Veeco Instruments Inc (VECO) 2005 Q3 法說會逐字稿

Good day, everyone and welcome to the Veeco third quarter 2005 results conference call.

As a reminder, today's conference is being recorded.

For opening remarks and introductions, I'd like to turn the conference over to Senior Vice President of Corporate Communications and Investor Relations, Ms. Debra Wasser, please go ahead, ma'am.

Thank you, operator and thank you all for joining this morning's third quarter results conference call.

Joining me today are Ed Braun, our Chairman and CEO, and Jack Rein, our Chief Financial Officer.

Today's news release was distributed at 7:00 a.m.

Eastern Time this morning.

If you haven't yet seen the press release, please visit the Veeco.com website or call 516-677-0200, extension 1403 to get a copy.

We've also created a PowerPoint presentation to accompany this conference call, which can be found on the IR page of Veeco.com.

This call is being recorded at Veeco Instruments and is copyrighted material .

It cannot be recorded or rebroadcast without Veeco's express permission.

Your participation implies consent to our taping.

To the extent of this call discusses expectations about market conditions, market acceptance and future sales of the Company's products, future disclosures, future earnings expectations, or otherwise make statements about the future.

Such statements are forward-looking, and subject to a number of risks and uncertainties, that could cause actual results to differ materially from the statements made.

These factors are discussed in the business description and management's discussions and analysis sections of the Company's report on Form 10K, and our Report to Shareholders.

During this call, management may address non-GAAP financial measures, information regarding such non-GAAP financial measures, including reconciliation to GAAP measures and performance is available on our website.

This call is being webcast live at the Veeco.com website, and will be available for replay, and archived for future reference.

The Company does not plan to update the information on this webcast once it has been archived.

I'd like to turn the call over to Ed.

Thank you, Deb.

Good morning.

Today we reported positive Veeco Q3 results with revenue of $100.1 million, gross margins of 44%, EBITA of $8.3 million, and EPS excluding amortization of $0.14, all above our prior year, at or above the guidance and on-track with our multi-quarter profit improvement initiative that Deb spoke of, on the website.

Bookings of $84.6 million were above the prior year, but below our guidance and below the prior quarter.

We forecast that the Q4 orders will be up over 10%, and will be in the range of 90 to $100 million.

We expect Q4 performance to continue tracking our 2 point per quarter improvement to gross margin and EBITA , that's the initiative that we announced at the beginning of the year.

Overall 2005 Veeco results are forecasted to be in line with the financial model posted on our Investor Relations page at Veeco.com, and shows an increase of 2% per quarter to gross margin for each quarter of '05, and EBITA improving in '05 roughly 2% per quarter.

And ending in Q4 at a 46% gross margin and a 10% EBITA .

And that was the original model presented in the first quarter that I will review with you shortly.

The model developed back in the first quarter provided an unusual amount of visibility and detail, both in revenue by business segment and gross margin by business segment, and in the improved gross margin and EBITA by quarter.

I will refer to it in my remarks, and this quarter marks the fourth consecutive quarter of improved gross margin, and EBITA has improved in each quarter of 2005, per this plan.

To further highlight the third quarter results, again, revenues were up 3% to a little over $100 million, from $97.4 million in the third quarter of 2004, and in line with Veeco's guidance of 95 to $105 million, down 3% sequentially from the second quarter.

Net income was $1.6 million, $0.05 per share on a GAAP basis, while earnings excluding certain charges were $0.14 per diluted share, at or above Veeco's guidance both for GAAP and for earnings excluding amortization.

Veeco's gross margins were 44.2%, slightly above Veeco's previously-announced gross margin improvement plan, and 8 percentage points above the prior year 36.4%, and 2 percentage points above the prior quarter, which came in at 42%.

Bookings were $84.6 million, up 6% from the prior year.

But 29% down from a very strong $118 million second quarter, and bookings were below our guidance of 95 to $105 million, but expecting to be up 10% in Q4.

I would also comment that our six-month running rate of bookings is $100 million per quarter, $118 million and the $85 million.

