Photronics Inc (PLAB) 2005 Q3 法說會逐字稿

Good morning. My name is Monica and I will be your conference facilitator today. At this time I would like to welcome everyone to the Photronics third quarter call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. (OPERATOR INSTRUCTIONS) Mr. McCarthy, you may begin your conference.

Good morning everyone. My name is Mike McCarthy, Vice President of Investor Relations and corporate communications for Photronics and I would like to thank you for joining our call this morning during which we will discuss the record results of our fiscal 2005 third quarter, which were reported last night. Before we begin I would like to remind all participants about the Safe Harbor statement provision under the Private Securities Litigation Reform Act of 1995, and thus except for historical events the information we will cover this morning may be considered forward-looking and may be subject to certain risks and uncertainties that could cause actual results to differ materially from those projected, including uncertainties in the market, pricing, competition, procurement and manufacturing efficiencies and other risks detailed from time to time in our SEC reports.

This call will remain archived on our website until we report fiscal 2005 fourth quarter results the week of December 5th. Our call this morning will begin with Mike Luttati, our CEO, who will share some brief comments followed by Sean Smith, our CFO who will provide a detailed review of our financial results; after which joining Mike and Sean in the Q&A will be S.H. Jeong, our President of Asia and Chris Progler, our Chief Technical Officer as well as other members of the senior management team.

Thanks, Mike. In taking a moment to gather my thoughts before this morning's call, it is astonishing to think that June 7th was my first day as Photronics new CEO. Since then I have spent initial time becoming better acquainted with the business, key staff members, customers, suppliers, various strategic partners and investors. This has allowed me to gather the necessary input valuable in reaching our near-term goals and in shaping the longer-term strategic plans that the Board and I have established for Photronics. I am pleased that in this short time I have visited most of our worldwide sites, including our greenfield sites in China and Taiwan. We completed a high-profile equity offering, and I have met with several of our leading global customers. I hope to continue this over the coming months.

Through this process I have found the pace and energy of the employees of Photronics to be exhilarating. They share a passionate commitment to customer service and a keen focus on delivering positive financial results. As we look at the opportunities in front of us, I believe these values will continue to serve us well.

Revenue and operating profits for the third quarter reflect yet another record level for the Company. We are energized by this performance and of the great opportunities for Photronics to grow with the market, to take share and to expand into advanced technologies, including our new and rapidly growing flat panel display mask business. Our optimism is reflected in the guidance that Sean will provide shortly. And we will work diligently to meet these expectations; thereby validating the growth potential that we know is out there for us.

My many internal and external meetings substantiate the analysis that near-term the demand for mask technology and services are robust and broadbased. Both from a technology and a geographic standpoint. Design activity is healthy, and more customers are now finding it economical to move toward the 130 nanometer node. In the flat-panel display mask segments, demand is willing at a rate three times faster than the demand for IC masks. As our new facility in Thaichung begins to ramp in early 2006 we have every reason to believe we can grow at least as fast as the market.

Longer-term the three objectives I will be focused on include establishing Photronics as a profitable technology leader, executing on strategic market share growth opportunities and building Photronics into an integrated global company. This will include working with industry partners to identify the best ways to leverage and monetize our integrated lithography playing strategy to provide further differentiation from our competition.

In addition, we will increase our collaboration with strategic customers and suppliers to foster the development of leading-edge technology. But this must be done in a way that generates the necessary returns on invested capital, such that PLAB shares are among the top wealth generators for current and future shareholders. My discussions with customers thus far have been very frank and quite direct. I've been involved with many of these same contacts over the course of my career. They demand service, efficiency and innovation. But those that are most dependent upon advanced design nodes for differentiation, we will continue to be a consistent provider of the imaging technology solutions that are critical in bringing those products from their design teams and into yielded products in the fab.

For our mainstream technology customers we are focused on term times and integrating new enhancement technologies. At our leading-edge customers we are taking on a role of collaboration as Next Generation processes of record are developed. Growth in this segment requires that we invest both early and intelligently in advanced tools and R&D. At 65 nanometer and in Gen 7 flat-panel technologies we have leveled the playing field on which we compete. Our second 65 nanometer line is fully installed, and is well on schedule to begin operation in Korea. Complementing our U.S.-based 65 nanometer capability. Service is now becoming part of this nodes competitive dynamic. Playing into our strengths, Photronics is set to advance forward.

