Novanta Inc (NOVT) 2012 Q3 法說會逐字稿

Welcome to the GSI Group 2012 earnings conference call. At this time, all participants are in a listen-only mode. (Operator Instructions.) Please be advised that this conference is being recorded today, November 7, 2012.

I would now like to hand the conference over to your speaker today, Mr. Tim Spinella. Thank you. Please go ahead.

Thank you very much. Good morning and welcome to GSI Group's third quarter 2012 earnings conference call. With me on the call are John Roush, Chief Executive Officer of GSI Group, and Robert Buckley, Chief Financial Officer.

If you've not received a copy of our earnings press release, you may get one from the Investors section of our website at www.gsig.com. Please note this call is being webcast live and will be archived on our website.

Before we begin, we need to remind everyone of the Safe Harbor for forward-looking statements that we've outlined in our earnings press release issued earlier this morning, and also those in our SEC filings. We may make some comments today, both in our prepared remarks and in our responses to questions, that may include forward-looking statements. These involve inherent assumptions with known and unknown risks and other factors that could cause our future results to differ materially from our current expectations. Any forward-looking statements made today represent our views only as of today. We disclaim any obligation to update forward-looking statements in the future, even if our estimates change. So you should not rely on any of today's forward-looking statements as representing our views as of any date after today.

During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of the non-GAAP financial measures we plan to use during this call to the most directly comparable GAAP measures is available as an attachment to our earnings press release. To the extent that we use non-GAAP financial measures during this call that are not reconciled to GAAP in the earnings press release, we will provide reconciliations promptly on the Investor Relations section of our website at www.gsig.com.

I am now pleased to introduce the Chief Executive Officer of GSI Group, John Roush.

Thank you, Tim. Good morning. Welcome, everybody, and thank you for joining our call here today in the wake of the election and the ongoing effects of Hurricane Sandy. To those of you who may have been facing challenging circumstances after the storm, our thoughts and concerns are definitely with you.

So in the third quarter, GSI achieved a solid level of performance in a continued weak market for capital equipment, particularly in the microelectronic segments. Despite these conditions, we're pleased that we were able to report financial results that were within our previously provided guidance ranges. Revenue was $70 million versus the guidance range of $68 million to $73 million. Adjusted EBITDA was just under $11 million, or 16% of sales, versus the guidance range of $10 million to $13 million.

As I've said in recent quarters, the Company continued to execute well on our aggressive agenda of change and transformation despite the weak market. As an example of this, on October 29, we closed the sale of our laser systems business to Han's Laser for $7 million. In the transaction, we retained the Orlando, Florida, real estate of the business, which has an estimated market value of $6 million, and we do intend to sell that real estate in a separate transaction in the near future. So overall, we're satisfied with the economics here, given that this business was not contributing much at the EBITDA line.

Regarding our semiconductor systems divestiture process, that's still ongoing, and we don't have an update at this time, as we're in confidential discussions with the counterparties.

Despite the overall weak market conditions, we did see strength in specific areas of the Company during Q3. As has been the case throughout this year, our fiber laser growth platform saw strong demand. Sales in the quarter were nearly four times the level of a year ago. Customer demand remains strong, and our primary challenge in fiber lasers is managing the pace of our investment in this business, as we're seeing an ongoing need to increase expenses in technical, sales and marketing, and production areas several quarters ahead of demand. We did see this impact in our lower margins in the laser business, which Robert will cover in his section.

Our scanning solutions growth platform also saw robust growth in the quarter, with sales increasing 23% year over year as more of the initial launch customers for our scan heads transitioned to ongoing production volumes in materials processing and converting applications.

We also saw solid growth in a number of other business lines. Our Synrad CO2 laser business saw 7% year-over-year growth, driven primarily by an improved order rate from marketing customers in Europe. Our MicroE optical encoder business grew 5% year over year, driven in large part by a significant order from the disk drive track writing market. Our photo research color measurement business grew 22% versus last year, with stronger orders from the LCD flat panel market.

Unfortunately, the market remains challenging for us in a number of areas. Our Westwind Spindles business, which almost exclusively serves the printed circuit board equipment industry, saw sales decline by almost $5 million year over year in the quarter. That market has been significantly depressed now for five quarters, with no clear recovery in sight.