I commented in this morning's release that we are pleased that Veeco's third quarter profitability improved significantly, consistent with our previously-announced gross margin and EBITA improvement initiative.

This was the fourth consecutive quarter of gross margin improvement, while EBITA has improved in each quarter of 2005.

Our third quarter EBITA was $8.3 million, up 36% sequentially, and significantly higher than the 800,000 reported last year.

For the nine months, Veeco's EBITA is up 62% on relatively flat revenue, revenue was up 3%.

So, the cost containment initiative is very evident.

Also notable in the quarter, our Metrology revenue increased to a record $50.7 million, up 20% sequentially at a 53% gross margin, a result of increases in auto AFM, in research AFM, and in optical Metrology product sales.

I'd like to spend a moment to review the financial model, and if I can turn your attention to the three to four pages on the website, referred to as Veeco's 2005 Financial Model, you can see progress against the original plan, both in revenue, in revenue by business segment, in gross margin by business segment, and EBITA improvement per quarter.

So, on the page labeled page 2, the black figures are the original plan, and the red figures are the Q3 update.

And this page provides you with detail in Veeco's revenue this year by business segment.

So, you can see against the original forecast that Ion Beam and Mechanical equipment would rise from $134 million last year to $158 million, we now expect that it will be $160 million, up 19%, largely on the strength of strong consumer electronics in data storage.

Our Epitaxial equipment, MOCVD, for blue, green and white backlighting, which was $93 million last year, was projected to decline 27% to $71 million, and we currently think it will decline a little bit more than that to $60 million, off about 36% from prior year.

And Metrology was $163 million last year, we had expected it to grow 3 to 5%.

It appears to be growing about 10% to an expected $180 million level and auto AFM, itself, is up -- will be up 25% for the year, and revenue was up about 45% currently in the nine-month period, along with some growth in optical Metrology.

So, overall, you can see that the expected 390 to $400 million in revenue is being met.

We're looking now at about a $400 million revenue expectation, up 3%, in line with the plan.

And I would comment on this page that this revenue mix, as we predicted earlier, favors higher gross margin products, in that the Ion Beam business and the Metrology business are outgrowing LED, and you can see that in our improved gross margin.

I would comment that our early view of '06 -- and this is not yet guidance, I would wait until the end of the fourth quarter to actually give formal guidance for '06, but our early view of 2006 is that we would see continued consumer electronic growth in data storage, driving that business segment up probably another 10%.

We would expect that blue and green and white backlighting and LED recovery would occur in '06, and we would anticipate a 20% growth in our MOCVD sales in '06.

In Metrology, new products in research and auto AFM, and the further penetration of 70-nanometer in semiconductor, and the use of auto AFM in data storage, would allow that sector to grow another 10%.

So, in all, we probably expect something about 10% in revenue growth for Veeco in 2006, supported by very strong influence of new product introduction, that we'll speak of later.

On the page 3, you can see for those same business segments, the gross margin improvement by business segment, ending the year with what was to be an expected 42% gross margin in Ion Beam, a 30% Epitaxial equipment gross margin, and 53% Metrology margin, for a blended margin in the 43 to 44% range, and you see next to it in red, that we currently expect 43 to 44% gross margin, with 42% in Ion Beam, right on target.

Epitaxial equipment, 20% gross margin, lighter than the expectation.

And Metrology coming in right at the expected level of 52 or 53%.

Because Ion Beam revenue and Metrology are higher than the original plan, we are hitting the target for the blended total Veeco of 43 or 44% with the fourth quarter expectation being something between 45 or 46%, most likely 46%.

So, good margin improvement in two of the three businesses per plan, and the revenue mix allowed us to hit the total gross margin expectation for the year.

And on the fourth page, you see now gross margins per quarter and EBITA per quarter, and you can see we've hit exactly the gross margin, 40, 42 and 44% expected in the first three quarters, and we are forecasting hitting the fourth quarter at 46%, as well.

EBITA has tracked or exceeded the plan. 2.8% in the first quarter. 5.9% in the second quarter. 8.2% in the third quarter.

So, controlled operating spending has pretty much let the improvements in gross margin fall through to the EBITA line, and we're looking for a 46% gross margin in the fourth quarter, and a 10% EBITA as a result of this initiative.