Both the near-term and longer-term goals are, I believe, very achievable. Certainly we will require some flexibility, but this is primarily to seize upon both anticipated and unanticipated opportunities as they present themselves. Such as our recent action of increasing our ownership in PKL. As I have said to employees, customers and investors, this is a great time to be leading Photronics. The environment is right, and our position is getting stronger. In summary, because of the fast turns of our business model, our visibility is short and limited. However, the business outlook is positive. The global demand for the full range of photomask technology, services and products should continue to grow as should Photronics ability to service a larger share of the worldwide market.

I will now turn the call over to Sean after which we will be happy to address your questions.

Thanks, Mike, and good morning everyone. I will provide a brief analysis of our financial results for third quarter of fiscal 2005. I will also review our balance sheet and cash flow during the period and review our outlook going forward. Before we begin I would like to congratulate the entire Photronics global organization for their continued teamwork, dedication and focus in servicing our global customers which has enabled the Company to achieve its second consecutive quarterly record for revenues and net income.

During the quarter our results were impacted by the following items. We completed a secondary stock offering of 8,050,000 shares, raising approximately $163 million of cash which is net of offering expenses. As a result, we experienced a dilutive impact of $0.02 per share related to the additional weighted average shares outstanding from the offering.

We also had an accretive impact of 2.7 million or $0.06 per share related to the favorable settlement of an existing grant obligation, increased investment income associated with the offering and favorable foreign currency gains.

Net sales in the third quarter amounted to a quarterly record of $114.9 million, an increase of 11.2 million or 11% as compared with third quarter of last year. The increase is a result of improved demand for both flat-panel display FPD and IC photo mask. Total sales outside North America, including export account for approximately 72% of third-quarter 2005 revenues compared with 69% in the third quarter of the prior year and 71% sequentially. As a percent of total sales for the quarter sales were approximately 52% in Asia, 32% in North America and 16% in Europe.

Sales of advanced photomasks increased to 22% of total sales during the quarter which amounts to a sequential increase of 12% in absolute dollars. Included in this percentage would be mask sets for semiconductor designs at below 130 nanometer and for FPD sets used to fabricate flat-panel products using G-6 and G-7 technology.

Gross margins for the third quarter was 34.4% as compared to 35.9% in 2004. Sequentially gross margin improved by 40 basis points as a result of an improved high end mix. Selling, general and administrative expenses for the third quarter were 13.8 million as compared to 13.5 million last year. Sequentially, SG&A increased approximately 300,000 as a result of startup costs associated with our China and Taiwan ventures and costs associated with Sarbanes-Oxley compliance. SG&A as a percent of sales was 12% during the quarter as compared to 13% in 2004 and 12% sequentially.

R&D expenses which consists principally of continued development for advanced process technologies were $7.9 million in the third quarter. R&D represented 6.9% of sales in the quarter as compared to 7.3% last year.

During the third quarter we generated operating income of 17.9 million or 15.6% of sales. Sequentially net sales and operating income increased by $2 million and $1.1 million, respectively. The efficiency of our operating model continues to demonstrate significant leverage and is working in accordance with our guidance. Our global team continues to do an outstanding job in matching our cost structure to the changing demand and opportunities in the global market environment. We are intensely focused on improving this metric. Over the next few quarters we will likely experience some moderate fluctuations here as we continue the expansion of our greenfield facilities in China and Taiwan, but these will be short-term in duration and are not expected to reflect a negative change in the fundamental operating model of Photronics.

Net other income or expense for the third quarter was $2 million of income as compared to $2.6 million of expense in 2004. The change year-over-year related to decreased interest expense associated with reduced debt, increased investment income associated with increased cash and improved return, the previously mentioned settlement of a grant obligation and increased foreign currency gains. During the quarter we recorded a tax provision of 3.6 million, which amounts to an effective tax rate of 18.1%.

Net income, of 14.8 million for the quarter represents an all-time quarterly high for Photronics. Net income exclusive of the accretion related to the favorable other income items was 12.1 million for the third quarter of '05 as compared to income of 8.4 million in the third quarter last year. Net income per diluted share was $0.35 for the third quarter of 2005 as compared with $0.23 in the third quarter of 2004.

EPS for the third quarter exclusive of the net accretion of the two items previously discussed, was approximately $0.31 per share. As we exited the third quarter we had approximately 1485 employees, which equates to sales of 309,000 per employee on an annualized basis.

Now let's take a look at our nine-month, year-to-date operating results. Net sales for the first nine months of 2005 were 329 million, up approximately 38 million or 13% from the first nine months of last year. The increase is a result of increased sales at FPD photomask and increased design releases associated with the improved semiconductor market. Year-over-year gross margins decreased by 50 basis points due primarily to the increased costs associated with our expanded manufacturing base.

