Novanta Inc (NOVT) 2005 Q2 法說會逐字稿

Welcome to the second quarter 2005 GSI Earnings Conference Call. [OPERATOR INSTRUCTIONS]. As a reminder, today’s conference is being recorded for replay purposes. I would like to turn the conference over to your host for today’s presentation, Mr. Ray Ruddy, Director of Investor Relations. Please proceed sir.

Thank you, operator. Good morning and thank you for attending our second quarter conference call. This call is being broadcast live over the Internet and listen only mode at www.gsig.com. Chuck Winston, CEO and Tom Swain, CFO join us this morning.

Before proceeding, I must mention that certain remarks made during this conference call may constitute forward-looking statements. These statements are based on Management’s beliefs, assumptions and current information and, as such, are subject to risks and uncertainties in changes. Our Safe Harbor statement can be found on any of our financial press releases available also on our website and applies to this call as well. With that, let me turn the call over to our CEO, Chuck Winston.

The press release was on the wire last night. Today, Tom and I will provide insight into quarterly results and answer questions.

First, I will quickly review GSI for new listeners. GSI has 3 main business segments; we make a range of lasers using medical, industrial and electronic applications. We also make precision motion generating, controlling and positioning products used for high-accuracy applications to the nanometer scale. Lastly, we make laser systems for the semiconductor industry. Our 14 leading brands can be categorized into 3 major product segments by which we report – Precision Motion, Lasers, and Systems. We are pleased with the overall revenue growth book-to-bill as above 1 and the improvements in margins resulting from product mix and the absence of non-recurring charges in Q2.

Now, let us review each business segment. The Precision Motion segment consists of 5 brands of high Precision Motion control products that enable manufacturing of high precision products such as multilayer printed circuit boards and high density disk drives.

Second quarter revenue was 34.2 million, up slightly from 33.9 million in the previous quarter and we are significantly gross margins improved dramatically from 37 percent to 42 percent from first quarter to second quarter. The major improvement was due to an improved mix of higher margin products and the absence of non-recurring charges.

Formatting of high density disk drives and printed circuit board manufacturing are 2 most significant business drivers in this segment. Orders for May and June were at high levels compared to prior quarter and as high as about a year ago for both and that is a good sign. We believe that PCB manufacturers may have allowed inventories to get too low and are replenishing their pipeline.

Another reason is that GSI has established distribution in China, which is an expanding region of PCB growth. As mentioned in our earlier calls, we are also expanding our manufacturing capabilities in China.

The second driver in the Precision Motion is the production of hard disk drives where we have a dominant position in the formatting of high density disks. There has been a significant increase in hard disk manufacturing. IDC reports growths at 40 percent going forward through 2009. One major customer told us recently at SEMICON West they are expecting the next wave will be in cell phones and digital cameras.

Another major customer saw heavy growth when they want to contract to manufacture hard drives for Apple Computer.

Other market drivers in Precision Motion are semiconductor wire bonding, which has picked up, measurement, and medical devices. All showed improvement.

GSI’s Laser segment enables high quality repeatable cutting, welding and drilling applications. This includes applications such as “parts marking.” Quarterly sales were up 11 percent from 10.3 million to 11.4 million from stronger demand for high-end lasers, especially in the Asia-Pacific’s region. Gross margins improved from 25 percent to 36 percent, both from volume and again the absence of non-recurring charges cited in first quarter.

Our third segment, Laser Systems, supplies leading edge capital equipment to the semiconductor industry, which has been in a downturn. While we would not attempt to predict the bottom of the semi capital equipment cycle, we feel that it appears to be at or near the low point right now. We expect to remain here for another quarter and then improve gradually.

In looking at the Micro E market indicators industry book-to-bill ratio has risen from 0.71 to 0.93 during the last 4 months. Also, at the end of March analysts reported excess semiconductor inventories were largely worked off although capacity utilization remained at approximately 84 percent.