So, you can see that -- essentially, the EBITA for the year will have nearly doubled from $13.9 million in 2004, to something between 27 and $28 million now projected for 2005.

And I would expect that these improvements would continue into 2006.

So this plan has turned out to be a useful way for you to track Veeco revenue per business segment, as well as profitability per business segment.

I commented earlier in the press release that Veeco is clearly seeing the benefit of improved gross margin and revenue growth in the Ion Beam and Metrology business segments.

We've experienced significant revenue increases in the nine-month period in data storage, which is up 31%.

And in semiconductor, which is up 19%, which were offset by a 37% decline in LED/Wireless as expected.

And it appears that LED/Wireless has bottomed.

Veeco's data storage order growth, which is up 54% for the nine-month period, reflects continued market penetration of small format hard drives as embedded high density storage in emerging consumer applications of PVRs, DVRs, set-top boxes, information appliances, video iPODs, photo printers, high-end digital cameras, and cell phones.

Industry unit growth of these consumer devices is forecasted to be 60% this year, and consumer electronics will represent about 18% of total hard drive shipments this year.

Within Veeco data storage, orders -- we see a continuation of both capacity and technology buys, which benefit our broad line of Ion Beam, Lapping, Precision Saws, and Metrology products.

We expect continued technology spending associated with the introduction of perpendicular recording, small form factors of Femto, the next small form factor head, followed by the anticipated introduction of 200-millimeter wafer size in data storage.

Currently orders are largely capacity, about 75% of our data storage orders are capacity buys, in response to high factory utilization rates, and 25% of our buys seem to be technology investments.

I think I'll pause here and let Jack review the Q3 financial results, and then I will come back, and comment further on market sectors and take your questions.

Jack?

Thank you, Ed.

Good morning.

For the three months ended September 30, 2005, sales were $100.1 million, an increase of 3% versus third quarter 2004.

The increase is attributable to a $17 million increase in Metrology products, including $9.9 million in Atomic Force Microscopes, and $7.1 million in optical Metrology instruments, as well as a $9.1 million increase from Ion Beam and mechanical products.

Partially offsetting these increases was a $23.4 million decrease in Epitaxial equipment.

By market, sales were up compared to the prior year by 85% in data storage, 18% in semiconductor, 11% in research, and down 73% in LED/Wireless.

Sequentially, sales decreased by $3.3 million, or 3%, primarily due to an $11.7 million decrease in processed equipment, partially offset by an increase of $8.4 million in Metrology products.

Third quarter 2005 orders increased to $84.6 million or 6% from the third quarter of 2004, but were down 29% sequentially from the second quarter of 2005.

The third quarter '05 orders were made up of $33.6 million from data storage, 25.1 from scientific research, $14.6 million from LED/Wireless, and $11.3 million from Semiconductor.

The book-to-bill ratio was 0.84:1.

Historically the September quarter has been the lowest order quarter for each of the last five years, mostly attributable to vacation shutdowns at many of our customers.

Gross profit was $44.3 million for the quarter or 44.2% of sales.

Compared to $43.4 million or 42% of sales for the second quarter of 2005, and $35.5 million or 36.4% of sales for the third quarter of 2004.

The sequential increase is due to a high concentration of Metrology sales, which have higher gross margin.

Metrology sales were approximately 51% of total sales for the third quarter versus 41% for the second quarter of 2005.

This represents the fourth consecutive quarter of 2% sequential increases in gross margin as Ed has noted.

We achieved gross margins of 52.6% in Metrology, compared to 49.5% in the third quarter of '04.

And 41% in IMB Mechanical compared to 34.8% in the prior year quarter.

So, good improvement in both of those segments.

The Epitaxial equipment business saw a decline in gross margins to 14%, compared to 24.7% in the third quarter of '04.

Due to a 70% sales volume decrease.

Gross margin should improve in the Epitaxial business in the first half of '06, as volume increases with the introduction of the new [Gant] products.

We are continuing to focus on gross margin improvement, and the Company's fourth quarter '05 gross margin target is 46%.

