Onto Innovation Inc (ONTO) 2006 Q3 法說會逐字稿

Good afternoon and welcome to Nanometrics' Third Quarter 2006 financial results conference call. The speakers today include John Heaton, President & CEO, and Doug McCutcheon, Executive Vice President & CFO of Nanometrics. The Q&A session will be held at the end of the call. Until that time, all participants will be in a "listen only" mode.

The following discussion may include forward-looking statements regarding, among other things, Nanometrics' future financial results, business performance and market conditions. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from these statements. Factors that could cause such differences include, but are not limited to, changes in demand for the Company's products, changes in the Company's ability to ship its products in a timely manner, changes in business or economic conditions, and the additional risks and uncertainties set forth in the related press release and in the Management's Discussion and Analysis section of the Company's latest Annual Report on Form 10-K filed with the Securities and Exchange Commission. I will now turn over the call to Mr. John Heaton.

Great, thanks Steven, I appreciate that. And I want to welcome everybody to our call today. A pretty big day for the Company and I can tell you that two things have changed for us today. The first is we are having an afternoon call which is quite unusual, we are usually early in the morning which is a nice change for us. And also it's the first quarter of the new combined company, the New Nanometrics, which is the combination of Nanometrics and Accent Optical. So, our pleasure to welcome all the new employees as well as investors.

So, just kind of quickly, I want to go first today, because I think realistically the complexities of our financial statements this quarter are such that I am going to let Doug finish off the end of the call and then we'll just go right into the question part.

Our goal today is going to be to give you some insight into how the merger is going, try to help the investors unwind these financial statements to make a value judgment on how we are performing as a company, and then lastly to give you a view into our business and what the next quarter is shaping up to look like.

Before I get into those topics though, I want to speak a little bit the announced results. Revenues came in at $29.1 million which is in line with consensus. That number includes $7.6 million in contribution from Accent Optical Technologies.

In the second quarter call, we guided revenues to be up 5% to 15% for the Nanometrics standalone and flat for Accent. But, I want to take that apart for a second.

In Q2, the last quarter as a privately-owned company, Accent Optical had $14 million in revenue. The fact that we are recognizing $7.6 million from Accent in Q3 is not at all indicative of business falling of a cliff. The difference is the result of three reasons. Accent's results are for just 10 of 13 weeks in the quarter, number one. Number two, the purchasing accounting rules required us to wipe out nearly all of Accent's deferred revenue. And most importantly, Accent was a private company. Accent recognized all revenues upon shipment, which is a significantly different policy than ours at Nanometrics.

If Accent had been combined into Nanometrics' Q2 results, we would not have been able to recognize anywhere close to $14 million in revenue, just to make that clear. The big issue for us is that it's impossible for us to go back and look at every 'what if' scenario to arrive at a representative pro forma revenue number for the quarter. What we know is that neither $7.6 million nor $14 million is representative of Accent's revenue contribution for the quarter.

What we can do is start with a clean slate, recognize that revenues that our accounting policies permit us and then we guide to where we expect Q4 as a combined company with one revenue recognition policy.

When you split out Accent's contribution, Nano's business was in fact down 8% in the quarter. While this is a miss from a Nano stand-alone perspective, we felt it would only confuse the investment community to preannounce a shortfall when revenues were actually in line with analyst estimates, especially with all of these moving parts around the Accent acquisition.

The decrease in revenue is reflective of a quarter-over-quarter increase of $6 million in deferred revenue due primarily to delayed acceptances on new systems in Korea and integrated metrology upgrades from certain customers in Japan. We will now see that business appear in the next couple of quarters, and Doug will reflect that in some of his conversation.

This is a huge time, a huge change, and an exciting opportunity for a new company and is really unprecedented for Nanometrics year-over-year growth, 550 employees, very exciting for everybody in the company, and things are going pretty well.

While there are many acquisition accounting adjustments that cloud our results, you can clearly see that we have more than doubled the revenue year-on-year, which was the primary driver for us going through acquisitions. Again, reviewing our past thoughts about acquisitions, we felt that the combined -- the company needed to have a larger base of revenue in order to minimize the ongoing compliance and accounting issue that our government has decided to implement on publicly traded companies. So, overall, the theme has been achieved. We are now significantly larger than we have been in past quarters.

We were hoping that we would get all the merger adjustments accounted for in Q3, but some of those adjustments, especially related to the purchase accounting on the backlog, will fall into Q4. So, while we had hoped in our last conference call that Q3 would pretty much have most of the merger costs in it, it looks like it's going to actually affect some of our Q4 numbers, and again Doug is going to reflect that in some of his comments.

Doug will also go through the numbers in more detail, provide a clearer picture of the results, and I am now going go on to some of the other issues that are more business related.

On the integration front, we've had a number of months to prepare for the integration prior to the actual date, and we are three months into the completed merger and I am happy with where we are overall.