Our Systems Business is driven by sales in 3 to 5 product lines. In order of increasing market size at this time these are wafer trim, wafer marking and wafer repair. Overall, the segment improved 1.7 million quarter-to-quarter due to increased sales in the wafer repair product line used for memory production.

Looking at wafer trim laser systems used to tune mixed signal devices, we have a dominant market share and analysts are projecting some order activity for late this year for delivery beginning next year.

Our second major product line, wafer marking systems, is used to scribe tracking codes on wafers for identification. This segment is driven by continued transition to 300 mm wafers. We have a dominant position here as well. The second quarter experienced a decreased demand from Q1 levels because utilization rates remained at about 84 percent. However, industry analysts are forecasting growth in wafer starts in Q3 based on normal, seasonal and cyclical drivers.

We have received multiple fields in the past few weeks requiring quick delivery to meet increasing expected demand.

Our third and largest product line, wafer repair, is used to enhance the production yield of both flash and DRAM memories. We are currently qualified at customers who represent 40 percent of the total market. We have approximately half of their business. Currently, we are in qualification processees at 4 major memory producers representing the bulk of the remaining 60 percent of the market, which we do not serve today.

We feel GSI has the potential to significantly grow market share during this slow period. At one of the new prospects we are in trial and on target. In 3 others evaluations begin this month. For wafer repair, overall visibility is improving for the end of the year. Chipmakers are forecasting a 10 percent increase in capacity utilization. Elpida, for example, recently publicly announced that they would be increasing investments in memory chip production.

At this time, the third quarter appears light due to both cyclical and seasonal affects though we believe Q4 will be strong. We are seeing some pull-ins for Q3; however, order activity, as measured by RFQs, is up sharply for Q4 and we have had no pushouts in this quarter.

For guidance for the entire company, we expect revenue for the third quarter to be down between 2 and 5 percent mainly due to a combined seasonal and cyclical slowness in the systems business segment. Gross margins could be lower by 1 to 3 percent due to combined volume and product mix. We anticipate EPS to be in the range of $0.01 to $0.03.

Looking forward to the fourth quarter, based on the higher quote activity that I just mentioned in our systems business at this time, we believe Q4 revenues and profits will be above the Q3 levels and in the vicinity of second quarter.

There are a few additional matters that deserve comment. Gross margins increased six points from Q1 driven by a mix of things. Systems had an inventory warranty adjustment that brought gross margins down last quarter. This did not repeat. Precision motion had a favorable product mix increase and lower fixed manufacturing costs.

Lasers also had a more favorable volume and a product mix increase, aided by a favorable currency exchange and again, there were no non-recurring charges as there were in the first quarter.

We expect gross margins to be lower by one to three points in Q3 due to combined mix shift and a slight decline in revenue in Q3 on the systems side. The bulk of our 8 million use in cash and corresponding increase of 8 days in day sales outstanding came from an increase, first in accounts receivable, $8 million is due to timing issues, primarily from major semiconductor accounts. Demo inventory in the systems group were higher to support new account penetration. We expect improvement in VSOs in the next few quarters. Also cash should increase in Q3 as we close in the sale of a Michigan facility for $6.5 million.

We expect tax rates to be within the normalized range of 38 to 39 percent for the year.

And now to Ray Ruddy for final comments.

I just want to remind the listeners that we will be holding our annual Analyst Day at the Crowne Plaza in Times Square, New York on September 22nd. Anyone that is interested, please register on our web site at www.gsig.com.

With that I'd like to open the call up to questions and answers.

[OPERATOR INSTRUCTIONS] We would like to take our first question from Jed Dorsheimer with Adams Harkness.

Couple questions, first when we look at the laser business we certainly saw a nice increase in gross margins. I was wondering, Tom, if you could maybe give a little color on how much of, if any, was that a result of the foreign exchange? Looking at this business going forward, is this a sustainable level from a margin perspective?