SG&A was $21.2 million or 21.2% of sales, compared to $19.6 million or 20.1% of sales in the third quarter of 2004.

The increase is mostly due to higher legal and insurance costs, as well as accrued bonuses.

SG&A was down $800,000 sequentially, principally due to lower selling and commission expenses resulting from the decrease in sales.

R&D expense totalled $14.4 million, a decrease of $500,000 from the third quarter of 2004, and sequentially down $1.5 million, largely due to spending reductions in the Epitaxial division.

As a percentage of sales, R&D was 14.4%, compared to 15.3% in the third quarter of 2004, and 15.3% in the second quarter of 2005.

Overall operating expenses decreased sequentially by $1.4 million to 36% of sales.

This compared to 35.6% in the third quarter of 2004.

We expect operating expenses to decrease 1% as a percentage of sales in the fourth quarter of '05, but to be up approximately $1 million due to bonus accruals.

We are reducing our September 30 '05 employment level by 5%, which will result in an approximately $1.2 million charge in the fourth quarter of '05.

Many of these reductions have already occurred.

Amortization expense totaled $4 million in the fourth quarter of 2005, versus $4.3 million in the third quarter of 2004.

Net interest expense of $1.8 million was unchanged from the comparable 2004 quarter.

Third quarter operating profit before amortization totaled $8.3 million, compared with $800,000 in 2004.

This improvement is the result of the improved gross margins in Ion Beam and Metrology, Veeco achieved third quarter 2005 GAAP net income of $1.6 million, or $0.05 per share, compared to a net loss of $2.2 million, or $0.07 a share, in the third quarter of 2004.

Earnings per share excluding amortization expense for the quarter was $0.14 compared to a loss of $0.02 for the 2004 third quarter, utilizing a 35% tax rate.

Street consensus was $0.12 for the third quarter of 2005.

For the nine months of 2005, sales totaled $297.3 million, or a 3% increase from the 2004 period.

Due primarily to an increase in $19 million in Metrology sales, and $10.3 million in Ion Beam and Mechanical equipment sales, which were partially offset by a decrease in Epitaxial equipment sales of $19.4 million.

The nine-month sales of $297.3 million were comprised by market as follows: Data storage, 41%.

Scientific research, 28%.

Semiconductors, 16%.

And LED/Wireless, 15%.

For the nine-month, orders were $302 million, comprised of 46% from data storage, 25% in scientific research, 15% semiconductor, and 14% from LED/Wireless.

The book-to-bill ratio for the nine months was 1.02:1.

Gross margin for the first nine months of 2005 was 42.1% of sales, up from 39.9% for the first nine months of 2004.

Excluding a $1.5 million purchase accounting adjustment recorded in the first quarter of 2004.

As a percentage of sales, SG&A has decreased to 21.1% from 21.3% in 2004, but is up up $1.6 million when compared to the first nine months of 2004.

R&D expense totaled $45.1 million, an increase of $1.6 million from 2004, due to an increase in product development in Ion Beam and Epitaxial equipment, as well as the MTR acquisition in October of 2004.

As a percentage of sales, R&D has increased slightly to 15.2% in the first nine months of 2005 from 15.1% in 2004.

Amortization expense totaled $12.6 million in the first nine months of 2005, compared to $13.8 million in 2004, as a result of achieving full amortization in certain intangibles.

Net interest expense totaled $5.9 million, compared to $6.2 million in the comparable 2004 period.

EBITA was $16.9 million, compared to $10.5 million in the first nine months of 2004, which was a 61% increase.

Veeco's nine-month 2005 GAAP net loss was $3.6 million or $0.12 per share, and has been reduced compared to the net loss of $6.5 million or $0.22 per share, in the first nine months of 2004.

2005 year-to-date income tax expense of foreign taxes totalled $2.1 million compared to an income tax benefit of $4.5 million recorded in 2004.

Earnings per diluted share, excluding certain charges for the nine months of 2005, were 24%.

Compared to $0.09 in the first nine months of 2004.

The charges excluded from this calculation are amortization, severance and 2004 acquisition costs, utilizing a 35% tax rate.

