currently dominated by lower cost silicon-based devices. Rapid advance and early introduction of 150-millimeter diameter substrates will enable device manufacturers to lower their device cost and enable them to manufacture using existing 150-millimeter diameter silicon and galium arsenide device processing lines, in effect, expanding the potential market share for silicon carbide devices and accelerating the transition.

In September, we celebrated the grand opening of our new 10,000-square foot facility in Starkville, Mississippi. The new facility is fully operational and will support the expansion of capacity for wafer finishing, cleaning, and packaging.

As noted in today's earnings release, we are pleased to announce the appointment of Dr. Giovanni Barbarossa as the Company's first Chief Technology Officer. Giovanni comes to II-VI with significant experience, and will assist all of our businesses in their research and development efforts.

So in summary, despite market challenges and a world fraught with economic and political uncertainties, we are committed to identifying opportunities to capitalize on our competencies. We are committed to make investments in organic growth, as evidenced by our development work in free standing diamond, which is facing an expanding opportunity in the EUV lithography systems. We also are opportunistically exploring acquisitions to enable the Company to benefit from near-term demand when worldwide economic conditions stabilize.

Craig, this concludes my prepared remarks.

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 we announced on October 3, 2012, effective for the beginning of fiscal year 2013, the Company's VLOC business unit is now included in the military and materials segment for reporting purposes. This business is currently 100% dedicated to military-related products, and is now being managed by the leadership of our military and materials segment. Prior to July 1, 2012, the VLOC was included in the Company's Near-Infrared Optics reporting segment. All current and prior year information presented in our earnings release has been adjusted to reflect this change.

As described in today's press release, consolidated bookings for the quarter ended September 30, 2012, were $114.4 million, 12% lower than the same quarter last fiscal year. Total company backlog at September 30, 2012 was $161 million, which was down 10% or $18 million from the June 30, 2012 backlog level. The components of the backlog at September 30, 2012 were Infrared Optics at $44.5 million, Near Infrared Optics at $36 million, Military and Materials at $58.5 million and Advanced Products Group at $22 million.

During the just completed quarter, we saw signs of stability in the index pricing for both tellurium and selenium. In addition, we have taken measures to reduce our inventories of these raw materials. As of September 30, 2012, the index price was $110 per kilogram for tellurium and $43 per pound for selenium.

During the current quarter, the Company recorded a lower across the market adjustment of $0.5 million or $0.01 per share loss. Profitability was negatively impacted during the quarter from a strategic initiative to penetrate new markets for our tellurium material using aggressive sale prices. As we disclosed in today's press release, during the quarter, the Company repurchased $5.9 million of its common stock as part of the $25 million board authorized repurchase program announced in May 2012. The number of shares repurchased during the September quarter was over 317,000. To date, the Company has repurchased approximately 619,000 shares for a total amount of $10.9 million. It is the intent of the Company to continue with the board approved repurchases for the remainder of the fiscal year 2013, in accordance with a 10B518 rules.

We have not forecasted further decreases in our share count beyond the actual purchases made to date and the outlook that was provided in today's press release. We plan to continue to report the actual repurchase activity as part of our future quarterly earnings releases.

During the quarter ended September 30, 2012, we did not receive further contractual or insurance proceeds from the flooding that impacted the facilities of the Aegis' contract manufacture in Thailand in October 2011. As we passed the one-year anniversary of the flooding event, we continue to work diligently to fully recover funds that are contractually due to Aegis and AOFR, the Australian subsidiary of Aegis. Our outlook for the quarter ending December 31, 2012 and for the fiscal year ending June 30, 2013 excludes the potential recoveries of contractual and insurance proceeds because the exact timing and amount of recoveries have not been determined.

During the quarter, there were a few items that impacted other income line items on the income statement in a positive manner for a total of $800,000. These components included equity earnings from our minority investment in China based Fuxin of $400,000, interest income of $300,000 and miscellaneous other income items totaling $300,000. These positive items were partially offset by foreign exchange losses of $200,000, due to the strengthening of the euro against the US dollar.

The effective income tax rate for the quarter was 24.2%. During the quarter, there were no material changes to our tax reserves. We expect the income tax rate for fiscal year 2013 to range between 22% and 24%, which is unchanged from the original guidance for this fiscal year.

During the quarter, we generated $23 million in cash from operations, a 62% increase from the September 30, 2011 quarter. We also borrowed $5 million on a credit facility to help fund the share repurchases and to assist with working capital needs. During the quarter, we used $6 million of our cash for capital spending and $6 million for the share repurchase program. During the quarter, our cash balance increased by $18 million and now stands at $158 million, while our current debt balance is $18 million. The interest rate on our borrowings at September 30, 2012 is approximately 1%.