Jed I think probably, that one of the larger parts of the Laser business is from the UK to the US, so there was some benefit in this last quarter. And as the pound drops it could be favorable in the long-term. It wasn't a large part of the increase in margins, but the biggest effect was that we got rid of the special charges that we incurred in the first quarter. That was the greatest contributed improvement. Going forward we would expect the margins probably to be just a little bit lower than they were this quarter, primarily because of the mixed fluctuations.

Right, maybe moving on to the Systems business. Chuck, it seems a little odd that we have seen the increase and then a little tick down next quarter, but seems that things are getting positive in Q4. I was wondering is the right way to look at this, do you have a couple Systems orders that were pulled into this quarter that is creating the somewhat "lumpy" outlook here.

I don't know that we would call it a pull-in Jed but when you are dealing with orders that are over a million dollars per unit, one or two of them falling into one quarter or another, can balance out a quarter or make a quarter lower or higher. So there is a little "lumpiness" in there, but the second part is that there is some seasonality involved where Q3 is typically not as strong as Q2 and then Q4 comes back again. We are seeing that again this year with the RFQ activity that we have in our hand right now.

And 1 of your competitors recently talked about capacity utilization in the memory repair market that was greater than 80 percent that was necessitating capacity expansion. I was wondering if you could give any commentary on what any of your customers, since many are the same, are telling you, about capacity utilization in the DRAM market and is this what is driving your increased outlook for Q4 or is it more of the number of new fabs that are coming online.

There is a combination. We are seeing some RFQs that are just involved in capacity in existing places where we are selling. And as I mentioned we are also looking at the penetration into some new accounts where we haven't been before and we expect to start seeing some business coming in from there. As we get qualified, our qualification tests, where we are involved right now, have been going very well.

What has kept you out of the 60 percent? Are there IP issues associated with that or how come you have not penetrated? Why are you all of a sudden starting to penetrate this market?

That is a good question and what has happened, when we entered the memory business a few years ago, back in 2002 we had to get qualified. We picked the biggest places and the ones that were most receptive, such as Samsung, PDAC, Powerchip, and we only had so much human resource to put into a test and some tests can go anywhere from 3 months to 6 or 7 months before you get qualified and start receiving orders. And then by the time we did get qualified at these 3 or 4 major houses, that we have been serving, the up-kick started in 2003 and continued through into middle 2004. And in that up-tick people were buying and getting equipment, as quickly as they put it online. They did not have the time at the other locations to support testing. The testing does take place on the factory floor. The last thing they wanted to do was in a severe crunch to get chips out the door, was to test the second source. When things slow down, both the potential customer, as well as ourselves have the resources to put in place, so we waited and we are taking advantage of the down cycle, to do that the whole case - if you have a box of lemons, you can make lemon-aid out of it.

Great, thank you for the added color. Last question, Tom, just moving to taxes, is the 38 to 39 coming in a little bit higher that what you expected, because it is a little bit higher than what we expected, what is the reasoning for that?

Our tax rate is a blend of worldwide and what we are seeing is that there is more taxable income in the US jurisdiction and that has pushed the rate up towards the higher end.

Okay, so as you look at the possibility of a recovering Systems business would that have a positive impact to your taxes?

Generally they should stay in the 38 to 39 percent range. It is possible they could go down a little bit. That is pretty much well in deed.

We will take our next question from Theodore O’Neill, with Wells Fargo Securities.

Theodore O’Neill: Guidance is great for the industry at large. My question, Chuck, has to do with the qualification for the memory repair. I was wondering if you could give us qualitative or quantitative description for some the milestones and some of the timing of the qualifications.

Theodore, you are breaking up, can you repeat the question.

Theodore O’Neill: I was wondering if you could tell us about the 3 sites that are being qualified for memory repair, could you give us some qualitative or quantitative information of the milestones or timing for those.