Backlog at September 30, 2005 was approximately $132 million.

With regard to guidance, we are currently forecasting fourth quarter revenues in the range of 100 to $105 million, gross margin of 46%, and earnings per share between $0.03 and $0.09 on a GAAP basis, and earnings per share between $0.13 and $0.17, excluding amortization of $4 million and severance of -- and restructuring charges of $1.2 million, and assumes the Company is fully taxed using a 35% tax rate.

With regards to the balance sheet, cash and equivalents totaled $111.7 million at September 30.

We are pleased that we generated $2.3 million in cash for the third quarter, and $26.5 million for the year-to-date, exclusive of $15 million of the first quarter 2005 earn-out payments for acquisitions.

While accounts receivable increased $10.5 million during the quarter, DSO is 61 days, lower than the industry average of 76 days.

Inventory decreased $1 million to $99.5 million in the September quarter.

Year-to-date inventory has been reduced by $11.2 million, as each business segment has continued to work and reduce their inventory levels.

Capital expenditures were $4.0 million for the third quarter of 2005, and $8.6 million for the nine-month 2005 period.

Depreciation expense totaled $3.3 million in the third quarter of 2005, and $9.8 million for the nine-month period.

Our balance sheet and cash position remain quite strong.

At this point, we return to Ed for some additional comments and your questions.

Thank you, Jack.

Let me review some comments by market sector, then we'd be pleased to take your questions.

I will start in data storage, where business has been quite strong.

Again, the third quarter data storage revenue of 50.1 million was a record, up 85% from Q3 of '04, and up 6% sequentially.

Nine-month revenue in data storage is up 31% to $123 million.

Data storage orders were $33.6 million, up 78% from third quarter of '04.

But down 44% sequentially.

Nine-month orders are up 54% to $139 million.

Q3 included multimillion dollar orders from all five of the worldwide thin film head manufacturers, who purchased some combination of Ion Beam, etch, deposition, atomic force, microscopy, and optical Metrology, and the third quarter included the second auto AFM, now being ordered by data storage for wafer fab applications.

We are forecasting our data storage orders to exceed $180 million this year, which will be up over 40% year-over-year, and we expect continued double-digit growth in 2006, maybe around the 10% level, reflecting further penetration of consumer devices, such as DVR, set-top boxes, information appliances, and video iPods.

Indeed, consumer electronic devices are expected to have unit growth in excess of 20% next year, and we'll provide Veeco with both capacity equipment and technology growth opportunities in 2006.

Veeco recently introduced eight new data storage products at the September DISKCON trade show in September, including new Ion Beam etch, Ion Beam, and atomic layer deposition.

Single and multiple target PVD disposition systems, and our new line of precision lapping, and single and dual spindle saws from Camarillo.

With orders for the new products expected in Q1, and new products revenue expected in Q2, Q3 and Q4 of '06.

I'd like to address some questions that you've asked recently concerning the comparison of flash memory and hard drive storage, and we see both technologies as growing at different capacity points, but clearly in the 1" hard drive, capable of 10 to 20 gigabytes now, and the flash capable of 1 to 5 gigabytes, that these are complementary growth opportunities, at different storage capacity and price points.

We think hard drives will remain dominant for capacity-intensive applications, like PVR and MP3, or all video applications.

As well as drives being used in high end converged handsets, where high density storage and faster writing speed, and better stability, and lower cost per gigabyte are important.

Both flash and drives benefit from increased aerial density.

We think both will grow significantly, with drives providing higher capacity and flash lower capacity.

Last week, three new product announcements I think make this point.

Apple introduced a new video iPod with a hard drive.

Samsung introduced a new cell phone with a 3-gigabyte hard drive, and Hewlett-Packard introduced a new photo printer with a 1" drive.

Hard disc drives currently offer a 20:1 cost advantage compared to flash, and most industry experts say that cost parody between flash and drive is unlikely in this decade, although both will have increased capacity.

In some regard, we also see the threat of flash as motivating our hard drive customers to accelerate their perpendicular programs, reaching for higher aerial density to maintain their important capacity and price advantage over flash.