We have taken significant costs out of that business. Production is now predominantly in our China site, and the operating expenses have been reduced to the bare minimum in what is actually a highly technical product technology that is machined and balanced to a very tight tolerance. While we do not yet see the signs of a recovery in the spindles business, we are confident that when it occurs, we will see extremely favorable profitability in the Westwind business.

The other area of significant challenge for us was the scientific laser business. As we discussed on the last conference call, this market has been impacted by funding delays on direct government and government-related programs around the world. The issues first started impacting us in the spring, mainly in Europe, but they have spread to other regions.

We did see a slight recovering in the order rates at the very end of Q2, but that recovery, unfortunately, did not sustain itself into Q3. Our scientific sales in the third quarter decreased 20% from year-ago levels, with a book-to-bill ratio of only 0.6. This market is also not showing signs of recovery at this time, so customers generally communicate to us that programs are being delayed rather than canceled.

These two areas -- spindles and scientific lasers -- accounted for more than three-quarters of the year-over-year impact on our revenue line.

In terms of our overall order rate for the Company, we had a book-to-bill ratio of 0.93 in the quarter. This obviously reflects the soft market conditions that we are seeing, but it also reflects the fact that we had much higher orders in book to bill early in 2012, as customers at this time were anticipating a market recovery in the back half of the year. When the recovery did not occur, customers brought their order backlogs down to lower levels. On a year-to-date basis through the third quarter, we have a cumulative book-to-bill ratio of 1.02.

In general, the majority of our customer base is operating on a planning and order cycle of one quarter or less. It varies a bit by end market, but at this point we have at most a quarter of order visibility into our demand. And with the current order rates where they are, we do not yet see a sign or a catalyst for a broader market recovery.

In addition to the previously mentioned growth platforms, we did continue to make progress on our medical component strategy. As I discussed on the last call, we worked with an outside consulting firm to map out the medical and life sciences component space. Though this whole market area today accounts for less than 20% of our revenue, we actually have five different technologies that in turn sell into over 20 distinct application areas within the medical device industry.

So working with these consultants, we've mapped out a number of attractive adjacencies that leverage our technical and application capabilities as well as our OEM customer relationships and channels to market. From this analysis, we've developed a nice pipeline of attractive acquisition candidates. We're working actively on a number of these possible transactions, many of which significantly leverage our channels to the market. These deals are at varying phases of maturity, so it's not clear how soon any of them might close, but we are encouraged by the opportunities, and this remains an area of significant focus for us.

So during the quarter, we continued to make progress on our 12 X 12 restructuring program and other cost reduction initiatives. During Q3, we substantially completed the consolidation of our European sales and applications facilities. We began the initial employee moves of our Lexington facility into our Bedford headquarters. We remain on track to complete all of the 12 X 12 site consolidation moves as scheduled.

As I mentioned, we also completed a significant restructuring within the Westwind Spindles organization that will save between $1 million and $2 million on an annualized basis, and we should see initial savings from that effort in Q4.

We've also continued to make progress in our efforts to upgrade the talent across the organization. As we have previously announced, Matthijs Glastra joined in October as Group President of Laser Products and will serve as a corporate officer. He had a tremendous run within the Philips organization, serving as President or GM of a number of different businesses, including CEO of Entertainment Lighting, COO of the Lumileds LED business, and GM of Philips' LCD Backlighting and Philips Semiconductors.

Though he's only been onboard for a few weeks, Matthijs is already making a significant impact on our laser business in terms of the strategic roadmap and the execution of the business. And in addition, we've had a number of other key additions to our team that expand our capabilities going forward.

So there's one other point I wanted to make before I turn things over to Robert for some more detail on the financial results, and that relates to stock buybacks. We have had considerable discussion on this topic internally and with our Board. We've also gotten a question from some of our shareholders. In the midst of a cyclical downturn in our markets, with our stock's current valuation, we certainly do view a buyback as being financially attractive.

The challenge for us at this very moment is that we're in fairly advanced negotiations on several acquisitions that will play a key role in our strategy. A buyback at this very point in time would make it more challenging for us to be a strong buyer for these assets. However, to the extent that these particular deals end up not moving forward, we will look very closely at a buyback, as it is certainly an attractive alternative at these valuation levels.

So with that, I'll now turn it over to Robert to provide some more detail on the financials. Robert?

Thank you, John, and good morning, everyone. I'll now provide additional details on our third quarter 2012 results.