Sure. In one we probably have about 5 or 6 weeks behind us now and on weekly reports it has been going very well. We have not seen any major issues, you always run into some minor, little things, but in general very well there. The other two we are just getting in. We just shipped the equipment, got it installed in the beginning of July and so they are just cranking up the test. We don't expect any problems there either. In every one of these cases we have run decks of wafers at our own factory before they approved us to put a machine on the floor.

Theodore O’Neill: Okay.

We expect by the end of the third quarter, beginning of the fourth quarter to have approvals.

We will take our next question from Jim Ricchiuti with Needham & Co.

Chuck, just wanted to go a little deeper into the -- what you see in the precision/component business. Looks like you had the highest gross margins in about 5 quarters. Could you expand a little bit about where that improvement is coming from, and also just a follow-up question on bookings.

In precision components, Jim, first of all, as I mentioned, and Tom mentioned, we have gotten the one time non-recurring charges due to layoffs of personnel and some other inventory adjustment issues behind us.

If you look sequentially with that, is that the biggest part of the improvement?

Yes that would be most of it. Actually the mix part of it came into play primarily looking at our components business exclusive of Westwind.

In addition, I mentioned several quarterly calls that we had some quality problems that were in our scanner product line. They are now behind us; so rework charges are down and we should see improvements remaining in place on that line and then as Tom pointed out, Westwind is the other area we are working on and that will be benefiting margins as we turn on production in our China facility.

Chuck it looks like as you are going through some of the problems with the scanner product line that you may have lost some share. Do you feel you are regaining some share there as you work through that?

Well we know we have gained back some business at 1 or 2 of the accounts, the larger accounts and we are working diligently on several others so right now things look positive, but again, in this business, at the component level customers want to make sure, like [inaudible] from Missouri, they will take small quantities and test them quarter-by-quarter and when you don’t have any failures, which is the case right now, we are doing very well with small quantities and then they will gradually crank it up. I think it will take several quarters to regain some of the revenue side, but eventually we will get there. In the meantime we are doing good profitability at the lower levels.

Okay, can you characterize the bookings into 3 groups if they were up sequentially in all3 or if you could just give us a little bit more color on the bookings versus Q1?

Well in general the bookings were up, going into Q3 for both the components, the precision motion, and the lasers. The systems business, as I mentioned is lower and that is why we are seeing some softness for Q3, but again the RFQ activity going on right now in the systems business for Q4 is up sharply.

Okay, and as you talk about gross margins in the September quarter, Tom, did you say down a couple of hundred bases, I was not sure I caught the guidance here, could you just repeat that?

Yes we think they will be down 1-3 points and the dry run is primarily going to be mixed.

Okay, even with the strength or the, I do not know if you would want to characterize it as a mixed shift, possibly toward components?

It is hard to say that because it can vary from quarter to quarter, but it should stay within a certain range.

We will take our next question from Susan Streeter with Sprott Securities.

I am just wanting a couple of questions in terms of the Westwind; the China facility that you spoke about, I think you said that expect some volume out of that facility in the fourth quarter?

That is correct. We start production there around the September/October time frame.

What type of volumes would you expect to see in terms of, can you characterize that at all, how the relative size of that facility to some of your other existing ones?

At this point we would rather not try to put numbers on it.

Okay.

Suffice it to say it will be an improvement.

Okay. The other question I had related to the Wafer Trim business, I think you said that you were seeing some signs of light there, I think you probably dropped off in the last few quarters, are you expecting it to pick up in the fourth quarter or is that more into ’06?

Well we are looking more to ’06. We expect to see some order activity taking place in the backend of this year and really toward the very end of Q4 for deliveries that could be taking place sometime in ’06.

Are those the type of volume orders that you would have experienced a year or 18 months ago in that business?

I don’t think they will be at that level early on, I think as we get further into 2006 we should start to see pickups. I think it is going to be relatively quiet through the end of this year and into the beginning of next year and if anything towards the middle or end of next year we should see some nice pickups there.