We are already consolidating manufacturing as many of you may have seen, moving almost all of our manufacturing out of York and splitting the manufacturing efficiently between two different divisions, so the two divisions being Nanometrics in Milpitas and Nanometrics in Korea. Part of that manufacturing strategy is also to outsource some of the lower-volume products to outsourced manufacturers on a turnkey basis.

I can report to you that service organization is improving, we've already cut the negative service gross margin in half. Milestones are established and we've got a solid plan for making our service business profitable over the next several quarters.

On the reliability side, and also reflected in some of our deferred, improvements have been made for the most part and have been resolved, and those improvements are being rolled into the field. So, the perspective there, the point that I am trying to make with the reliability issues is that when you fully understand what the problems are and how to resolve them, then you can properly account for them because you have a good financial understanding. So, it wasn't possible for us to make adjustments relative to upgrades until we actually had the solutions identified, cost it out, and then ultimately put into field.

So again, we feel very good about the improvements now. We are moving on and currently we took most of those adjustments in this quarter as much as we could at least, and we feel good about where we are from a reliability standpoint from this point on.

Engineering is the lifeblood of the Company, and now that the merger is complete, I can really feel momentum returning to our engineering organization, renewed enthusiasm, and we can expect new product introductions in the next few quarters.

One of the other issues I want to talk about through the integration is the inventory reduction. As you've seen and you'll see in our balance sheet, we have a significant inventory in the combined company. I think that's on the order of $50 million. That is a primary focus area, and obviously an area where we have a lot of cash tied up. So that is going to be one of our #1 goals for 2007 is to really drive that inventory down, really understand what parts are (inaudible) required in the new company, and also the fact that we will be doing a lot more offshore manufacturing or outsourcing of some of these subcomponents. We expect significant improvements in the inventory on a year-over-year basis from this point on.

We are also did scrub the inventory in the new Company, obviously Accent did bring -- Accent Optical did bring a large amount of inventory into the Company. We made sure that all of the policies and procedures that we've had in place relative to inventory were followed at Accent. We scrubbed, again, the entire Company and feel very good about the current evaluation on that inventory.

Other cost savings that we can expect in this integration will allow other financial benefits. But it's really a multi-quarter story, it's not going to happen today, it's happening in Q4, it's happening in Q1. You don't move manufacturing out of facilities overnight, it takes a significant amount of time. We have to build, in some cases, duplicate manufacturing, and then transition over smoothly. So, in some ways, you are actually increasing the cost of some of your manufacturing on the short-term and don't realize the true benefits of the outsource or the relocated manufacturing for at least a quarter after that. Just want to make sure everyone understands that.

Another part of the complexity and it's -- one other things that's driving some of this accounting is that we've also increased the number of entities in the Company. So, Nanometrics on its own had four entities within the Company, fairly straightforward to track and to account and to audit. The new Company, we have 22 entities, and 19 of those are international. They don't unwind quickly. Some of these are foreign based and time and tax consequences are sometimes involved in consolidating these entities. So, that's not something that's going to happen overnight, it's going to take a few quarters to get that straightened away and reduced in numbers and complexity.

On the business outlook standpoint, we really feel good about where the products are today, where we stand as a new company with combined products, especially in the overlay part of our business. I think you probably last week saw a very important announcement for the Company which was a cross-licensing agreement with ASML. It is really an example of the emerging opportunities we are seeing in patterning metrology.

Our position in overlay, which went from being a bit player to #2 out of two, is part of what made this partnership possible. What I mean by that is if we had not been viewed by these partners as a clear leader within the market, the possibility or the likelihood of us coming to these kinds of arrangements would have been far less likely. So, as we move up the food chain, as we move up the market position for optical CD, for overlay, for thin film, what we see is a growing importance on both our customers and our potential partners' radar screen.

Just to clarify, there are opportunities for metrology and inspection in the patterning process, in the patterning really meaning the scanner, track and etch. But our focus is just metrology which includes that overlay component, overlay meaning two subsequent layers being aligned properly. Optical CD, meaning using optical technologies to measure critical dimensions. And then thin film using optics. We are not, and we believe that there are many opportunities for the company in inspection, but our primary focus is metrology.

While we are excited about the opportunities for the combined company to grow, we are seeing some softness in Q4, mostly due to the integrated push-outs into the first half of 2007. I think this is a common thing we've been hearing recently, some of the memory folks have moved some of their production by a quarter out, in some cases by two quarters out. We don't see that as a significant issue in the industry. I think it's more of an air gap in anticipation of the new Vista operating system. Most of you are probably aware that we are heavily concentrated from a business perspective on memory. We still believe memory is a key driver for our business, and haven't seen anything from our customers' perspective to change that. Further capacity expansion is on track, although in some cases delayed, but we still believe in 2007 will be a great year for the memory market and in general for the overall semiconductor equipment business.