During the third quarter of 2012, GSI generated revenue of $69.5 million, a decrease of 11.7% from $78.7 million in the third quarter of 2011. The impact of foreign exchange represented approximately 2 percentage points of the 11.7% decrease in revenue in the third quarter of 2012 compared to the third quarter of 2011. Included in the revenue for the third quarter of 2011 was $1.3 million of net revenue that had been deferred under multiple element arrangements delivered over multiple periods and entered into prior to the adoption of ASU 2009-13.

Turning to our segments, sales of the laser products segment for the third quarter of 2012 decreased 4.8% to $28.3 million compared to $29.8 million one year ago. This was primarily due to a decline in sales in our specialty lasers sold into the scientific markets. This product line was negatively impacted by the continued economic challenges and as a consequence of rationalizing certain products with lower profit margins.

This decrease was partially offset by significant increases in our fiber laser products, which more than quadrupled in sales since last year's comparable period, following the launch of our kilowatt-class product offerings earlier this year and an increase in sales volume of our industrial field CO2 lasers as a result of a temporary uptick in demand in the China manufacturing sector.

Sales of our precision motion and technology segment for the third quarter of 2012 decreased $7.8 million, or 15.8%, to $41.2 million. The decline in sales was primarily due to a significant decline in demand in the microelectronics market, principally related to mechanical drilling of printed circuit boards. The decline in demand in the mechanical drilling market resulted in a roughly $5 million decline in sales in our Westwind Spindles product line as compared to the prior year. In addition, we also experienced some pressure in our galvanometer products as a consequence of the downturn in the microelectronics market.

Finally, in the third quarter of 2011, the Company recognized $1.2 million of net revenue with no comparable amount in 2012 for orders that had been deferred prior to the adoption of ASU 2009-13.

Turning to profitability, third quarter gross profit was $28.9 million, or 41.5% gross margin, compared to a gross profit of $34.6 million, or a 43.5% gross margin, during the same period last year. The decline in gross margins was driven by our laser products segment. Laser products' third quarter gross profit was $9.5 million, reflecting a 33.5% gross margin compared to $11.7 million, or 39.4% gross margin, in the same period of last year. The 5.9 percentage point decline in gross margin was primarily attributed to a significant ramp-up in manufacturing costs for our fiber laser product line to meet demand expectations for this business over the next 12 months and the mix impact of selling more fiber lasers, which have gross margins significantly below our Company average.

In addition, we also experienced some pressure on our gross margins as a consequence of revenue recognized in Europe for a high-energy specialty laser product project within the scientific market.

Precision motion and technology's third quarter gross profit was $19.7 million, reflecting a 47.7% gross margin, compared to $23.4 million, or a 47.8% gross margin, for the same period last year. The reduction in gross profit dollars was primarily driven by the drop in sales from our Westwind Spindle product line due to a significant drop in demand in the microelectronics markets. Gross profit margins remained flat year over year.

Operating expenses amounted to $22.3 million for the third quarter of 2012, excluding $2.7 million of restructuring expenses. This compares to operating expenses of $23.7 million in the third quarter of 2011 and $23.1 million in the second quarter of 2012.

Research and development expenses were $5.5 million, or 8% of sales in the quarter, compared to $6.2 million, or 8% of sales in the third quarter of 2011. The reduction in R&D spending dollars was largely attributed to savings achieved as a result of our 2011 restructuring program.

SG&A expenses for the quarter were $16.1 million, or 23.2% of sales in the third quarter, compared to $16.6 million in third quarter of 2011. The $500,000 decrease in expenses was primarily driven by the elimination of external professional services and savings achieved by the 2011 restructuring program. In addition, we achieved these savings despite significant investments made in our people and our three growth initiatives -- fiber lasers, scanning solutions, and medical products.

Adjusted EBITDA non-GAAP financial measures, which includes the adjustments noted in the non-GAAP reconciliation attached to our earnings press release, was $10.8 million in the third quarter of 2012 compared to $15.2 million in the third quarter of 2011. Included in adjusted EBITDA in the third quarter of 2011 was $600,000 of net profit recognized on the $1.3 million of net revenue deferred prior to ASU 2009-13. Adjusted EBITDA was within the guidance range we provided in the third quarter of 2012, despite the difficult economic environment, continued investments in our fiber laser product lines, and some negative impacts from foreign exchange.