Fran, this concludes my prepared remarks. Before we begin the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements, which are based on current expectations; actual results could differ materially. For information about factors that could cause the actual results to differ materially, refer to the risk factor section of our form 10-K for the fiscal year ended June 30, 2012.

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

Certainly.

(Operator Instructions)

Our first question comes from the line of Jim Ricchiuti from Needham & Company. Your question, please?

On the comment that you made about the after-market business in North America and IR optics. Can you characterize that business? It sounds like it was relatively stable in the quarter, so it doesn't sound like you saw much in the way of weakness there, certainly, versus the OEM business?

Exactly right, Jim. We have found that steady and the order intake we get in that after-market business is such a good indicator of how lasers are being utilized throughout the US. And it was steady, which is a nice surprise, let's say because with all other factors being a little bit dormant like this, you might think it would be not that good.

Interesting. Now, how does that compare with, I would assume there was a different scenario in Europe and what are you seeing in Asia?

Yes, Europe is a little slower. I think I made that comment a little slower. Asia holds in there pretty well except for Japan, which has been slow for what, three to four quarters. So, relative quarter-over-quarter, about the same for Japan. But the one that picks up slowly, I think, would be going more rapidly is China. It's going well because they have deployed so many lasers, so for us, we are picking up more and more business. I think it's picking up business that was -- lasers that were put out there two and three years ago, and now that people are buying the optics as opposed to having them come from their OEMs.

Okay, then just a follow-up. Are there trends that you are seeing in that portion of the business? It's early in the quarter, but what can you say about what you are seeing thus far in Q2?

I think we are about on with what we just guided toward. I think it will be an interesting quarter. It will be up and down, volatile. And our weeks, a good week and a bad week, and a good week. That's been what we've been having here the last two, three months, and I think it is going to be that way for awhile.

Okay, thanks. I will jump back in the queue.

Thank you. Our next question comes from the line of Avinash Kant from D.A. Davidson & Company. Your question, please?

Good morning, Craig. First question in terms of the guidance that you have given for Q2, could you give us some idea how do you see the different business segments doing, like which one is going to be up and which one is going to be down?

Yes, I would say, Avinash, we are looking at a quarter that overall, is shaping up to be very similar to the quarter we just completed. I would say when you look at the kind of the outlook that we have, we do see some puts and takes. I think during Fran's comments, we talked about the continued strength that we are seeing in our telecom businesses, but we do expect that to be relatively flat. We do expect some little bit further strengthening of our other businesses, for instance, HIGHYAG, we also have looked at all of the other different businesses, as well. And I think we are looking at a quarter that, again, is shaping up to be pretty similar and maybe even pretty similar business by business from the quarter we just completed.

We can go a little further, which we really don't always go this far, but we might have a little bit of improvement in military and materials. The rockiness on the price on selenium and tellurium might have bottomed out, or we were having that feeling, so that might take away that $500,000 hit we took this quarter. We might not have that next quarter. And our advanced product group, I would like to think we can do some better there because we really have cut our costs, and we usually don't go into a big discussion about where we are cutting costs. A lot of people line up for a big cost program. We try to do it constantly among all of our 11 businesses so we stay in tune, so we don't have too much cost compared to our revenue, and we have now had to make another couple adjustments in our advanced product group, in both our Marlow and our AP and our WBG group. So I think we will do a little better there.

Okay, and if you could comment a little bit about the JSF program. Of course, what are you seeing this point and what kind of gross should we expect on a year-over-year basis?

I think, Avinash, we are seeing continued demand there. We continue to be a good provider of the Sapphire panels that we are providing to our customer. That demand, as has been well documented, is over the last couple of years, has been slower demand, but it is a demand where we are continuing to be the sole provider on that program for the time being. I would say that our feedback from our performance from the customer is very, very strong and our team at EEO is doing an excellent job of delivering very high tolerance panels for a very critical military component. So, I think we are doing very well there. Continuing to ramp that program up. Although, be it at slower levels than what were expected, you know, say one or two or three years ago.

And finally --

And to add to what Craig has to say, so we are close to the running rate that we are going to plateau at for maybe a couple of years. The dilemma on what's going to end up being funded after this election and the next big budgeting round. So I think we can say FY '13, FY '14, into early FY '15, we are pretty set, and we are close to that rate. After that, it's not able to -- we cannot project what will happen, but it's not likely it will change. If it does, it won't be upward.