Looking a little bit at some of the geographical trends for our company, and we've talked about this as one of the motivations for the merger with Accent Optical, we were highly concentrated on the US, Japan and Korea and somewhat in Taiwan. Now that we are a combined company, we start to see some balance in these territories with Europe now becoming a much more significant part of the combined company. Doug is going to break those down for you as well as some of the product breakdowns by integrated, standalone, and so on and so forth, so I'll let him kind of speak to those. But, the important part here is again Europe is now an important part for us, and in being a worldwide metrology company that services all customers it was really critical for us as a company to have application, service and support, sales in all of these different territories to accommodate any customer requirements. So, if one of our key customers is expanding in Europe, we now have the bandwidth and personnel in place to accommodate any of those growth plans.

Other areas to kind of speak to a little bit the status of some of our legal suits, which again to some extent are driving some of these financials, we do spend significantly on legal defense. Again, we were sued by some of our competitors. On the Nova front, last or two weeks ago we did have a Markman hearing, and as a result of that Markman hearing we haven't changed our view on the case, we still feel very positive about our position. We also have had additional discoveries since the Markman that also leads us to believe that we are in a very positive position relative to the Nova lawsuit. The KLA [inaudible] lawsuit, just for your -- a reminder here, is on stay as the patents being litigated are being reexamined by the Patent Office.

I also want to remind everyone that this new company has a great team of management in place now. Some of the folks from Accent have taken significant positions within the new company. Bruce Rhine being a Chief Strategy Officer, who was the previous CEO of Accent, has been a major contributor to the company, has really helped spread the message in the company, helped us think through some strategies, and is a welcome addition to the team.

Same thing goes for Bruce Crawford, who is our Chief Operating Officer, has made significant improvements, and we will see these play out over the coming year. Operationally, he is really an expert, many years in the industry, and we are already seeing significant improvements in how Nanometrics runs operations here in Milpitas. He is also going to be the team leader for driving these manufacturing offshore changes for the company. He has had lots of experience with this, especially with his background at Accent, we think that since he's done it with him, he has a lot of insight into how do it right. So, we believe excess credibility for our offshore manufacturing in Korea, especially for overlay, is on track and high likelihood of success.

Last, really a senior person I'll talk about is Raj Mundhe, who is our Vice President of Sales. Raj has really brought a great rigor to the sales process. We expect to see vastly improved sales forecasting, and hopefully that's going to translate into a better guidance and financial insight into where the company is going for our team here which ultimately will translate into a better insight for our investors.

So, in summary, before I turn it over to Doug, I just want to hit on the main points again. Our merger is on track and we feel great about the new company. We think we have the right products, we think we have great employees within the company, and we have customers that are really supporting us as a company.

Synergies and efficiencies should be realized over the next few quarters. Again, this is a multi-quarter story, it's not happening today and it shouldn't have been expected that it will all happen within Q3. It's a complex company, but we feel very confident in the efficiencies and synergies that we've been talking about over the past couple of quarters, and as a result of the mergers.

The market for OCD and overlay looks very promising to us, especially with our expanding partnerships and customer base. I think the thought process around duel patterning and shrinking geometries is one that's really driving and high in the customer's mindset and we are on the forefront of that and we have a compelling solution of combined products that I think ultimately is going to translate into tremendous growth for the company.

So, we look forward to further growth and to return to profitability in the coming quarters. And with that, I think we will grind away on some of these numbers with Doug. So, Doug?

Thank you, John. I'm going to address the significant financial aspects of the announcement that we made earlier today. Of course the most significant matter is that we now include in the financial results for the acquisition of Accent Optical Technologies, which we closed on July 21, three weeks into this third quarter.

As is required for purchase accounting, in the first few periods following an acquisition, there are some unusual accounting ramifications which may have quite significant effects, but their impact declines as the new combined company reaches a steady state equilibrium. We noted that such would be the case during our second quarter call and I will try to share the impact of some of these as I step through the lines of the financial statements.

I would like to note here that we are not maintaining a separateness of Nano and Accent going forward, exactly the opposite. To realize the synergies of this merger, we must operate as one company. We will try to give you clearly transparent view to the New Nanometrics along the lines of how we are managing the business. We have made significant progress on the integration activities as John mentioned and we are optimistic about the future.

Revenues for the third quarter were 29.1 million for the full quarter of Nano and the 10 weeks of Accent. Effective July 21 the prior Accent products revenue recognition came under the practices of Nanometrics. You will note on our balance sheet that deferred revenue now stands at $12.7 million versus $6.7 million at July 1, so we added a net 6 million from additional shipments in the quarter that have not yet qualified for revenue recognition.

On the other hand, revenue for any products which Accent had shipped prior to July 21, but deferred the revenue thereupon, would drop from ever being recognized since Nano cannot assume the Accent deferred revenue. We will receive the cash from collections of those receivables however.

We've previously reported our revenue by our two channels, standalone and integrated metrology along with services revenue. We will continue to do so. For the current quarter, all of the integrated metrology revenues originate from the prior Nano products. However, as we emphasize extending the former Accent products into integrated metrology, this will change.

For the third quarter, the revenues were divided by channel as follows. Standalone metrology was 19.1 million or 65.6% of the total. Integrated metrology was $5.7 million or 19.6% of the total. And, services revenues totaled $4.3 million or 14.8%.