The Company reported diluted earnings per share from continuing operations of $0.06 as compared to $0.22 in the third quarter of 2011. Diluted earnings per share were adversely impacted by total restructuring charges of $2.7 million related to the Company's 2011 and 2012 restructuring programs. To better understand the impact of these charges on our earnings per share, our cash tax rate for the quarter was approximately 10%. In addition, earnings per share experienced a $0.01-per-share impact from the higher GAAP effective tax rate in the third quarter of 2012 as compared to the prior year and quarter.

Finally, we experienced a $700,000 foreign exchange loss in our P&L as a consequence of the intercompany trade account balances denominated in non-functional currencies. To better understand the impact of these losses on our EPS, our cash tax rate for the quarter was approximately 10%.

The Company's reported effective tax rate on income from continuing operations was 21.5% for the third quarter of 2012. This differs from the Canadian federal statutory rate of 25%, primarily due to the income earned in jurisdictions with varying tax rates, the release of a portion of the Company's valuation allowance, and adjustments to record the estimated impact of the IRS audit on our prior year tax plans. We made considerable progress with our discussions with the IRS and expect to reach a final agreement shortly. The nature of our discussions with the IRS are confidential, and we are therefore prevented from expanding on this topic until we have reached a final agreement with the Congressional Joint Committee on Taxation.

As we've mentioned throughout the last 12 months, GSI Group has been executing on our 2011 restructuring program, focused on permanently reducing our operating costs while significantly streamlining and simplifying our organizational structure. During the third quarter, we completed the closure of our optics production facility in California, we substantially completed the consolidation of our German sales and service operations, and we began executing on the consolidation of our laser scanning product line located in Lexington, Massachusetts, into our corporate headquarters located in Bedford, Massachusetts.

On October 29 of 2012, we completed the sale of the laser systems portion of our discontinued operations to Han's Laser for cash of $7 million, subject to working capital adjustments. The laser system businesses, sold underneath the brand names Control Laser and Baublys, reported sales in the third quarter of approximately $4 million. To maximize the value of these assets, we retained the Orlando, Florida, facility, which has an estimated market value of approximately $6 million. We are currently marketing this building for sale as a separate transaction.

In addition, our efforts to sell our semiconductor systems business continue to progress, and we expect to complete the process no later than the end of the second quarter of 2013, but we are working on a shorter timeline.

Finally, in the third quarter, we initiated and executed a new 2012 restructuring program in response to the continued uncertainty and volatility in the macroeconomic environment. As part of this program, we announced the restructuring of our Westwind Spindle product line, which will significantly enhance the product line's profitability at these lower sales levels. This program is expected to achieve an additional $1 million to $2 million of annualized cost savings.

Turning to the balance sheet, as of September 28 of 2012, cash and cash equivalents was approximately $53 million, while total debt was $47.5 million, of which $32.5 million is in the form of an amortizing term loan. As of the end of October of 2012, our total debt decreased another $2.5 million to $45 million, of which $30 million is in the form of an amortizing term loan.

Operating cash flows in the third quarter of 2012 was $2.6 million. Operating cash flows include the cash flows of both continuing and discontinued operations. Operating cash flows in the third quarter of 2012 were negatively impacted by three significant factors -- a significant deterioration in the Company's sales linearity, which resulted in higher recorded sales in the final month of the quarter versus the second quarter of 2012. This was driven largely by operational challenges in our Lexington, Massachusetts, production facility, which have now been resolved.

In addition, we made approximately $2 million in cash payments during the quarter as part of the Company's restructuring plans, and we experienced $900,000 of operating cash outflows related to the losses from the discontinued operations.

Turning to the fourth quarter of 2012, we expect revenues from our continuing operations to be in the range of $65 million to $67 million. The sequential decline in revenue is largely driven by double-digit declines in our encoder product line caused by the conclusion of an upgrade program for a customer in the data storage market. To a lesser extent, we are also seeing a sequential decline in our industrial CO2 laser product line, primarily caused by the continued volatility in the China manufacturing market.

Turning to profit, we expect the fourth quarter of 2012 adjusted EBITDA to be in the range of $9 million to $10 million. Gross margins will be roughly flat sequentially. We expect that operating expenses will see a slight decrease from the third quarter of 2012 due to the benefit of the restructuring programs, depreciation and amortization in line with our third quarter, and a GAAP tax rate of approximately 15% on a continuing operations basis.