SG&A expenses were essentially flat at $40 million; as a percent of sales SG&A decreased to 12.2% in '05 compared to 13.8% in 2004. Research and development costs were 23.8 million for the first nine months of 2005 as compared to 22.6 million last year. R&D was 7.2% of sales for fiscal '05 versus 7.7% of sales last year. Our investment in this area are viewed as strategically important to the Company's future growth and ability to provide the innovative lithography solutions required by our customers.

Operating income. For the first nine months of 2005 was 46.2 million or 14% of sales as compared to 36 million or 12.4% of sales in 2004. Net other expense decreased to 3.1 million in 2005 compared with 8 million in 2004 as a result of reduced interest expense, increased investment income and the previously mentioned grant settlement. For the first nine months of 2005 we recorded a tax provision of $8 million, which amounts to an effective tax rate of 18.7%.

Our net income year-to-date amounted to 29.9 million or $0.77 per share compared with 16.6 million or $0.47 per share last year.

Now turning to the balance sheet, cash and short-term investments were 316 million at the end of the quarter, including cash and short-term investments are the net proceeds of the recent secondary offering of approximately $163 million. Working capital at the end of the third quarter was very strong at 351 million, a sequential increase of $148 million. Goodwill increased from year end by approximately 20.5 million as a result of our increased investment during the first quarter in PKL.

At the end of the third quarter our long-term debt including the current portion was $262 million. The principal components of outstanding debt include 100 million, 4.75% convert which is due in December of '06, 150 million, 2 1/4 convert due in April of '08 and approximately $12 million of other term loans. It is our present intention to call the $100 million 4.75 convertible note on or after December 15, 2005, the date at which the redemption price is reduced by approximately $1 million.

Shareholders equity aggregated 557 million which amounts to a book value per share of $13.51. Taking a look at our cash flows, cash provided by operations for the third quarter of 2005 was approximately $32 million. Year-to-date cash provided by operations was 91 million, an improvement of approximately 9.2 million as compared to the first nine months of 2004. Cash flow used in investing activities during the first nine months of 2005 amounted to approximately $113 million, of which 75 million represented capital expenditures and 40 million of the additional investment in PKL. Free cash flows from operations which are net of capital expenditures was 15.5 million for the first nine months of 2005.

Cash provided by financing activities for the first nine months amounted to 113 million, which primarily relates to the secondary offering proceeds offset by the repayment of $56 million in long-term debt. Taking a look ahead, our short-term visibility continues to be limited as our order backlog is typically only one to two weeks. We believe, however, that we will continue to see increased design activity across all technology nodes. We are also encouraged by a number of strategic opportunities that should enable us to increase our revenues through organic growth and market share gains from competitors, including our expanded presence in FPD masks and increased ability to support 65 nanometer development with our second toolset being installed in Asia.

Based upon our current operating model, the outlook for fourth-quarter revenue is to be in the range of 115 million to $121 million. While we're not providing any specific guidance beyond the fourth quarter, I would like to remind the participants in this morning's call that our first quarter which ends in January includes the Thanksgiving and year end holiday periods.

Throughout 2005 we have been selectively expanding our operating infrastructure to capitalize on strategic alliances and opportunities with key customers. As a result, our operating expenses are projected to increase modestly during the fourth quarter of '05 and into 2006. This will have some manageable impact on our meeting our near-term operating margin goal but when evaluated over the longer-term horizon, we believe these investments in the manner in which they are being made will provide a greater stability and diversity in our revenue base. And enable the Company to generate improved return on its invested capital.

As an example, we are very encouraged with our position at 65 nanometers and in the growth in FPD photomask, an area in which we began to invest in over the last two years. CapEx in fiscal 2005 is forecasted to be approximately 110 to 125 million as we invest in capability and customary relationships to enable us to achieve additional growth and market share gains. We continue to expect to fund our remaining 2005 capital expenditures from our operating cash flows.

I would like to emphasize to you this morning that we maintain a significant degree of flexibility in how we invest capital into our organization so that if trends accelerate or decelerate we can move quickly to optimize our competitive position while also aggressively managing our cost structure. At the same time we feel it is important to remind members of the investment community that we see opportunity for growth and are confident that we can increase our market share. Our investment to successfully extend our FPD capability is a very visible example of this strategy.