Also, as John mentioned, as a reflection of the New Nanometrics, our geographical distribution has shifted to be less concentrated in several regions, and indeed very global. North America contributed $10.2 million or 35.1%, Japan contributed $5.3 million or 17.8%, Korea $5.8 million or 19.9%, Taiwan and China $4.3 million or 14.7%, and Europe and other $3.6 million or 12.5%.

Now, I would like to move on to the gross margins. Our reported product gross margin was $10.2 million or 41.1%. Our reported services gross margin was a negative $0.5 million or 10.7%, and our reported overall gross margin was $9.7 million or 33.4%.

These figures, however, as previously noted, included a number of acquisition-related charges, plus some additional accruals for additionally agreed customer upgrades. We believe we have established the basis for going forward with our customers then any such further material upgrade provisions will not be required.

Included in the product cost of sales figure is a non-cash purchase accounting adjustment of $1.7 million to mark the former Accent inventory to fair value. There was also an additional accrual for roughly $1 million for further future retrofits and upgrades. Without these costs, the product margin would have been approximately $12.9 million or 52% of product revenue. This compares to the 46.7% product gross margin reported for the second quarter.

Service gross margin includes the contribution of historical Nanometrics for the full quarter and the former Accent operation for 10 weeks of the quarter. As previously noted, we intend to leverage the experience of the former Accent management in managing the profitable service businesses in the future. The blended services margin of the combined entity resulted in a negative service margin of 10.7% as compared to the Nano-only services margin in the second quarter of negative 22.9%.

The addition of the former Accent positive margin for the full quarter in the fourth quarter should cause us to approach the break-even level for blended services gross margin. Further improvements over the next several quarters should lead us to approach our target services gross margin model.

Operating expenses were up quarter-on-quarter as expected, due to the inclusion of the Accent Optical expenses for 10 of the 13 weeks. Total reported operation expense was $15.5 million, up from $11.3 million in the prior quarter.

R&D expenses were $4.2 million or 14.5% of revenue. This is very close to our target model, and we will be refining it over in the next few quarters. As recently announced in the UK press, we intend to maintain, and perhaps expand when appropriate our R&D presence in the UK.

Sales and marketing expenses were reported at $5.9 million or 20.2% of revenue. This is an increase of $2 million from the $3.9 million level of Nano-only prior to the merger. However, only $1.2 million of that $2 million increase is due to an actual increase in the cash-based expenditures for this function with Accent. An increase of $800,000 is due to the increased amortizations of sales-related intangibles contributing to this expense. These non-cash merger-related costs will continue to impact selling expense in a material fashion in the fourth quarter, but will then decrease thereafter as I will outline later.

G&A expense were reported at $5.4 million or 18.7% of revenue. This is an increase of $1.1 million from the $4.3 million level of Nano-only in Q2. This includes both outside SOX consultants cost and litigation expenses, but both have trended down this quarter. Outside SOX consulting expense was $350K down from $370K in the prior quarter, and will continue to decline this quarter and next as we reduce these costs substantially by transitioning to in-house internal audit department in lieu of consultants.

Litigation was also down markedly this quarter at $384K down from $556K in the prior quarter.

Our reported operating loss was $5.8 million. In addition to the $2.3 million in non-cash amortization charges associated with the acquisition, the figure also includes $1.4 million in amortization of stock-based compensation charges in accordance with FAS 123R. These charges are distributed across the P&L as follows -- product cost of goods, $82K; service costs, $84K; R&D expense, $362K; sales and marketing expense, $276K; and G&A expense, $601K.

Below the operating income line, other income and expense was a net expense of $0.5 million. Our interest income of approximately $150K was offset by foreign currency losses of approximately $650K. These FX losses originated primarily from the new-formed subsidiaries of Accent Optical. Despite the pre-tax loss, we needed to provide for small tax provision due to generating a profit in several foreign operations during the quarter.

Our headcount increased from 355 people at the end of the second quarter to 510 at September 30, an increase of 155 people. This was the net effect of adding roughly 200 folks from Accent, as John mentioned, to a total of about 550, and then staff reductions which netted approximately 45 during the balance of the quarter, as we continue to carry out our integration planning and to realize the synergies that we have planned from this merger.

Turning to the balance sheet. Cash at September 30 was $15.1 million, down $14.5 million from the second quarter. This was expected due to the retirement of Accent's debt obligations and various merger-related expenditures. Even though this transaction was a stock-for-stock deal, at closing Nano paid out over $18 million in cash for retirement of the [BioRad] debt payoff of Accent bank debt and various transaction-related expenses.

The combination of cash from the Accent balance sheet and slight positive cash from operations reduced the net decline for the quarter to the $14.5 million I mentioned.

Accounts receivable stands at $27.6 million, an increase of $4.8 million from $22.8 for Nano-only at July 1. DSOs were reduced to 85 days from their previous levels of 88 days. As John mentioned inventory levels for the [combined] company stand at $47.9 million, an increase of $17.3 primarily as a result of the acquisition.