Okay, thanks. Just the last question I had is sort of a housekeeping question, I’m wondering what, in terms of the recognition of stock-based compensation, what your plans are with respect to expensing options and that kind of thing and what the impact would be?

Yes, we are still analyzing this, Susan, we don’t see any significant impact at this point but there are obviously options and a lot of complicated calculations that have to be made but we don’t have any impact computing at this time.

Okay we will take our next question from Duncan Stewart with Orion Securities.

I am now in the sell side now as a Research Analyst and not just a Fund Manager anymore, not that there is anything wrong with being a Fund Manager. Precision Motion Control as you are moving to China, just sort of some stuff we have been noticing of they are probably more focused on the Westwind than the PCB side. Are you seeing any delta in the last quarter or two on either ASPs or margins? It seems like anecdotally there is some pricing pressure out there.

We have not seen any, to be honest with you in the PCB area for our products, but there may be at the Systems level, I know that is a very competitive area, but at the Component level we haven’t seen anything.

As you move to China though, is it possible that maybe he will be leading some pricing pressure there?

We do not expect that, to be honest with you, because of the way the product is being priced we believe that the pricing area’s piece should stay relatively where they are and the real benefit is, of course, the reduced manufacturing cost we expand our margins, which is our whole idea behind this.

You commented in the press release that cash burn was due from AR but also some demo inventory, would that demo inventory primarily be the [inaudible] you guys are going through at those 3 sites on the memory repair?

Yes it is, primarily at those sites plus we have several other sites where we have some equipment on demonstration right now, smaller houses, but yes that is where the bulk of it is.

We will take our next question from David Hodgson with Genuity Capital Markets.

Thanks, good morning, this is Richard for David. I had a few questions for Chuck this morning. The first one is what was the contribution from Westwind and Micro E in the quarter in terms of revenues and sequential growth witnessed and what is the expected growth in the second half of the year for these units?

We, unfortunately Richard, we never break those out because then we get there in the product line reporting so what we have done is go to the 3 segments 2 years ago and that is as fine as we can cut it for you.

Okay, the second question is can you outline which of the 4 core segments being the semi electronics, light industrial and medical, is showing the most strength and is there anything that remains very weak?

I would say both industrial and electronics are showing good strength. Medical has been a steady performer for us, the weakest one has been semi and that is what we are looking for, some pickup later in the year and going on into next year. As I mentioned the DRAM business is an opportunity for us to pickup some additional business form new accounts as well as some improvement in overall semi convector CapEx for memory. Wafer marking, same thing, as the Wafer starts improve and the specialization goes up, then the weakest part, as I mentioned was the Wafer trim for mixing all devices is still quite quiet and that as been a big producer for us from the end of 2003 into the middle of 2004 but that is a very cyclical business.

Third questions is, based on the third quarter that has begun, do you expect to see a book-to-bill in excess of one for the third quarter?

Well, we are hopeful it will be based on the RFQs coming in.

Okay, and I guess based on the first month of the third quarter, is that well above 1?

You know I don’t have that in my hand at this point since we are just in the first month so I don’t look at that on a daily basis.

Okay, just one last question, are you comfortable with the current inventory level or do you expect this to decline in Q3?

We have had some build up in Westwind for the move to China and then we expect also to be burning down some of the other inventory so there will be some slight declines going into the next 2 quarters.

We will take our next question from Brian Piccioni with BMO Nesbitt Burns.

I would like to go back to the question of gross margins, I know you had the question earlier, but I guess I would like to ask it from a slightly different perspective. We tried to estimate what the operating gross option would have been last quarter, and you still seem to have had a sharp improvement there in a number of the categories. Can you talk towards what operating changes led to the improved gross margins by category?

Well probably the most significant impact is we had about 2-3 points as cost-reduction in terms of thing that did not repeat from last quarter and just stabilization of our manufacturing overhead cost levels and also the service overhead costs. About another 3 points of the 4 points was really an improvement intermixed, which is attributed to a little better margin and a little better selling price and there is also some material costs reductions but I think the larger dry run is just better price yields.