During 2005 our tax rate will be impacted by the flow of income from jurisdictions which we may have tax holidays or credit and upon our limited ability to recognize tax benefit in areas which we are taxable. Accordingly we are estimating an effective tax rate for 2005 to be in the range of 17% to 20%. For the fourth quarter this will range, this will equate to a range of 2.2 million to 2.7 million in whole dollars. Accordingly based upon our current operating model we estimate EPS for the fourth quarter of fiscal 2005 to be in the range of $0.25 to $0.31 per share.

In summary, I again want to emphasize that although our visibility is short, customer sentiment remains positive. The global demand for the full range of photomask technology, services and products should continue to grow as should Photronics ability to service a larger share of the worldwide market. That wraps up our prepared remarks. We would now like to turn the call open for questions.

(OPERATOR INSTRUCTIONS) Suresh Balaraman of Think Equity.

In terms of your October, how do you anticipate the (indiscernible) and your advanced 130 nanometer or 90 nanometer segment to trend up sequentially? Can you also give us some color on how flat-panel business is progressing beyond just Korea? Thanks.

Let me start, then I'll ask Sean to help me out on some of the detail in the percentages. But we've been increasing our mix of high-end product 130 nanometer and below and the Gen 6 and 7, and Gen 8 products going forward. So we expect to see an incremental increase going into our October quarter. I think we moved from about 20% to 22%, and we expect that will continue to increase and probably at an advanced rate, we are seeing 130 take off. The Taichung facility which will come online in first-half of '06 will help us further certainly in expanding our business in Taiwan. We are starting -- we are still getting some business from Taiwan, which we are sourcing out of PKL at the present time.

Is it possible for you guys to give a more color on how much, what percent of your revenues come from 130 nanometer IC business? I know you guys used to give that, but now it is lumped along with the flat-panel segment.

For competitive purposes as a result of Photronics being the only stand-alone publicly traded entity, we are not disclosing the specific percentages, but what we can say is that both our 130 and below revenue and our flat-panel G-6 and G-7 increased sequentially quarter-over-quarter, and we do expect that trend to continue throughout the fourth quarter.

Tim Arcuri, Citigroup.

I actually have several questions. The first question is can you give us some idea of the $2.7 million sequential uptick in leading-edge revenues, how much of that was due to flat-panel?

As I mentioned just previously for competitive purposes we will not be breaking that out but what I can tell you, though, that our flat-panel business did grow again sequentially, which I believe was the seventh consecutive quarter, which is a good indicator for us.

So you could say that much of the uptick was from flat-panel?

I see revenue also increase sequentially.

Okay, so it's both?

At the end that is high-end.

I think the design cycle for the higher end technology is fairly strong as well, so I think it is a positive trend. And we are improving our qualifications with 90 nanometer and we are on schedule for a 65 qualification this year. So I think the vector is very positive for us.

Maybe one for Mike. Mike, coming from the equipment world, I seem to remember that if you look at the mask cycle that typically you see photomask revenues peak some period after equipment revenues peak, be it six months, be it nine months. In your early analysis that is kind of the mask business versus the equipment business, is that accurate? And does that kind of concern you that maybe we are getting a little peaky in terms of the mask cycle?

No, in fact it's interesting, the thing I have observed is that there is no direct correlation between the equipment buying cycle and the mask order cycle. In fact, it is so heavily driven by design takeout and design iterations that it is really decoupled. It's interesting coming into the fourth quarter I think if you remember of last year, many of the foundries had guided their utilization rates down and we in fact started to see increasing orders for tape outs and we are starting to -- the few customers that I visited over the last couple of months have indicated increasing design tape outs in the coming months. So we are very much feeling like we are not peaked out here, that there is plenty of growth opportunity for us. Coupled with the fact that as the industry has consolidated there is market share opportunity for us to gain, so we get sort of a double, I think a double advantage point here.

Maybe one more for me. You know, you are kind of talking -- it seems like there was a pushout in Europe, yet the guidance is below normal seasonality. Is that just for the Europe piece go away or is that not the right way to read it?

No. We had an equipment issue at the end of the quarter that unfortunately in most circumstances we would have potentially moved the product to another site but it was too close to the end. I will just say that it wasn't substantial, but it was enough to -- we were hoping that we could hit more of at the higher end of the range, and we would have, but we are not concerned about it. The issue has been resolved, and we are very optimistic about the current quarter.

But that piece of business basically is gone?

No.

Okay, so it is going to book in the October quarter?

Yes, it will.

Robert Maire with Needham and Co.