Other notable additions to the balance sheet are the goodwill and intangible assets accounts. Goodwill increased by $48.5 million and now stands at $52 million. Intangible assets increased by $26.6 million and now stand at $30.7 million. As described earlier, amortization of these intangibles generated $2.3 million of additional expense in the third quarter. Amortization of intangibles will be approximately $3.1 million in the fourth quarter, and then decline to approximately $600,000 in each of the quarters of fiscal year 2007, and then gradually decline thereafter in the ensuing years.

The final comment on the balance sheet is to note the significant increase in the deferred revenue account. As John mentioned, deferred revenue at September 1 was $12.7, up $6 million from the Q2 level. This additional $6 million of revenues were shipped in the quarter by the combined company in addition to the $29.1 million in recognized revenues, but did not qualify for revenue recognition. Some of this will be recognized in the fourth quarter, the balance including the portion due to retrofit/upgrade programs should be recognized in the first half of 2007.

Turning to guidance for the fourth quarter. Revenue guidance for the fourth quarter is flat to the reported Q3 figure, plus or minus 10%. Q4 will be the first full quarter in which Nanometrics and Accent are combined, and we will still see variances to prior revenue levels because of deferred revenue and differing accounting policies, as well as the near-term softening in our integrated metrology business that John mentioned, as customers have pushed some orders into the first half of 2007.

Operating expenses should tick up slightly from Q3 to Q4 as Accent operations will be part of Nanometrics for the full 13 weeks of the quarter, but mitigated by the cost reductions associated with the 45 net headcount reductions I mentioned previously.

So that concludes our prepared remarks. Operator, you may now poll for questions.

[OPERATOR INSTRUCTIONS]. And our first question is from Avinash Kant.

Good afternoon, John and Doug.

Hey, Avinash.

Hello, Avinash.

Hi. Of course, trying to understand a few things here. Now, did you state that in the product sales revenue number that you put out, $14.6 million or so, the $2.3 million is in that, the acquired intangibles, is that...?

No, the $2.3 million is in the cost of products.

Yes, exactly.

Is split between the cost of product sales and in selling expense.

And what's the split, cost of product sales, how much is that?

That's what I mentioned, $1.7 million in cost of product sales.

Okay.

And some $7 to $800,000 in the selling expenses. It rounds to $800, but the combination rounds to $2.3.

Okay. So $1.7 in the cost of product selling expenses. So, basically when you are doing your -- giving me the product gross margin of 52%, basically what you are doing is you are taking out $1.7 from the $14.6, right, the cost of...?

No, I am taking out the -- yes, the $1.7 of the purchase price amortization and I also took out the extra $1 million accrual for upgrades and retrofits.

Okay. So, I am trying to understand, if you didn't have these charges, what would be your corporate gross margin overall other than the $2.3 million charge?

As I said, the product gross margin would be about 52%, and you saw that the services margin -- services gross margin was reported at negative 10.

Right, okay.

So, Avinash, if you do an apples-to-apples comparison, Q2 Nano products for 46.7%.

Right.

Gross margin, it went up to 51% in Q3.

51 or 52?

51 for Nano-only.

Okay, Nano alone, okay. I see, I see, I see.

Apples to apples.

I see, I see, got it. Now, when you -- could you talk a little bit about how -- what was the percentage of memory in the revenue that you reported just now overall?

You know, we didn't break it up by memory, that's...

Alright. I know in the past you've talked about kind of the memory will become a little bit smaller percentage of business as you might just [inaudible] in but still will be pretty strong I believe.

Well, if you think in terms of the geography of our revenues, the European business was not driven by memory, frankly. And, the additional business in Japan was driven primarily by the FTIR and compound business.

Right.

As well the increase in Japan. Korea is obviously all memory. So, the US was -- that's kind of hard to say as that goes into the integrated parts. That's the down part of that.

Right.

So, it's still -- I don't really see a significant change other than probably 5% or 10% down based on the increased part of our business in Japan from compound and FTIR and also the European business.

Okay. And the slowdown you talked about in the integrated metrology business, what kind -- is it just some push-out or is it some calculations?

No it is a push-out.

Okay, okay. So, just the timing, I will come back again.

Yep.

And you did talk briefly about the Nova. Should we expect additional expenses because of this going forward, the Nova lawsuit?

We don't have our trial for Nova until first half of next year.

May.

May of next year. So, frankly what we are doing right now is we are waiting for the judge to make a ruling on the outcome of the Markman. Between now and then, it will be just be trial preparation.

And I presume that your Nano revenues alone came out down 8% or so, was this what the guidance was, which was up -- for up. Now, is it only the integrated metrology where you saw the weakness or was it something else also that kind of brought the numbers down?