Okay and on the cost-reduction, which presumably is different from the materials costs, is that related to better utilization or is that outsourcing or which?

It is primarily we had reduction in course and it was just tuning the overhead costs to our manufacturing levels.

Okay, it is interesting to note that the blended gross margin of 41.4 percent is not that far away from the peak that the company has had up to the combination of the 2 firms. I don’t think it has been much over 42 percent in all of the quarters since General Scanning and Lumonics joined forces. Do you see that as a natural limit based on customer feedback or do you have greater objectives use of the gross margin?

We still believe we can do better but again, part of that is tied to volumes we have always modeled ourselves financially that if we can start doing better than about $80-$85 million per quarter we can push past the 42 percent and get up to the 45 percent level.

Okay, so 45 percent you would view as running in all cylinders type gross margin, right?

Once we got beyond about $320 million annualized run-rate on revenues, I believe that is fair, and if we can push beyond those rates I think we can do a little bit better. The hardest part is getting those revenues back because we are in a cyclical business and that requires us to grow the non-cyclical parts, through both some organic growth, as well as acquisitions we did. And we have not done an acquisition in about 12 months because of a number of reasons.

Okay, and 1 final question of course, you have maintained some pretty strong control over operating expenses. In particular, there has been not a great deal of variability in R&D over the past few quarters. Now, usually selling at min there is some level of variability relative to the sales level. To what extent is selling at a min variable compared to the sales level?

There is some variation, but frankly, it is not very much. And that reflects basically on the sales efforts when we go in to a down term, particularly in the semiconductor segment, probably has the most direct sales force, and the highest selling expense and we maintain that investment of down turn as we work on penetrating new accounts. So, we actually stay fairly consistent.

We will take our next question from Todd Coupland, with CIBC World Markets.

A few questions. First of all, on the semiconductor Systems business, can you size for us the pipeline opportunity in the DRAM memory?

No I cannot.

Okay. And these market share gains that you are speaking about. Do you think you get a one quarter bump or is this something that plays out over a few quarters?

I think it will play out over several quarters.

Okay, and if you think about 2006 and this Systems business, would you expect it to follow normal seasonal patterns so even though you get some share gains, the business rolls a bit in the first quarter and picks up again in the second quarter?

Yes, I think at this point that is a fair way to look at it.

Okay, one last question on this semi business. In these RFQ's where you are looking to take share and you are, in the context of talking about the gross margins in the coming back 2 or 3 points over the next couple of quarters. Have you baked into those assumptions more aggressive systems pricing in order to get that share? Could you talk a little bit about the pricing environment?

Well, it is competitive, obviously, and there are only 2 competitors, and there are limits as to how far the aggressiveness can get, but yes, it is pretty aggressive.

Okay. And then finally, on the printed circuit board business, you talked about the inventory replenishment. Is that all that is going on or do you think the business is starting to pick up, because we have seen from some of the board manufacturers, in North America any way, some pretty choppy results. Just talk a little more about that please.

We are seeing enough demand to believe that there is more than just type-line replenishment going on, because we have been able to calculate approximately how much that should have been and we were seeing better than that, so we believe there is some increased production going on. We are seeing more of that in China and Taiwan, than we are in North America.

And it is primarily on the handset side and the camera side?

Yes, the mobile devices in general.

Yes, okay.

Including iPods.

Yes, great. And last --

We will take our next question from Daniel Kim with Paradigm Capital.

Given the fairly light macro outlook we are seeing from several players, we are wondering if you can give us a better sense of what you are seeing going into Q4 given your limited visibility. I guess what I am asking is to what degree of confidence do you have that your semiconductor market will start to show some strength going into Q4, and how sustainable do you think that is?