(inaudible)

Bill Ong, American Technology Research.

Just a couple questions. If you have to push out the European business into the October quarter, I guess if it had not occurred you probably would not essentially be sequentially down in revenues for the October quarter? And I have a couple of nonoperational questions, maybe some insight in terms of interest income going forward as well as minority interest.

First, we guided 113 to 118 for the current quarter. We hit at 115, roughly, so we are very near the midpoint. There was a little upside that we had that will go into the fourth quarter, and our guidance for this quarter is up from 115 to 121. So I'm not sure I understand the point, but that is sort of where we are at. I'm sorry I didn't get the second question.

The second question related interest income and minority interests, some insights just given that you completed the PKL as well as paying down some debt.

I think going forward with looking at our net other income, other expense line item with the impact of investment income and exclusion of the onetime items this quarter, it should range anywhere from expenses say 400,000 to expense of $1 million in that bandwidth for the next quarter. The minority interest line on August 5th we put out a press release saying that we announced the tender offer to acquire the remaining shares of PKL. That is in process; I can't comment any further on that because that is -- there is nothing more to say -- we're not sure how that is going to turn out. So I would not be at liberty to say that minority interest line is going to move or not.

And I just want to follow up on the revenue shortfall, just rough numbers, let's say instead of 115 maybe you hit 116. With that I meant by your guidance October within maybe 114 -- maybe I am being too fine a point to the revenue discussion.

Maybe I can add a little color to this, Bill. We get orders in on a daily basis. And to the extent we don't have a tool line running we may or may not be able to recover that order. So while we hit 115 in revenue we did have the opportunity to dip slightly up, we were in the range that we had forecasted. We feel very confident about the forecasted range for the next quarter. And it is just part of day in, day out business here. We have got to make sure that we deliver and execute on every order that comes in the door, and --.

And it is one of the reasons why we give a wide range, because of that variability.

Okay, great. Appreciate the color.

Matt Petkun of D.A. Davidson.

Mike, kind of a follow-up to a previous question. We've seen and it's hard to draw direct corollaries but sometimes during periods of rising capacity utilization, actually a fall-off in tape outs only due to the fact that there is just not a lot of capacity to run the designs, and actually in some cases as you pointed out when capacity utilization drops there is some room for designs to come into the market. So do you expect that at least in theory we could see if we see rising capacity utilization a bit of a slowdown in the mask growth rate until new capacity comes on line?

Well we don't really -- it's hard to say. As I said earlier, the few customers that I've talked to and sort of getting calibrated with my team here, the feedback we are getting sort of on the street is that the design activity is still very strong. It is projected to remain strong and certainly into the October quarter. Our visibility beyond that is a little bit limited, but I don't know if there is maybe anyone else has any color on the correlation between capacity utilization or not.

I think the utilization is very high in wafer fabs, you might conclude there is no room for new designs, but I think at this point yields are pretty solid at 130 and even 90 the yield, the design confident is pretty high. So companies are refreshing fabs with new designs even though they are fairly highly utilized. So I think to some extent this utilization and tape out trade-off is a bit node and yield dependent. I think overall the confidence is higher in the industry now for design cycles and yield ability so people are refreshing designs and fabs even though the utilization is high.

Thanks, and then Chris, a follow up for you, we haven't really been discussing some of the new technology trends in the mask space. What are seeing from your customers as you look at your qualifications in 90 and 65 in terms of OPC and phase shift mask type technologies? How is that impacting your yield, and how is that impacting your opportunity to raise ASP's?

I think as we had expected very heavy dependence on resolution enhancement technologies, OPC and the traditional things that started at 130; we are just seeing more use of the same 90 and 65, not a lot of fundamentally new resolution enhancement methods coming in. So we have good skills and competencies in building those masks and what we are seeing now is refinement of existing OPC methods. So we think the technology we have is adequate to serve the needs for 90 and 65. Moving beyond that, it seems to all be around 193 (ph) at continued extensions of many of the same methods. So I would say continuous improvement as opposed to something very disruptive or new.

You are seeing more OPC than phase shifting?

Definitely OPC is pervasive, 90 and 65 very, very pervasive, no question about it. It is a key part of lithography solutions. Phase shifting as well is used selectively, so-called strong phase shifting is used in a more limited way, but OPC is pervasive, no doubt about it.

And the increased OpEx that Sean was mentioning, how much of that is going to be allocated to R&D? And really you guys are flat almost with a year ago in terms of your absolute R&D spend. Where should we see it a year from now?