No, it was mostly OEM business that was the push-out. So, if you take into consideration the deferral of the upgrade business, because as I said as soon as we get into a situation where we are going to be doing some sort of an upgrade to a system, then any -- not only the upgrades themselves have to be accounted for, but any system that is supposed to have an upgrade can therefore no longer be recognized. So, revenue recognition [means] that the product is sold to a customer and it is accepted. And if you have additional things that need to be done to that tool in the future, you cannot accept revenue for it. So, really what we have to do on the integrated part is to reset our revenue recognition for them until we get to the point where the upgrades are included with the machine and accepted by the customer on delivery. So -- and also I want to say one thing about the Nova I didn't mention that we did within the quarter file another countersuit against Nova. So, if you recall the timeline here, they sued us about two years ago over integrated metrology. We sued them in response to that with the UV patent. And then, we have filed additional suit on them relative to the optical CD system from use of libraries as well as normal incidents. There are two patents involved in that countersuit, and that is primarily a result of the acquisition of IP from Accent Optical on the first hand. And the second one is an issuance of a new patent on the Nanometrics side.

And one final question, the flat guidance you have, are you expecting flat business from both Nano and Accent side, and what kind of gross margin should we think about?

Well, the gross margin we are, if we think in terms of pro forma gross margin of around 52%, that's really what we are targeting for in Q4. And from the business perspective, we are not going to segment it out, because it's kind of -- again we go back to we are one company and we are trying to balance these in order to kind of grow the company and I don't think it really helps the investors try to understand or try to guide which part of the business Nano or Accent, because we are not going to track it that way.

Okay. Thank you so much.

Okay, thanks.

Our next question is from Raj Seth.

Hi, thank you. There are a lot of details in this release. I wonder if, John, maybe we can abstract away from some of the finer moving parts, I am curious if you think over a couple of quarters how one -- where do you think -- what's your plan in terms of headcount? Is there a way to describe what currently cash break-even is and where you think that goes? Or maybe is there a way to describe the synergies over some period of time and costs that you expect to be able to take out of the combination, maybe assuming sort of a flat revenue level, just to some make some clarities here? How should we think about what you think the aggregate opportunity on the cost side is over the next two or three quarters even? I mean, where are you trying to head, what do you think you can take out of the business?

So, just first of, I can -- I'll address a part of it and let Doug talk a little bit about the break-even and such. You know, we think there is going to be a significant reduction in headcount purely based on the plan of moving manufacturing out of York and also the outsourced manufacturing. So, those two are big drivers in headcount reduction. Obviously we've -- as Doug mentioned, we have 40-plus people who have already been reduced in the company as part of synergies, we expect to see a lot more of that play out over time. But, we -- this transition is significant and takes a quite a bit of time to get the manufacturing moved from one geographic location to another. And so, in the interim, we do have redundancy in manufacturing, but that's going to be obviously an area especially in a flat -- if it is a flat revenue environment, then we need to work substantially to get the break-even down, which is not where we are at today.

Yes. And John, you mentioned you've taken 40 people out and probably a number to follow over some period of time, any way to quantify what your target is, I know that's hard?

Yes, that's really hard to do. Go ahead...

I'll take that. Just a couple of reference points here for you Raj. If you go back and look at our S-4 that we filed with the SEC for this acquisition, and you look at the pro forma for the first quarter of 2006 that's contained in that number for operating expense for the combined company back in Q1, and you look at that number and then you look at what we expect to do here in the fourth quarter with the combined company all together, and that -- we are expecting a number that's in excess of $1 million lower than that number. And so, on an annualized basis, that would be a savings of $4 million, well on our way to our overall synergies goal of $6 to $8 million. And then, the other piece comes, as you know as John noted, from the improvements in the manufacturing and getting the manufacturing cost out. So, kind of looking at the blended margin that we kind of see for the fourth quarter here, our cash break-even is about $33 million in revenue per quarter. But, as we then accomplish the improved margin and so on going forward, if you take it all the way up to our target blended gross margin of 55%, that would reduce our break-even point to around $26 million, again cash earnings break-even down to about $26 million.

And that's -- forgive me for interrupting, but that is inclusive of both improvements in gross margin and some fixed costs coming out of some -- even variable costs coming out from OpEx, right, to get you to $26?

Yes.

Okay.

So, that's -- I think that's -- hopefully that's sort of, you know...

That that does help. John, could you talk a little bit more about the push-outs from some of the memory guys that you are seeing maybe -- I mean how are those conversations, what are they telling you they are doing, and why are we confident this isn't sort of the -- a yellow light that precedes order cancellations and actually some projects being canceled?

Well, mostly because they look like regulatory problems or delays in facilities. So, it looks like a one quarter push-out by a couple of folks, one in the US, one in Korea, and one in China, and most of those seem to be just complexities in their business and not meeting their schedules for the fab fillouts. So, some folks seem to have gotten, in some cases, Phase 1 done and they are delayed on Phase 2 for various and sundry reasons. And, they don't look like decision making within the company which has been traditionally what we've seen where they've said "No, we're going to slow down for six months and let's plan accordingly." That's not what we are seeing. What we are seeing is purely, "Here is a reschedule date and we are not ready for it yet, so move it to there." And that's -- we see those pull in and we see those pull out and we did see a couple here. And so, yes, first-off, you're going to say, "Well, a red light, red light" and we are hearing that from other people now. On the other hand, it doesn't look significant; it looks like just a timing perspective maybe for the Vista stuff more than anything else.