And final question, just checking, I think Fran was saying that you expect Photop business to be up 3%, that was on a revenue basis sequentially?

I think we said it -- we'll go back and check that comment. I think it was that they did grow 3% in Q1 FY '13 versus Q4 of FY '12, was the comment.

Okay, and what do you expect it to do in the next quarter? Kind of stay at these levels?

I think I had a comment in there that in the second quarter, expect revenues will be flat as compared to the first quarter. And probably the areas that look better because of the combination of Photop with Aegis, our optical channel monitors, which we're producing more of at Photop than the combiners. I think those might be products that might pick up a little bit. We -- it's hard to predict the -- our opto -- our passive optical business out of China. We have had a nice run here for the last 90 days or so, whether that will continue, that's -- it might continue, it might fall a hair. That's the part, because if it would continue, I think we would do a little bit better at Photop.

Perfect. Thank you so much.

Thank you. Our next question comes from the line of Jiwon Lee from Sidoti & Company. Your question, please?

Good morning.

Good morning.

Just wanted to circle back on your fiscal '13 outlook. Obviously, it implies a fairly substantial rebound in the second half and just wanted to know how do we get there?

Yes, I think we do have, again, some views of where the strengthening of our business will be. A couple that we touched on, a couple of brighter spots relative to new products including, for instance, our rare earth material that we mentioned, that will be kicking in the latter half of the year. Continued demand from diamond optics and I think overall, just a continued strength primarily from our industrial business is where we are expecting that to be stronger in the second half. I think we also have a viewpoint past the second quarter, that we should be able to see some further growth from our Photop and Aegis businesses, as well. So I think that the areas where you are going to see that strength is primarily in the industrial facing businesses and maybe to a lesser extent, within Photop and Aegis.

Staying on the diamond optics, just wanted to get your thoughts, early thoughts, on how your diamond window business with Cymer in light of their acquisition may change positively and negatively over the same.

I think that whole business opportunity is very good for us. We have been really closely aligned with Cymer, and their whole supply chain, which gets all the way to ASML and Zeiss and others in the chain. So we are well-aligned, and this buy is probably good because the money to do all this, it's pretty expensive. We have been at it for a number of years but we see a very, very good opportunity. We are producing three and four inch diameter diamond optics, so these are very, very large, and the prices are very, very high. So the amount of money that's being invested to maybe put out a half a dozen of these systems in the next 12 months or 12 of them, a lot of money.

This helps the whole establishment get funded because everybody at times, are funding themselves, and we have been funding ourselves for many times. So I think it's going to help. I'm not sure it changes how that money flows down to us in this part of the food chain right away, but we do have good, steady orders and we have got a lot of work to do to perfect our product a little bit more. I think everybody in the food chain does because the wafers per hour that can be produced right now are just not where it needs to be. So very, very good opportunity though, so I think we feel optimistic because of that investment.

Terrific. And Fran, just staying on the IR optic side, the order decline that you saw, when you continued to see into this quarter, how does that feel to you? Does that feel like your key customers are just temporarily tightening their pulse? Or does that feel like everybody is trying to adjust to sustain lower demand?

I think it's a -- just volatility. Because we are so -- the CO2 lasers that are out there doing work, they are so tuned into the worldwide economy. If the economy is down, there is less utilization, if it's up -- we are so closely aligned to consumer spending also that it's hard to predict. We have to say it's volatile. Does it feel right? I'm afraid it feels the way it is with the economy. It feels that way. We don't have an idea that there is anything substantially going wrong. It's just people don't have the demand for the goods that they run the lasers for.

That's what in kind of the OEMs are saying when they are turning down their assembly line. They are producing less or that's what they're telling us, they are going to be producing less, so as opposed to 5,000 units a year, they may be turning them down to 4,000. I don't have that exact number, but we will by the next meeting, how things are being turned down. The main assembly line is turning down, that's probably 5%, 10% of our optics demand. The other 90% is from this after-market laser utilization, and if people are starting to see their capacity as more than adequate, they are going to stop buying new machines and we are seeing the tip of that.

Okay, great. Very good. On the margin front, two questions, I noticed your SG&A has spiked a little bit during the quarter. I wonder why that is? And on the second question on the margin, despite the revenue pressure, your margin, although at a smaller base, has been picking up. How should we view that product margin moving forward throughout the fiscal 2013?