However, it should be noted that a final agreement with the Congressional Joint Committee on Taxation could cause our tax rate to be materially different than forecast. The state of the current discussions with the IRS make it difficult to forecast our GAAP rate for the fourth quarter.

We also expect fully diluted shares outstanding to be approximately 34 million and restructuring charges of approximately $1.5 million. Finally, we expect operating cash flow to return to normalized levels in the quarter.

This concludes our prepared remarks, and now I'd like to open up the call for questions.

(Operator Instructions.) Lee Jagoda, CJS Securities.

This is Michael covering for Lee. But he actually just stepped off and he's on one other call. Can you roll him back into the question queue?

Absolutely. That's perfect. Okay, let's go to the next call. The question, operator.

Jim Ricchiuti, Needham and Company.

John, I wonder if you can give us an update on some of the efforts you have underway to drive down some of the costs, manufacturing costs, in the fiber laser portion of the business, just given the growth rate of that business?

Yes, absolutely. There's a lot of work being done on the design of the product as well as the supply chain. And Matthijs Glastra just got onboard a few weeks ago and had the opportunity to go and see this. He participated in very similar types of scale-up and cost-down. He was over five years in the high-brightness LED business at Lumileds. He's seen a lot of similar kind of ramp-up cycles. So he's just taking an initial look at it.

But it's a combination, as I said, of a different design, a different base architecture to the technology, as well as supply chain initiatives that are fairly different from what we're doing today, where we're just essentially buying off-the-shelf types of products. So I don't really want to comment in more detail about that.

I do want to position this, though. The things that we're implementing in that business that will significantly bring down the costs are 12-month types of initiatives. They're not going to help us in one or two quarters. So we will get the benefit of volume as that thing ramps. There is a certain -- we're investing a little bit ahead of the revenue now, with engineers and apps people and even people out in the field. That won't continue forever, so you start to get a leverage on that.

But the product costs are the bigger deal, and our whole architecture and approach to the product cost is going to take a good 12 months to really be in place.

Okay, that's helpful. And there was a comment you made about the scan head business, the Cambridge business. I thought you said it was up approximately 23% year over year. And then I thought you mentioned something about some pressure in the galvo business. And I wasn't sure how to reconcile that.

I think Robert made a comment that there were some production issues there. It was actually, a lot of it's supply base driven. We had a couple of vendor issues that cropped up, and it was the kind of thing where we recover the revenue for the most part in the quarter, but it's back-end loaded at all, because we had a few weeks where we really couldn't produce because we couldn't get some critical components. So the production got kind of stacked up late into the quarter in that business, and then the revenue went with it.

That's a different phenomenon, because it's a larger business. Scan heads are a minority of the business, and they are what grew 23%, although they were somewhat affected by production as well.

Got it.

So obviously, the galvanometers go into the scan heads, so if you have component problems with your vendors, it affects both galvanometers and scan heads.

So your galvanometer business in general is holding up -- it sounds like it's holding up fairly well in general, demand-wise?

Well, we sell the scanning products into a number of different end markets, so the microelectronics applications of that are struggling. Industrial has got some challenges. But there are some areas doing better, and particularly the scan heads being a new product line, so it's benefiting from penetration, even if the market isn't great.

Okay, one last question and I'll jump back in the queue. The MicroE business, you benefited from, it sounds like, from a fairly decent-sized order in the disk drive market. Ex that, how was that business? Was it down? Flat?

In the quarter, it was actually up, so the data storage upgrade program with one of the large customers lasted for a couple of quarters. That's coming to conclusion, and so we're going to be under some pressure in the fourth quarter as a consequence of that. The base businesses are actually doing okay, so it's not a broad base. It really comes down to a single customer.

So in Q4, it's going to show a little year-over-year growth, but off a lower base. So sequentially, it's coming down, but it will still probably be slightly up year over year in Q4. So I think the encoder business is holding up okay. It's just kind of had a bubble cycling through it because of this one big program.

Okay, thanks a lot.

Joe Bess, Roth Capital Partners.

I was hoping -- I know you guys aren't going to give too much color on M&A right now because you're in a quiet period. But are you able to talk about the size of the deals that you're looking at?