So, we think many people who previously were looking at '07 for introduction of perpendicular recording, might accelerate that.

So, overall drive business continues to be a very high growth area for '05, and we expect its growth to continue into '06.

In it LED/Wireless, where orders were $14.6 million, up 10% sequentially but flat year-over-year, it appears to us that the industry has bottomed.

And we see interest now from Korea, Taiwan and China improving.

Last week, we made an important announcement -- announcing the acceptance of our first two GaNzilla II MOCVD tools, that's our new product.

One from Korea from LG, and one from Taiwan from Huga.

Both companies reporting improvements in uniformity, reliability, brightness and through-put coming from the new Veeco tool, and we will make our GaNzilla II technology available, in the form of upgrade kits to our rather large installed base of Ganzilla I users, in addition to the purchase of GaNzilla II new systems.

We expect the LED market to improve in 2006, with the penetration of LCD TV backlighting, automotive applications, solid state lighting in cars, architectural lighting opportunities, I think, are all scheduled for products introductions in 2006.

And lastly, in semiconductor, our Q3 orders were about $11.3 million.

Our nine-month orders are down 7%, but our revenue is up 19%.

And for the year, we expect very strong 2005 revenue growth in auto AFM, about $50 million compared to $40 million in the prior year, up about 25% year-over-year.

We're seeing very good acceptance of the newer X1D and X3D Veeco product lines, for applications in etch, CMP, and lithography.

There is new interest in line edge roughness at the smaller geometries, as well as interest in sidewall angles.

We have a unique ability -- unique 3D ability to measure the sidewall of these deep trenches, and we see continued interest in lithography CD control at 90- and 70-nanometer nodes.

We've had success at foundries this year, important to our growth of 25% in revenue, and we see a new market for auto AFM in data storage, where by the end of the year we will have three auto AFM orders from major data storage wafer fab applications, really at finer geometries for higher aerial densities, and for perpendicular recording.

So, auto AFM continues to be a critical tool, both in semiconductor, and now in data storage.

We maintain our view that 2005 will be a relatively flat revenue year, with significant improvements in profitability compared to last year.

We look forward to 2006 growth being driven by Veeco new product introductions in Ion Beam, in MOCVD, in Metrology, and in scientific research as well.

That should allow us to address growth opportunities in data storage and LED/Wireless, in Semiconductor, and in Scientific research.

Operator, I think we'll pause at this point and answer some questions.

[OPERATOR INSTRUCTIONS] We take the first question today from Timothy Arcuri, Citigroup.

Actually I had several questions. #1, Ed I think last quarter we were talking about the guidance for the Epi business to be margins in the low 30s, between 30 and 33% in the fourth quarter.

Now it looks like we're down in the low to mid-20s.

What is that a result of?

Tim, that's the GaNzilla II product introductions being shipped a later than we thought.

There are still some GaNzilla I's in the pipeline.

The GaNzilla IIs are that are on the manufacturing floor right now clearly have a 30% gross margin capability.

But with the decline in MOCVD revenue being steeper than we thought in '05, we've still got some GaNzilla, some older tools to ship.

So, I remember we were talking about, you know, by the middle of 2006 that that division could kind of have gross margins somewhere in the mid-40s.

Is that still a possibility?

Or have we pushed that out, as well?

Tim, that's still a possibility.

If you look at -- let me find that page.

If you go to your page 3 that has gross margin expectations by business segment, I would say that the '06 expectation for the three segments, are Ion Beam being in the sort of 44 to 46% gross margin.

That's pretty much as we had previously said.

Epitaxy would be between 35 and 40% next year.

And Metrology between 53 and 55% next year.

So that the blended, depending on mix, the blended gross margin for Veeco would be about 48% next year, with Epitaxy being in the 35 to 40% range.

Okay, thanks, Ed.

And then, you know, last one from me, if I I look at the ASM revenues, it looks like they were particularly weak this quarter.

I am wondering what the dynamic there was?