Yes, I would say, Jiwon, we had some SG&A items, more I think from the G&A perspective. It was just slightly up from where we were running in the June quarter. We did about $25 million of SG&A in that quarter, did $26.6 in the September quarter, the quarter we just completed. I would say there were a few items in there from a general administrative standpoint. We have been active in several different areas. We have been continuing for acquisition-type activities, and spending dollars on those fronts. And I would say that there is nothing too unusual about that.

Again, I think pretty much a consistent level there; down a little bit -- the revenue is down a little bit. Kind of highlighted it as a percentage of sales going up, but still right around that 20% -- 18%, 19%, 20% usually, you will see that's where that SG&A level is. We were right at the top end of that level, right around 20% or so. For the gross margin, we did see an improvement overall in gross margin. Part of that is due to a lighter load, if you would, of the lower cost of market adjustment we had at PRM. We were at 37% this quarter. We do feel like that's probably about where we will be ranging for the year. Maybe a little bit higher than that, I think, if we go back to our original guidance for the fiscal year, we said that we would be more so and in the range of 38%, 39%. So somewhere in that 30%, kind of 37% to 38% to 39% range, I think, is where we will be for the fiscal year.

Okay.

Only thing I would add to what Craig is -- yes, we had to take the M&A expenses and SG&A, and this PRM write-offs, but we had another charge we might want to mention. Craig, we took a provision, on news that came to us in the last couple of days. One of our accounts that is going to go, probably out of business, and we had quite a receivable from, so we had to take a provision on that. Could you talk about that?

Yes, we did. Really toward the -- right at the end of the reporting process here. We did feel it prudent to make a reserve for one of our customers for our sil-carbide WBG business. This company, as it was I believe, publicly announced yesterday by another public company, and they will be ceasing or winding down operations. The company is SemiSouth, and we thought it prudent to take some reserves and that also impacted the SG&A for the quarter, as well.

Okay, thanks for the color. Lastly for me, as much as you can, could you try to give us a sense for this opportunity tied to the rare earth business once it starts moving?

Would you repeat the question, please?

The market opportunity or your revenue opportunities tied to these rare earth.

Yes, okay, yes, and I do think I put them in our comments that we have to reduce our -- we were expecting $8 million to $10 million of revenue in this fiscal year and we had to reduce that $5 million to $7 million just because we are now 3.5 months into the year. I do think second half of the year will be shipping on that much better. We had some learning curve problems that we are starting to get behind us, but -- we can make the product, and we can do it at a very high purities, which is what we have been working hard to do. And now we have cleared the hurdle that we can meet specification now to ramp it to the volume that we need to ship by month -- for the next six months, and that will be our challenge here in the next couple of months. I think it's a good platform for us, and the opportunity is very good, and can we parlay that into another rare earth product in a few years? Maybe. That is the reason why we are wanting to understand how to produce these products, and we are gaining on the understanding.

Very good. Thank you very much.

You're welcome.

Our next question comes from the line from Mark Douglass from Longbow Research. Your question, please?

Hi, good morning, gentlemen.

Hi, Mark.

Can you talk to the IR optics margins? Is it being impacted just from, let's say, pricing out there is it a more difficult price environment, or actually is it because of the diamond windows on the investments you are having to make in diamond windows? Is that dragging it down temporarily until you get those processes figured out? Can you discuss that a little bit?

Yes, I can start it and I maybe let Fran add to it, Mark. I think you have a couple of factors in there, you touched on one, and that is diamond optics and us spending dollars on our own and working on that and ramping that product line up. I think the other thing you are starting to see in our infrared optics business is these higher cost selenium starting to roll through the products that we make. We obviously make quite a number of transmissive optics, mostly made out of zinc selenide that we grow here in Saxonburg, and the selenium cost inside that zinc selenide has increased quite a bit. And that's been a phenomenon that we can see the increase in pricing of that material over the last couple of years, now starting to see it flow through in a heavier way in our production cost. I think that's the other component that we have in there, as well, and I will let Fran add to that comment, as well.

Just because how we report it in segment reporting, in infrared optics, we include in the IR optic segment our HIGHYAG subsidiary, or joint venture, and that has a lower margin than IR. So if we progress this year, HIGHYAG has had nice growth and it's been just at a little bit lower margin so it does have a weighted effect, and I think maybe overall IR might be down a percent gross margin from where we would like to be. Something like that.

Okay, thank you.

Thank you. Our next question is a follow-up question from the line of Jim Ricchiuti from Needham & Company. Your question, please?