I think we are going to continue to invest in R&D, Matt. The gentlemen to my right, Chris, is lobbying for additional funds, obviously. But that is part of running the business we want to make sure that we maintain our operating margin target. And it is something we discuss, we certainly have improved significantly the quality of our R&D spend, which is benefited us and helped us penetrate at 65 and 90. So we are going to continue -- you will continue to see dollars spent there as we move forward. I don't believe, and Chris can back me up on this, we're missing any opportunity because we're not funding it.

Well, I don't think so. We have very tight customer alliances this time around on the leading-edge nodes. So we believe we are covering the bases, and I think particularly for the 65 lives in Austin and PKL, we are in good shape there. The equipment is in. We have capacity and the technology is coming on line. So I don't have any concerns to be able to meet the needs.

You announced the Freescale relationship. Are there other type alliances you want to specifically mention?

There are others. That is one we have had for quite some time. They've been a really supportive customer on the technology side for us. We have done a lot of good work with them. The model we deployed with Freescale and how we interact with customers on the leading edge. we are using that same model to interact with other customers in the same space. So it was a good learning experience for us. We are taking advantage of that with other customers, as well.

Mark Fitzgerald of Banc of America Securities.

Given the shift to the more advanced masks here, I am a little curious why gross margins haven't moved more at this point. Is that just a utilization issue, or what's going on there?

No, we did see some sequential improvement in our gross margin, but we are adding additional infrastructure to our operating model, additional tools came on line during the quarter and the related equipment expenses did drive up some of our costs. So we do expect to see our gross margin to improve sequentially, to continue to improve sequentially.

So ASP's were definitely up for the 130 or the mix of ASP was up?

I can't say our blended mix is ASP. We don't quote specific -- tech nodes was up quarter-over-quarter.

Okay. How is the margin impact from the flat-panel business? Is that typical for the semiconductor mask, or is it above or below?

The target margin for FPDs is equivalent to the IC. While you have increased material costs, you have decreased labor and decreased tooling. So all in, it should be the same. And I can't say that our FPD masks are -- the gross margin on there has improved again sequentially.

One final question. Given the guidance for the fourth quarter, can we assume gross margins are going to be up again slightly here?

I would assume or I would project that we should see some sequential improvement in growth and operating margin based upon the guidance that we're providing.

Okay. Then one final question; with the buyback of the convertible, I'm not sure if you bought some of these back already, but how much money have you got to outlay to do this and what is the impact from your interest income for -- I assume that happens in the April quarter?

Our $200 million -- previously outstanding 200 million 4 3/4 convert, we've bought back $100 million of that over the last year or so. We -- in my (indiscernible) announced that our intention is to buy the remaining piece back in December when the premium drops by approximately $1 million, and it has an effective rate of about 5%. So you can run the numbers and see that it would be accretive once we do buy that back. We certainly aren't earning 5% on our investments as we speak today.

And that would be done by the end of the January '06 quarter?

Our current plan today is to do it in the first quarter of fiscal '06, yes.

Okay. Thank you.

Philip Lee, J.P. Morgan.

Hi, guys. Generally at the end of the year, you guys normally see a sequential decline in your revenues of about 3 to 4%. And would you expect to do significantly better than that this year, given the ramp of the 65 nanometer in Korea, Shanghai and where we are in the cycle?

We aren't providing any specific guidance related to the first quarter. We are optimistic with our increased penetration with certain accounts in our advanced tool offerings, product offerings. But we will be providing our guidance once we close the fourth quarter in our December conference call.

One other question on gross margin leverage. The incremental gross margin leverage has been in the mid '50s the last two quarters. Do you expect that to stay the same for the next two quarters or go down slightly as you ramp up the other facility?

What we focus, Philip, is on our incremental operating margin leverage, and we target it to be about 50%. This quarter we're a little bit over that. But we won't -- as we put additional cost into the system that is going to put some pressure as I mentioned in my text, but our target is still on the 40% to 50% range.

For operating margin leverage?

For operating margin.

Brett Hodess, Merrill Lynch.

Two questions. First, I just wanted to on the Freescale partnership that you announced for 65 nanometer node, I believe when Freescale is Motorola they were working with one of your competitors in the leading-edge line at that competitor. So does this signal some increased share at the leading edge? Although I know you had a long relationship with the predecessor company. And then the second question, when you look into the first quarter where seasonal, you see the dip in revenues, your comments on the operating expenses, would you expect operating expenses to continue to grow because of the expansions, or would they take some dip if you had a seasonal dip in revenues in the first quarter?