Yes, Tim, you know, because that's a business of, you know, 11 to $15 million per quarter, and each tool is a 1.5 million to 1.8 million, if one or two tools slip out as they did in Q3, you see a decline, and also, if you remember, that sector for us includes Ion Beam deposition tools, that we don't sell every quarter, but we sell probably 2 or 3 a year, to Photo mask applications.

So, in a again quarter where one or two tools slips and we don't show up with an Ion Beam tool, you get sort of a severe result.

And revenues are up, Tim, but bookings were down.

Okay.

Thanks.

Up next we'll hear from Brett Hodess, Merrill Lynch.

Hi, good morning.

Just to clarify that -- so the dip -- the shortfall in orders this quarter was the timing of a couple of tools, is that --

The timing of a couple of tools in semiconductor.

That's correct.

Okay.

And so those would be the higher-priced auto AFMs?

That's correct.

Okay.

Second, when you start to ship the GaNzilla II upgrades to your large install base in the field, I think historically upgrades carry higher margins.

Is that correct, and is that one of them that gives you confidence to move that segment back up?

Brett, that's a very important point.

Next year we will benefit by both the higher margin of the GaNzilla II MOCVD tool itself, which will have -- you know, let me call it 35% gross margin.

But the kits, which have a sales price of about $500,000, actually have gross margins in excess of 65%.

And then on the data storage side, you know, your comments about the strength in utilization rates, and the technology changes, as well as the small form factor consumer demand items -- I wonder if you could talk a little bit about the timing you see in the marketplace, for -- if you will, the lumpiness that you see from your five main data storage customers, given those good drivers.

Because obviously we had the big orders and the weaker orders this quarter, and moderated the fourth quarter outlook a little bit.

How do you think that plays out over the next couple quarters, Ed?

Well, a good point to make there is that even though we're seeing -- we will continue to see year-over-year data storage growth, this is still a cyclical industry.

It is important to look at the trough and peak levels in the cycle and, you know, if you look back a year in 2004, the trough was the same September quarter was $19 million, and the peak was $45 million.

And here we are in '05, even though we're disappointed with the September order from data storage, it looks now like the trough is $34 million, up from $19 million, and the peak was $60 million, up from $45 million.

So, we've seen a sea-level change here.

It will continue to be lumpy, that's the nature of data storage, but I think it grows again next year.

Now it's cycling between these 34 million and $60 million, that's lower levels.

And we're continuing to see the acceleration of perpendicular recording, so as to keep the capacity advantage against flash.

Utilization is so high.

I think somewhere in the next 12 to 18 months we will see a conversion from 150-millimeter wafer size to 250-millimeter wafer size to solve the capacity problem, and that will be a very big benefit to Veeco equipment.

Is that an upgrade for your equipment, or a new sale?

It's pretty much a new set of tools.

There's not very much upgrade-ability going from 150-millimeter to 200-millimeter.

Great.

Thank you.

We'll take the next question today from Robert Maire, Needham and Company.

Okay, thank you.

In terms of the Epitaxial business, are all the previous issues that we had, in terms of restructuring behind us, is there still some more restructuring to be done, in terms of getting the gross margin back up?

Or just a case right now of the revenues being too low to get to the right gross margin?

It's the latter, Robert.

There is no restructuring.

There's no -- we did reduce the workforce, as we commented, we're going to -- in this quarter we will take about 5% of Veeco headcount down, which comes to about 65 people, and about half of that has been done already, and that's been done in MOCVD.

So, you know, the struggle in MOCVD gross margins now are really the low revenues, they're not restructuring, or not any new discoveries and problems, it's that we're running that factory now at rather low revenue levels, where occupancy becomes --

- becomes the issue.

Yes.

Okay.

In terms of the data storage side of the business -- so, you're suggesting that you're not seeing any hesitancy on the part of disk drive manufacturers, or head manufacturers, in terms of moving to vertical or perpendicular recording, and you're suggesting the opposite, that you're actually seeing an acceleration.

So, there is no hesitance in terms of orders?

The lower orders are all out of the semi side?

-- No, you remember, Robert, we did have lower orders than we had anticipated in data storage in the September quarter.

We might have been more thoughtful in looking at prior Septembers, but I wouldn't say we're seeing pushouts, and I wouldn't say we're seeing a change in capital spending for perpendicular, or for the new technology points, or to improve capacity.