Size-wise, obviously, given our size, that's going to put an upper limit on it. I think most things we would look at would certainly be under $100 million. There are quite a few things we're looking at that are in the $10 million range and then anywhere in between that. We're looking at it more from the strategic fit and what it does for us. But I think when stuff gets below $10 million it's not as interesting, because it tends not to move the needle, and $100 million represents what might be practical for our balance sheet at this point.

Okay, thank you.

Somewhere in between, in the midpoint of that, is probably ideal. $40 million to $50 million would be our sweet spot for a deal, but we don't always get to determine that. So I think that's the working range.

Okay. And then I appreciate the book-to-bill issue for the quarter. Could you give us a little bit more color on any strength that that number came from, or are there any large orders in particularly, in any specific business or any sort of strength or weakness that changed that number?

In general, book-to-bill, we considered it not very good. Any time we're running below 1.0, we don't like it. I think the deal really was that it was much higher; it was 1.22 in the first quarter. So it was normalizing back. But if you wanted to say where was it relatively better or worse, there's slight differences, probably. The medical printing business was quite strong in orders in the quarter. The galvo scanner business was strong. Color measurement was strong. The scientific lasers, as I commented on, was lower.

And actually, the encoder business was low, just because of the dynamic that Robert mentioned, because they're cycling off this big project so that the orders they were taking in Q3 didn't match up to the Q3 sales. So it had a low book-to-bill. Because it's going to sequentially drop in Q4.

Okay. And then thinking about you guys' inventory levels, how do you think about that as these book-to-bills fluctuate? And what do you think of your levels that you're currently at?

I would say overall, our inventory tends to run a little bit high. And we were planning on bringing our inventory down more substantially in the third quarter, but we had some production issues in our Lexington facility that prevented that. As we get a better handle on that, then we start to look for new opportunities to bring that down. Certainly, the lack of visibility puts a handicap on that, and so we have to manage our way through that. For the most part, we understand where the inflows are coming from, where do we need to bring up a higher inventory level and why we need to do that.

As John mentioned previously, we have brought in talent into some of our production facilities to better run those facilities. That includes everything from operational leaders for the sites to material managers to get a better handle over the actual purchases of the inventory. So it's going to go nowhere but better than where we've been.

Yes, we put in, just a couple of months ago, a new worldwide leader of continuous improvement, lean six sigma, and all the operational metrics. Craig Popovich is his name. He's a 12-year veteran of Danaher and then four or five years with Crane after that. He's just in his initial cycling through all of our factories, taking stock of current state and what the improvement opportunities are in the areas and making recommendations to start to gear up an agenda with all of those sites. There's a lot of opportunity. The processes being used in these factories are fairly informal, and I think you reflect that and they cover some of that up with inventory. It's made worse right now because our demand picture is weak. So as we are, obviously, working hard to secure orders with customers and hold the revenue line, you don't know exactly which orders you can break free.

In a demand growth environment, it's very different, because customers are eager to order and they're almost pushing you. And so you have a higher certainty around your demand and you can run a little tighter on inventory. But when you don't know exactly who's going to order and they won't tell you until very late in the game that you actually get an order, if you then don't have any on-hand inventory, you can't realize the sale. That's putting a little pressure on us.

And I would say the other thing is, too, the moves. We're in the process of picking up right now and moving our Lexington shop over here, and that's a couple hundred employees and a lot of WIP inventory as well as raw material and not so much finished goods. But you're picking that up and moving it and not causing pickups for your customers. So we're staging that out. And all those things, I think, contribute to inventory isn't as good as it would normally be.

Okay. And then just a couple of quick questions. You say the tax rate for Q4 is around 15%?

Yes. On a GAAP basis, it should be around 15% unless there's some sort of final conclusion with the IRS and the Congressional Joint Committee on Taxation, and then at which point in time it might fluctuate a little bit. But for the most part, it should float around 15% from a GAAP basis. From a cash perspective, we pay something closer to 10%.

Okay. And then the $1.5 million restructuring in Q4 -- following that, the restructurings are largely complete then, correct?

That's correct.

Okay, great. Thank you, guys.

(Operator Instructions.) Lee Jagoda, CJS Securities.

I'll start with you, Robert. Can you comment on the tax refund status?

I really can't, because they largely -- all I can tell you is that we came to an agreement with the field office of the IRS that we feel comfortable with, and the package itself has been proposed to the Congressional Joint Committee on Taxation, and then they generally take some time to both hear the actual cases and then make a final conclusion on it. That's all I can really expand upon. We feel good about the position, I think. It's been a long, arduous process, and I think it's at its conclusion now. But the actual timing and specifics of it are still uncertain.