I can take the first part of a question, I am not going into too much detail, I think definitely you can interpret the relationship we have with Freescale is also an improvement of our market share at the leading edge for their tape outs. That's a very tangible benefit of that work. And I think it has at the expense of our competitors.

With respect to our operating expenses in the first quarter, why we are not providing any specific guidance. As we do add additional cost to our infrastructure the management team is tasked with pulling out other costs or reducing some costs. So if we do see a seasonal dip we will be tasked with and I'm looking at Mike as I speak to maintain the integrity of our model. So we will be doing whatever we can to maintain our leverage within our models.

Gus Richard, First Albany Capital.

First housekeeping question, any 10% customers in the quarter?

We disclosed, Gus, our 10% customers on an annualized basis. We had one last year, or over the last two years. And we will be updating that as we conclude our annual disclosure requirements.

Okay, and then a little bit more detail on question on the depreciation expense going forward. You started to install tools in your two new lines, it sounds like. How should think about the increase in depreciation relative to this quarter going toward the next couple quarters as those lines come on?

We should see our depreciation start to ramp up maybe $4 to $600,000 per quarter. The ironic thing is as we add tools into our system we have older tools that are dropping off. So when you look at the depreciation line you may not see year-over-year a significant increase. But where we are experiencing some additional costs related to our equipment it's embedded in our cost structure is on the maintenance side of these tools, keeping these tools up and running.

Okay, and just to circle back on the tool down in Europe, was that -- I'm assuming it was in Ebeam. Any more color and what the issue was and --.

We really don't want to go into a lot of detail on it. We just had a tool issue that was an unexpected problem. It has been resolved, and we don't want to sort of aim at where it is. But that had an impact, and it has been corrected and we feel like we are in okay shape. It is not something that is uncommon to happen in this area.

Just to remind everyone, too, we had a very, very successful quarter. We improved sequentially in our top line, our operating margin, our bottom line; we improved our balance sheet and we expect to see that continued growth move into the fourth quarter. So the management team is very excited about what we did during the quarter, and we are very optimistic about our prospects during the fourth quarter.

Stephen Chin, of UBS.

I wanted to ask about lagging-edge photomask. If we look at those sales, the 130 nanometer photomasks and above, sales have been relatively stable in the high $80 million per quarter range. Should we expect lagging-edge photomask to be (indiscernible)business to stay in this range going forward or do you still expect there to be growth in this segment? Thanks.

We expect that there will continue to be growth. We know we are gaining share as part of the consolidation that has occurred with our competition. Certainly in North America and Europe. And so we expect that to continue. That business is pretty stable from a volume point of view. At least projected to be pretty stable over the next several years. So to the extent that we can continue to capture and hold those accounts with the superior service that Photronics has provided for those customers, we think that is a solid base on which we can build. And again, those facilities and high utilization rates generate significant operating leverage.

Okay. Thanks. The second question I had it is in terms of sales by geography, would you expect Europe to trend back up to its normalized level into the high teens next quarter? And would you expect to see any other geographical shift in October?

We're not going to provide at this time any specific regional guidance, but we do expect I think over the longer-term our Asian business to continue to increase.

Okay. Thank you.

Kevin Vassily, Susquehanna Financial.

A couple or actually a question continuing on the earlier questions over on the correlation between fab utilization, design activity. I was wondering if you guys are starting to see any kind of evolving pattern developing on those dynamics in the FPD business for you.

You're particularly speaking to the same question related to masks or flat-panel displays if there's a correlation between, let's call it design activity, if you will and highly utilized flat-panel tests?

Yes, and maybe those aren't the right metrics to look at, but how you would characterize, how the design activity cycle seems to be evolving in flat-panel relative to kind of what you see historically in the IC business?

I can make a few comments and then maybe pass it to S.H. Jeong. I think that design drivers are a little bit different for flat-panel masks, they are related to peripheral circuitry, form factor of the display and of course, the evolution of the substrate size. So there are some similarities but some differences, as well. How that correlates in timing to utilization in the factories, I think I will let S.H. make a few comments on that.

Design change from the customer is mainly from a function, (indiscernible) their function for example their angles to see the display and I think that is the main design change (indiscernible). But compared to IC design changes are not very much but they need a new device anyhow. So but that is the main I think growth from (indiscernible) masks and also size is also the other growth for the (indiscernible).

Chip (indiscernible) of FM Global.