As I mentioned in my prepared remarks, we are seeing a higher level of RFQs and these are focused on Q4, not the current quarter, Q3. So, that gives us confidence. Now, the question always remains, will you convert? I mean, if you are rewarded the RFQ, will you actually see a hard PO? That remains to be seen, but the confidence level has been good, because the customers we have been dealing with are repeat customers for the most part, and they have always kept their side of it, which is, when you give them the quote, we do get the order.

Okay. With regards to, obviously given, your quarterly run rates change dramatically over the past couple of quarters, can you give us a sense where you would see your target operating model, perhaps not this year, but exiting next year, if you hazard to guess, in regards to operating expenses and gross margins as a percentage of revenues.

That is kind of a tricky question because as I mentioned before, when answering another question, a lot of this depends on volume and if the volumes are favorable and we can come back to the 80 to 90 million run rate next year on a quarterly basis, we certainly will be in the 42 to 44 percent range on gross margins, based on the way we have the company tuned with our outsourcing and cost reductions we have put in place and favorable product mix, so a lot of it is dependent on the revenue. A lot of that depends of course, on market conditions.

Okay, I guess I will ask you another way then. Let's assume, worst case scenario, there is no a tremendously strong recovery going into ‘06. I presume that you guys are continuing to have limited cost reductions, as far as head count and what not, could we expect a continued improvement in operating costs if, even if revenues were to remain, more or less at these levels going forward.

If we remain at these levels we have been at for the first half of the year, I think that operating in the 40 to 42 percent gross margin range is fair. We are not going to see any more reductions in head count that we can see. We are fairly, tightly tuned. But as I mentioned, improving cost of material reductions, reduction in China taking up in the fourth quarter this year. All these things will add 100 to 200 basis points to the margins.

Okay, and just finally, given the announcement, wondering if you can give us any idea with regards to finding a new CFO.

Well Tom and I are here, and we are starting a formal search and we are trying to do an orderly transition and we have asked Tom to remain for a couple of years, which he is going to do in the system's transition. We are just starting a formal search right now. We expect it will take a quarter or two to find the right person.

We will take a follow-up from Jim Ricchiuti.

Yes, thank you. Chuck, could you comment on the acquisition activity. How actively are you out there looking? You talked about that you have not made an acquisition in about one year, due to some factors. Could you elaborate on that?

Good question Jim. Part of it is, that we are looking for a very select types of companies, certain technologies that will be very complimentary, so there are not a lot of places in the world to find them and there are only a limited number and some of them are not for sale. Some that might be for sale, we have been talking to. Prices have gotten fairly elevated toward the end of last year. That is why we backed off from doing several possible transactions. We are actively out there looking and we believe that the slower market conditions may help us. We certainly do not want to overpay and again we are looking for cash transactions that will be accretive.

The answer to your question is, we have not done one because we have not found a suitable fit in terms of price and type of quality of company that we are looking for, as far as technologies. In addition, we have been quite busy with the integrating both Westwind and Micro E acquisitions. We have merged Micro E now, it is integrated into our former components business, which had the printers and scanners, and the earlier DRC encoder. That is now integrated together under one management team. We were doing a lot of internal improvements. Those are showing up now in better margins.

Okay. If you look at acquisitions, is it safe to assume that the activity will probably be in the component area versus [inaudible] area?

Our main focus is in the component and laser side of the business. We definitely have some technology needs that we recognize that will be beneficial to the company. Synergies, both the technologies working together to develop new products, as well as Synergy in the market place.

Just one final question, follow-up to some comments you had made about Micro E. In the past, Micro E, you guys have talked about the new customers in Micro E being designed in, where do you stand with some of that activity? You had a fair amount of activity going within Micro E and I wondered about some of these new applications and new customers and how you might see that rolling out over '06.

Well, we are starting to see some of that now. In our most recent quarter, we did see some business from some of the newer customers and some repeat customers with new designs. That is an improvement and that is what we are looking forward to in the future, to improve our margins as some more business coming out from some of those design wins that never made it into production yet.