Okay. And you obviously have a lot of moving parts related to your capital structure. You've done a fantastic job paying down high-cost debt. You've got things for sale, things you want to buy. Maybe if you'd take a step back and tell us what your view of what you think your limits or targets might be on capital structure, and that will lead into a follow-on question.

Sort of leverage ratios and that type of thing?

Yes.

Generally, the existing credit facility wouldn't put us much above 2, so it can go up to 2.5. I think if you get up to 2.5 on a leverage ratio, that's a little much for this sized company. And so I don't think you would ever go down that path. Other than that, we wouldn't be looking to go out into the marketplace at this point in time. We think we can finance most transactions with both cash on hand and what we can get through a bank facility. So we're not interested in doing anything else at that point.

Yes, we're not going to go do a high-yield offering or anything like that, at least in the near future.

Or a convert or anything equally shareholder-unfriendly?

That's correct. What we're really sitting and looking at, as John mentioned, is the acquisition opportunities are attractive in front of us. To the degree that they're not actionable for whatever reason, then I think we'll revisit our overall buyback initiative.

Okay. And it was one of the reasons I was asking about the tax refund and, frankly, about the possibility of selling the property you have. To the extent you picked up $15 million to $20 million of cash that some might think of as one-time, would that change your view on share repurchase?

It really comes down to --

It's a timing issue, I think.

It's a timing issue.

It's the case of you really don't want to be using up your cash in the window where you're trying to get a deal signed, because you weaken your position. But we do see that it's attractive at this. We believe the stock's going to be worth a lot more over time as the transformation of the Company continues to progress. So it's a bargain right now. And all other things equal, we would be inclined to use some cash to buy back, but not to the extent that it makes us lose out on a deal that's in the window. So there's some timing related to that.

You're right in principle, that some of this cash could be coming in from different things like the IRS or asset sales that is effectively unallocated at the time. And then that would be an opportunity, as you described.

Well, I think at some point your shareholders may say if your stock is trading at X multiple of EV to EBITDA, and you're doing even attractive strategic acquisitions at much higher multiples, at some point your choice ought to be buying the known versus the unknown.

Yes, that's not lost on us.

Yes, we get that point. You're right about that, and it is something that we take seriously and look hard at, and we'll continue to do that.

Okay, we've been involved with you guys almost a year, and I know you're trying as hard as you can to be conservative, but you've also dealt with an extraordinarily challenging macro environment. Can you give us a feel for maybe the shape of things during the quarter, what you're hearing as you have dialogues with customers into Q4? I know you don't have visibility that goes much beyond a quarter, but maybe you could share with us, John, what you are hearing when you speak to customers and how that's affecting your thinking.

Yes, absolutely. So if you were to take and say our sequential picture, Q2, 3, 4, we don't really see from customers that there's been a noticeable change in the conditions. There's some fluctuations in our actual results. It probably has more to do with specific projects. As we indicated, we had a significant project we did in the data storage market with encoders, and so that created a dynamic. But in general, if you average across all of that, customers are telling us it's kind of bouncing along the bottom, that there has not been a catalyst for recovery.

The problem was, people thought there would be a recovery. At this time a year ago, exiting 2011 and heading into 2012, customers across the board were saying we're in this down cycle that began around the time the US got downgraded. But they thought it would recover. Nobody thought that this was going to be a weak market all the way through 2012. Our spindles customers told us that, our scanning customers, our encoder guys, some of the laser guys -- all said this is going to get better, and then it didn't happen. What we've seen is basically just a continued stagnant market.

So I think the customers got burned once, where they were bullish and said this is going to resolve itself and it didn't. So now you almost have the opposite behavior, that I think customers are being very conservative and very cautious, which is causing us to do that.

The cycle's going to turn at some point, but nobody wants to be out there just forecasting that it will turn at some point when you have no clear evidence it will. We have not seen particularly any businesses that are starting to run very favorable in book-bill on a sustained basis, or that you can clearly discern an upward trend that is sustaining itself.

We have these pockets, so the CO2 laser was up, but then it's sequentially trending a little bit back down in Q4. Encoders went up; it's trending back down. The fiber laser is consistently trending up, but that's a secular trend from that technology.