You touched on the strength that you are seeing at Aegis from the fiber laser combiners, and then I thought you made a comment. I just wanted to pursue that a little bit, about how this is complementary with some efforts that you have to overall broaden the fiber laser offering, the component offering. Can you elaborate little bit more on that?

We are -- around the fiber laser area, just because our CO2 business is straight in the middle of laser processing and our HIGHYAG business is taking a output of a fiber laser and directing it to do work. And the people who are building fiber lasers are the ones who are coming to us to build these combiners. We are building combiners for people's fiber laser, and we look at it and say, well, is there other things around the fiber laser that we can do? We are working hard on 1 Micron focusing optics with multi-spectral zinc sulfide as a material to do that job maybe better and more cost effective, if you look at how easy it is to make optics with multi-spectral.

So we are looking at all ends of a fiber laser, 1 Micron beam delivery, 1 Micron -- other products that around the 1 Micron that are needed, and I think there are some. That's where we were trying to be creative. We understand many of these high power issues on C02 on 10.6-Micron, so we are trying to take our knowledge and apply it to 1 Micron. We are just starting on that, but I think we are coming.

Got it. And then this may be a tougher question, just in terms of your overall full year guidance. Is there anyway you can give us what you are assuming in terms of your overall military business this year? And does that take into account the potential for the sequestration that we are all hearing so much about?

I think our -- just to step back into your question just a second here, Jim. FY '12, about 18% of our total business was really defined as military, and I think, as you know, that really cuts across all of our segments. All of our segments have some component, for the most part, of military. Definitely most centric in our third reportable segment, our military and materials segment. We do have some opportunities for some slight growth in that business. They are definitely looking at programs where we have good orders in hand. We continue to still have good visibility for our military product lines, overall.

But I think to your point, we have not painted a very doomsday type of an outlook if there is a significant sequestration reduction or something like that. I think we based it based on where we feel our customers are at. Again, as Fran mentioned in his comments, kind of a more deliberate order pattern, a little bit more of a deliberate demand that we are seeing from -- demand process that we are seeing from those customers. We have taken that into consideration, but we haven't taken into consideration that there is going to be some sudden reduction in a particular product line or a particular program that we are on. We are fortunate we were diversified on a lot of different programs, covering air and ground and other platforms, so we have tried to take that into consideration the best we can. But again, I think we have committed that this will be a tough business for the foreseeable future to grow, but we do have some things that will help foster that growth a little bit in FY '13. Again, it won't be one of our higher growth areas --

So Craig, just putting that issue aside, the sequestration, it sounds like you still -- you can -- based on what you are seeing, you see, not to put words in your mouth, modest growth in military this year?

I think that's pretty good. The one part, and I made it in my comments, that there were a lot of our products are directed into what are called ISR, which are this intelligence surveillance and reconnaissance, and that's the part that you see the defense willing to still spend money. So maybe some major programs that are a big plane or something like that might get turned back or slowed down. But the ISR programs seemed to be on track because that's where we need these type of systems with all the terrorist activity. And we have been positioned for a good amount of the ISR stuff and we think we are well positioned going forward.

That's why I said we are a little insulated. What's happened to us is we are down in the food chain, and the prime suppliers, they have been stalling and delaying in the placement of their orders to us. And that's been going on now for maybe six months to a year at different times, so we are prepared for this turn it on, turn it off delay. We have been experiencing it, so I don't think it is going to change FY '13 compared to FY '12 for military. We are going to have it.

Got it. And Fran, you mentioned the strength you are seeing in HIGHYAG coming, in part, from good strength in automotive. Is that sustainable in your view?

Yes, well, it's such a world -- what, 80 million cars built right now, and only 14 million in America. So a lot of the work that we have done has made a lot of progress. A lot of welding heads in America, maybe 25% of our HIGHYAG business is welding heads here in America, and some other countries that do not use as much laser processing in cars. We think we will get into it. Whether that is a year down the road, or two or three. A lot of laser cutting, also. You can't predict how different cars will be laser processed, and we have gone through it, two or three iterations of a lot of laser processing over the last 20 years. Right now, it's really headed toward 1 Micron, as far as we can see.

Okay, thank you.

Thank you. This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Management for any further remarks.

If there are no more questions, I would like to thank everyone for participating today. Our next earning release for the quarter in fiscal year -- in the quarter ending December 31, 2012, is currently scheduled for Tuesday, January 22, 2013, before the market opens with a conference call to follow that same day at 9.00 AM eastern time. Thank you for participating in today's conference call.

Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.