And people would be pushing out for Vista, why would they be pushing out because of Vista?

Well, there was a suspicion that they may break it out earlier, and it looks like, if you look at both the PlayStation 3 and some of the delays, it's been pretty common here lately where people have been talking about the massive reduction in the amount of systems actually going to be shipped and delays on that part, as well as the actual channel for the Vista folks. I think Dell has gone through a transition in their own product line now, and I think everyone is just being a little more cautious about memory for the system.

Sure. So, last question from me. FormFactor talked a little about a delay relative to original expectations and the transition to 70 nanometers on kind of an industry-wide basis suggesting in part people were reluctant to move because pricing in DRAM is so good, they are making enough money they don't want to, and there are some technical difficulties. Does that kind of a shift impact you in a material way and do you have any perspective on what's going on there?

That's really surprising to hear, I didn't hear that from FormFactor, but I have been in most of their territories in the last two months and I haven't heard anything expect for 'go, go, go on geometry shrinks', and when they shrink it's good for us.

Yes.

It goes back to the pricing, they make more money when they shrink the geometries and we are constantly getting pressure relative to shrinks. And that's why we have so much confidence in frankly the overlay and OCD business. Folks are really pushing hard on the 45 and 32 now, and all of the swirl around what is going to be the control mechanism for overlay and CD where the double exposure is going to be a significant entry point at the 45 nanometer. These things are all happening very very quickly, and we feel very confident about that because -- and so it's really good for our business.

Okay. And then -- sorry, I know I said the last one, but let me sneak one more in. You mentioned that you were -- or suggested that you were quite confident in strong memory spend year next year in 2007, maybe some short-term push-out et cetera, but you sounded quite confident. From your perspective, any view on what you think CapEx is going to do next year, I might as well ask?

No, I don't have a crystal ball. I mean I think our scope is really limited in the metrology's -- part of the business anyway.

Yes.

So, I really --it's hard for me to give you a whole lot of insight into that.

I guess what I am asking is what does a strong year mean to you?

Strong year for us means better than we did in 2006. So, a strong year is the combined two companies, can we equal or better what we did this year, and that's the strong year. A weak year is we are going down, a strong year is we are going up.

Okay, got it. Thank you very much.

Yep.

Our next question is from Jerry Fleming.

Yes. Hi, John or Doug. Could you give me a little bit of a rundown on the deferred revenue account, are those revenues that are in there, do they contain a normal profit margin or are they based on costs incurred so that when those come through you won't see any profit?

No, it's -- but it is at revenue, it is at the revenue amount, it's not a net margin amount.

Okay. So there -- but there will be -- let's assume it's product, so there would be a 50% or so gross profit associated with it? Just off the top of my head, I am not asking you for a forecast.

No. Basically, you invoice the sale and then you back out the revenue and you back out the cost of goods to inventory. So, when it comes back in and it's as if it was a normal revenue recognition.

Okay.

And, with the exception of items that are in deferred revenue that were in the Accent backlog at the time of the acquisition attract this nefarious charge of marking up the inventory to fair value.

Well, that's what I was trying to get at, is that a significant part of the deferred revenues?

It's not part of the deferred revenue, but it will --when the deferred revenue...

Okay. Is it a significant part of the costs associated with the revenues?

Yes. In the fourth quarter we estimated that that number will be $1.9 million in additional cost of sale.

Okay. As you look to next quarter, how much more do you expect the deferred revenues to increase, again ballpark-wise?

No, we don't. No. I actually expect the -- I mean I expect the actual balance in deferred revenues to come down in Q4.

Okay.

As we recognize some, but we will still go into Q1 with a substantial deferred revenue for these -- all these upgrade units that John talked about.

Okay. So, if deferred revenues are coming down, it actually means that the amount of product shipped is coming down so that if you are looking at gross margins remaining at that 51% or 52% number that you gave us previously, it actually means you are showing continued improvement in the business.

That's correct, and also the mix change gives a margin improvement.

Okay. And then a question on the service numbers for next quarter.

Yes.

Ballpark, are they going to remain the same and where do the margins go?

As I mentioned because Accent will be in the -- the Accent product line will be here for a full quarter, they will contribute. They are expected to contribute a higher amount of revenue. And so, it will be incrementally higher, and we would expect as I have mentioned in my remarks that that incremental positive contribution should cause us to have service margins perhaps not achieve break-even, but certainly move much closer to break-even in the fourth quarter.

So, you are going to be profitable next quarter?

We didn't give guidance for profit, and -- but as I mentioned, our cash break-even is $33 million. So, given that we are guiding flat, you can see the answer to that.