So I see it as a steady picture. We will look, and we study the data all the time. We've gone back and looked at when things started to come out of the cycle in the '09 into 2010 timeframe. We looked at our own data and a lot of the other peer companies. And when this thing started to turn, it happened pretty quickly and pretty dramatically. But it was like you couldn't necessarily see it coming a long time in advance, and I think that's going to be the case here. But we just don't know, so we have to plan and assume, at least for the time being, that we're stuck with what we're stuck with. And we're going to manage as carefully and as prudently as we can in those circumstances.

But what we're not doing at this point is backing off the whole transformation of the Company, because we really believe that the roadmap we laid out is the right one for GSI, given the core competencies, given the businesses and technologies we have, the channels into the market we have. And we've been clear about what those priorities are, and it's been agreed with our Board and our investors, and we're staying with it.

It may not pay off in the next one or two quarters, but at a certain point, it's going to turn, and I think we'll be a much stronger and more vigorous and healthy company when the recovery happens from the actions we've taken.

Okay. Well, you know our thesis has been that you've got secular growth characteristics being matched by the cyclical issues. So it leads right into my final question for you. Spindles and scientific lasers, you indicated in your prepared remarks, accounted for three-quarters of the year-over-year decline. On both of those two key elements, would you view the issues or comment on whether your expectations are these are just cyclical issues and not a secular trend change?

I think scientific, I'll take first. Nobody anywhere would really characterize the scientific laser business as a high-growth market. All the data will tell you it's a zero to 2% or 3% growth, long run. But it's so episodic that it's always hard to see that. If you get a big order, it can be a $20 million order in a $20 million business, or whatever, hypothetically speaking. So then it doubles your size for a year and a half, and then you go back. So it's always a little hard to see, but I think long run, that always comes back to being a flat business because there just isn't a ton of long-term growth.

So the current cycle we're seeing, I don't think it reflects necessarily any permanent change, that we still view scientific as being a flattish business over time. It just happened to be negative, but I don't know that -- it could stay there for a year, but I don't think it's going to stay there for a long term.

The issue with spindles is a little bit different, because there have been some changes in the technology landscape there. The spindles are used in mechanical drilling of holes, of via holes in circuit boards. And there is an alternate technology, laser drilled holes. We do, by the way, participate in laser via hole drilling with our lasers and our scanners, so we have to hedge, to a certain extent.

But there's some trend there. The shift to tablets and to mobile handhelds, iPhones and these types of technologies, favors smaller holes, which favors the laser drilling. The mechanical drilling is PC and server driven. And of those two, I think everybody knows PCs and laptops is weaker, and it may not ever really get a lot stronger. The server market still remains pretty viable for mechanical drilling.

So I don't know. It never was a high-growth business. Mechanical drilling, if it was that one-time a couple percent positive as a growth market, it's probably a couple percent negative. But that's masked by 50% swings in the cycle, so how do you really discern a shift from a slightly positive to a slightly negative long-run growth trend when your business is cycling more than 50% due to the -- we're the whole, essentially, most of the market in mechanical drilling spindles. There's one other provider, but they're essentially a captive supplier. It's an OEM that owns their own spindles. But other than that, we supply all the OEMs. So we can see when they're not selling equipment.

Thank you.

There are no further questions at this time. Please continue.

Okay, thank you. So in wrapping up, I would say that for the most part, the third quarter ended up as we expected. The near-term economic outlook does remain challenging. We're into this fifth quarter of the cycle of weaker capital spending in our markets. The numbers reflect that, as do those of our competitors and peer companies. The cycle is a disappointment to us, as we've not yet seen the catalysts or the sign of recovery. We have to remain cautious, and we're doing that with respect to our expense levels, our hiring, our inventory policies.

But we know the markets will ultimately recover. We intend to be ready to capitalize on the upside. At GSI, our talented, committed workforce, we're all striving every day to make it an excellent company. We intend to remain the technology leader in our chosen market segments, plus we also want to become a simpler and more customer-focused and more operationally excellent company. We're not there yet, but we intend to be.

We're still in the early innings of this game, but we're convinced that our goals are the right ones and we're on the path to achieving them. We appreciate your interest in the Company, and we do thank you for joining today's call. We look forward to joining all of you on our fourth quarter 2012 earnings call in March 2013. This call is now adjourned. Thank you.

That does conclude our conference for today. Thank you for participating. You may now disconnect.