A couple questions, if I could. First, I just wanted to start with the accretion you listed of $0.06. Is that all in the other income line, and can you break that out so I can get some clarity on your true operating earnings?

Well, the $0.06 is all in our other operating line. So that our non operating line is below the operating income line. It is primarily consisted of a settlement of a grant obligation. Some increase in investment income related to the additional cash we had as opposed to when we announced that back in the middle of May and some favorable FX gains and some other small items. So the $0.06 I believe I would say was $2.7 million in absolute, is something we hadn't forecasted when we announced our guidance in May.

Okay. I understand that; I was looking for particular granularity there like how much was the obligation grant, etc. I guess specifically I wanted to know that.

What I can tell you is the grant obligation was the largest piece of that breakdown.

Okay. And then the other two factors were maybe equal in size?

No, they were of less importance, but they -- you know, we had an additional 163, $164 million of cash for a month that we didn't bake in there. You can --.

I understand that, I just needed the grant particularly. Okay. With the revenue guidance at the low end, you guided at 115, which would be essentially flat. Yet at the low-end EPS you would be below I guess operating earnings of somewhere between $0.29 and $0.31 this quarter depending on how you look at it. Can you help me reconcile how you get to that lower EPS? Is it coming out of gross margins or are we seeing what exactly is going up in the expense areas?

I did mention we would see some additional costs coming on, but the primary driver if you're looking quarter-over-quarter from our guidance at the low-end, is related to the additional shares, the full impact of the 8 million shares being outstanding for the quarter. As opposed to I believe in the third quarter calculation it was only 2.3 million weighted average. So primary driver of that drop in EPS.

Okay, and nothing to note then on in the gross margin area or in OpEx?

Just to refer back to my previous comments, we will see some additional capital come on line; we will see some additional costs that are controllable. And as we pull additional costs into the structure we are looking to remove other costs to maintain the integrity of our model.

Okay, and just on your guidance again, so despite some of these investments, then, I guess you still feel that you might not be too far off your kind of, off the mark or where the street was expecting you to be right? You still guided to at the high end hitting around 120 and EPS going up here. So if things go well in the quarter you are kind of on plan prior to some of these investments?

Our guidance, as I said earlier, for Q3 was 113 to 118. We hit about midpoint at 115, we feel very good about that. As I said, our only disappointment is we thought we could've done a little bit better. But yet we had a record quarter, and we are really pleased with that and our fourth-quarter outlook is above that. So we're going to drive the execution, the service as we talked about -- our visibility unfortunately based on the backlog and lead time is limited. So we can't and that is the reason we give the range, but we're going to be inside of the guidance and we're going to drive to perform as we have in the past.

Okay, and then you guys talked about some share gain coming from consolidation within the mask industry. Can you talk any more, give any more color on qualifying customers or second sources and then are you seeing any volume ramp from that at this point, or is that still too early?

It is a combination and the mainstream sector, the 180 and above, what you typically see as these customers as they will have two, at least two sources. And the mix could be one, I believe 70% and the other (indiscernible) its 30 or 60 40. We clearly have indications of customers where we have seen our percentage shift to the leading percentage, and our goal is to keep that and hold it and continue to grow it. But we are also making progress as Chris mentioned in the advanced nodes as well. So there's really not much more I can say without giving any sort of competitive advantage away to what we're trying to do here. But we are very optimistic about the marketshare opportunities we see in both the IC mask business and the flat-panel business.

So you like your competitive position right now?

Very much, we are very excited about it.

And just one last question, thank you, the flat-panel business is a new one for you, and if you can give any color on the seasonality of that business, is that going to be off next quarter, should it be seasonally stronger next quarter, anything around that would be helpful.

Yes, seasonally I think mostly from very active in from June and April time period. But at this moment total demand is very, very high compared to what our capacity. So I don't see any soft (indiscernible) for our revenue for (indiscernible). We are still growing more and (indiscernible) growth rate is much, much higher than IC.

If I could just add to that, I think the seasonal effect is offset by our ability to gain share. And so we are seeing growth while perhaps others even in a seasonal period might not.

And did I understand right now you are somewhat limited in capacity in that business?

No. We're not limited in capacity.

Okay, all right. Thank you for the questions.

At this time there are no further questions. Mr. McCarthy are there any closing remarks?

I would just like to thank you all as I mentioned, just to put an exclamation point on the comments that we've made. We are really please with the performance the Company had in the third quarter. Our outlook is optimistic. The management team is committed, and we look forward to talking to you again in December. Thank you.

This concludes today's conference call. You may now disconnect.