I think also it's -- again you are trying to look at how do you really judge, where the company is doing on a Nano-to-Nano perspective Q2 to Q3 we were positive cash flow, which is I think indicative of where our business is improving. And, we were thinking in terms of it was the Nano-only kind of flattish next quarter. So, I think we are close to break-even on a cash basis. But, these accounting issues that don't get fully realized until the shipments happen and revenues are recognized, it's really hard for us for predict Jerry. So, I think what we would hope was that -- was going to be that fourth quarter would be the clean quarter where we get these things all over our hair, but it looks like we are going to have some spillage from Q3 into Q4 and it makes it a little bit more difficult for us to figure out what the actual GAAP number is going to be.

Okay. Thank you.

Yep.

Our next question is from [Weston Twig].

Hi. I just -- I wanted to follow up on the Accent revenue. You said that $14 million was too high. I wanted to get a little bit more flavor on that, I am trying to wonder if we can look at historic revenue from Accent, can we use that as a guide moving forward or how do we need to look at this moving ahead?

Well, $14 million was what they reported in the second quarter. Again, using their revenue recognition rules and so on, that was a relatively high quarter to them. You can go back and look at the S-4 and see what prior quarters have been. But again, their overlay business and being coupled now with Nanometrics, we think they should be -- we think the Accent products will be real winners for us. So, whether we can get back to $14 or something approaching that, we'll just have to see.

Okay. Also I'm wondering related to the press release on ASML and Nanometrics cross-licensing of IP, is there any revenue associated with that?

No, there is not. So, what -- pretty clearly what we said was this announcement is a partnership agreement between the two companies especially related to IP that -- we both view that overlay and CD metrology are critical to the patterning process and that the fact that ASML has recognized metrology as an important contributor to the process that -- that's a big green light to us for growing importance. At the end of the day, I think our customers are looking for ways of improving the process, improving the geometry. And at the minute that an OEM really wakes up to the fact that metrology can improve or theoretically can improve the process, then what that means to us is that the value proposition for a metrology company, which traditionally is nothing more than a verification. If the verification goes to improvement, then I think the economics and the value proposition that metrology brings to customers increases dramatically. So, we don't know what's going to happen to all that at the moment, but we do know that they are obviously through this arrangement with us, 2now believers that there is something there and that it needs to be investigated and that they should partner with a metrology company to explore that.

Okay. Let me ask this then, would the agreement preclude Nanometrics from receiving revenue if some of your analytics property was used in an HTML tool?

We are not going to go into the details of the contract, all we are going to say at this point is that it's a cross license between the two companies. They have IP, we have IP. We think the two combined have a great portfolio that will protect both companies going forward. So, that's really the extent of it at this point.

Okay. And also I had a question on service gross margin. I wanted to go back to that for a second. At one point I think it was mentioned that it could potentially be achieved -- 19% could potentially be achieved in Q1. Is that still a realistic goal?

Given the softness that we are seeing in the industry and so on, it probably is getting more difficult at this point to achieve that in Q1, but it nevertheless still remains our goal to get there.

I think it's also -- so if Weston, if we see a softening, frankly if we do see a softening in the business into Q1, then what you will obviously see is ways for us to reduce costs within the company. That's an obligation that the company has on an ongoing basis. We don't hide from that. Our employees don't hide from that. We all realize that is a cyclical business and that when company goes through downturns or if the business does soften into the future that the company is obligated to take appropriate actions. And so therefore, if we see that in the future, we are obligated to take action.

Okay. And then just -- I guess one more back to the Accent revenue question. I guess if we had no revenue recognition issues before, could you guide a little bit more clearly what the combined company revenue might be?

No, that's -- as we've said -- John said in his remarks, there are just too many ramifications, too complex, and that's not reality. The reality is that we have these revenue recognition requirements and that's what we are going to deal with.

Okay, great, thanks.

Yep.

Our next question is from Matt Akman.

Hi, yes thanks. You in the past have talked about some target operating model. Based on what you've learned recently as part of this integration process, what's your thinking now in terms of your margins targets for some of the operating expenses?

They remain unchanged.

And what would you say is a realistic timing for getting that?

That's -- well that's depending on where the revenue goes into 2007. So, if we -- so let's say that we had a great year next year meaning that things go up, then we can expect I think in, including the first half of next year, that we should be able to achieve those kinds of targets because the production will be fully moved over, headcount will be reduced. As a result of that, the offshore manufacturing or outsourcing will have taken effect. All the synergies will be realized and we can fully expect that kind of performance. But again, that is dictated by the market and not necessarily 100% by the company. So, the margin means and the model is always based on a good business; if the business doesn't cooperate, then it's virtually impossible to achieve those kinds of targets.

Sure. That makes sense. Alright, thank you.

Yep.

It appears there are no further questions today.

Great, thanks Steven. I appreciate everyone's comments today and questions, and we look forward to a happy holiday season and end of the year, and we will communicate appropriately Q4 results. Thanks for joining us today.

Ladies and gentlemen, this concludes the call, you may now disconnect. Have a good day.