But you potentially could see some of these going into production in late '05 or early '06?

We are hoping by the end of this year, but certainly by early next year.

Due to time constraints, we do have time for two more questions. We will take our next question from Deepak Chopra with National Bank Financial.

Could you talk about a little bit about inventory levels. They seem awfully high to me, we are here at 150 days, what is the target on DIOs and what is the inventory comprised of?

Well the inventory we are up for two primary drivers on it. Other than just trying to go through the process of adjusting inventory levels as revenues decline, it takes a couple of quarters to smooth it out. There is some intentional increase in the case of Westwind because of transferring production to China. So we have had some build up, up there. And also in the Systems group we have several systems out in the qualification process. So those are intentional increases. We obviously did not want inventories at the level they are at now. We do expect that to go down slightly over the next couple of quarters, as opposed to increase.

Could you quantify the intentional increase and how much they represent under the current inventory?

It is probably in the range of about one and a half to three million.

What would be the target day of these sales, what is your typical target on DIOs?

For DIOs, as low as possible at 83 we are not where we want to be obviously. There is a mix, depending on how much systems mix we have, which tend to be higher. We obviously want to push it down ideally in the 60s and below.

Fair enough. Previously you were never willing to guide us on, since I have been covering the stock, it has been quite some time, you are always hesitant, given lead times are always so low, and now you are starting to give us some guidance for Q4, which are comparable to Q2, in terms of top line. Is it just the lead times that has given you more confidence to give that out or what is the change of attitude in terms of giving guidance at this point?

Just asking if things are materially better, in terms of lead times giving you that confidence.

We are feeling we have a better handle on the situation than we did before and we went through some pretty rocky times through the last 3 years and right now we think we are seeing a little more stability and the ability to look into the next quarter. Our relationships with customers are forming very well. We feel better about giving some range of guidance.

We will take our final question from J.D. Abouchar with Pacific Edge Investments.

Just remind me again on the 4 systems, the DRAM systems that are in test. How do you account for those now and then what happens if they approve them late Q3-Q4?

Right now they are sitting in inventory, if that is the question, I’m not sure. They are sitting in inventory, which is why inventory is up. They will convert to sales hopefully sometime by the end of the year beginning of next year. Some of these tests go on for quite a while, so far the ones – the one that started in June is doing well. We have two others who we just installed the equipment earlier this month so that is going to take a couple more months before we actually get tests results that are consistent and would lead to conclusion to the tests.

Great and ballpark ASPs on equipment is?

They are typically around the $1 million.

Okay great. Switching up to the components business, can you broadly break it out between PC board and hard drives for the revenues?

We really do not want to do that because then we get down, as I mentioned earlier, to product line reporting and with all the products we have got going on we would be reporting on 14 things instead of 3.

Maybe within the hard drive sector, are you selling to the Seagate’s of the world or can you give us any sort of -- more color on the customers there?

Yes, we are supplying basically a component that is used in the formatting on the high-density disk drives, in other words, we are supplying everybody that makes them from Seagate to Western Digital and [Maxtor] and [Hemstar], everybody that is involved in that that is doing the formatting is using our component from MicroE to do that formatting. It is also being used, the more exciting part is they’re being used in the mini-drives which we hope will take off into cell phones and other portable devices.

Is there a difference in those components that you sell, whether based on 1-inch drive or 2 ½ -inch drive or the density of the media?

Well density is what is more important when you are running around 300,000 lines per inch, that is the more important issue. The size of the media platter is not that important.

Okay. There is an upgrade cycle going on where they are going perpendicular media from the longitudinal, is that what you are seeing driving this or is it more just number of disks being consumed?

No, it is just basically the quantities of disks are more important than the change in density, the change in density. It does not matter whether it is perpendicular or not.

This does conclude today’s conference call. We thank you for your participation. You may disconnect at this time.