It's just going to be lumpy as data storage typically is.

But there's been a positive sea-level change, in that the business is going to be larger, certainly in '05, and certainly in '06.

But it will be lumpy.

Okay, so there's no sense of them delaying or anything, given that Apple went to a flash in the nano, as compared to a 7/8" drive or something like that, you're not hearing any things that -- ?

No.

Not at all.

Apple, a week after going to the flash and the nano, went to a hard drive in their video iPod.

Right.

So, we see both complementing each other.

I think flash continues to grow at low capacity points, and drive continues to grow at high capacity points, or anything that's video.

Okay.

In the MOCVD business, you mentioned you expect a little bit of a return in the beginning of next year.

Could you give us some background on why you feel that way?

Is it because we're just at a bottom point here, and it has to get better from here?

Or is there some customer activity that gets you there?

Well, I think it's all of the above.

The -- you know, we're seeing -- we had always said we would see recovery in '06 in the booking rate and the revenue rate.

I think the Q4 -- our Q4 will start to show order recovery from APAC.

I think they've had nine months to kind of absorb their excess capacity that they purchased in '04.

And -- and even with, you know, if you look at LED device unit sales, you know, they're up 10% this year.

So, they've eaten into some of that previously unused capacity, and we are seeing order expectations increase, in Taiwan and Korea and in China.

I think the Tier-1 accounts, which also are having sort-of 10% revenue growth or unit growth, will be purchasers of new equipment in the first quarter -- first and second quarter of '06.

Okay, great.

Thank you.

Up next, we'll hear from Matt Petkun, DA Davidson.

Hi.

Good morning.

Could you provide a little bit more commentary, Jack, just on the decline in R&D, and what your expectations are going forward?

Yes, R&D spending is down, as I mentioned, in the Process Equipment group, and predominantly that was in the Epitaxial business, where we did, as Ed indicated, complete some introduction of new products.

We are down about a million dollars in that group, and $500,000 in the Ion Beams group.

We would expect that R&D spending would probably be in the 14% range in the fourth quarter.

And looking toward next year, are there any specific initiatives you can talk about that would cause those R&D rates to rise above the 14% range?

No, that's about the range we'd expect.

Okay.

And then also just add any meaningful cancellations that you saw this last quarter?

Nothing in data storage.

We did -- Jack commented that we have about $131 million -- $132 million of backlog, which nicely supports the revenue expectations that we're forecasting.

We did take 7 or $8 million out of backlog in Q3, almost entirely MOCVD sales that have been on the books for over a year, where I think the new delivery dates will probably be pushed out.

But no -- there were no cancellations in data storage.

Okay, thank you.

Mark Fitzgerald of Banc of America has the next question.

Thank you.

I was curious on the backlog of $132 million, if that would be down again next quarter, given the order guidance that you're giving us.

Yes, Mark, if you did just the straightforward math, I mean within the guidance we're giving, it should come down another maybe 3 or $4 million.

The revenue we're projecting is 100 to 105.

The orders are 95 to 100.

So, at the top of the revenue guidance would come down $5 million.

The guidance -- I thought you were going to as for the breakdown, let me do that anyway.

The breakdown of the backlog, of the $131 million, is $66 million in Ion Beam, $31 million in Epitaxy Compound semiconductor, and $34 million in Metrology.

So, it's a broad backlog that even with another $5 million decline in backlog, I think allows us to go into '06 looking for growth.

And has there been any difference in timing between orders and shipments or revenues here over the last six quarters?

Because according to my data, I'm not sure if I'm right here, but $132 million is the low end of the backlog range for six quarters at this point.

Yet you've been very consistent keeping your revenues in this kind of 90 to $100 million range over that period.

The -- it's helped a little bit by the fact that, you know, with revenue recognition being what it is and, you know, you have a little more visibility on when the revenue is going to land.

You know, there might be some pressures going forward, Mark, with more new product introductions next year, we expect expect a lot from new products in '06, we will need to be careful about forecasting revenue recognition on those new product sales.

But in general, we've always said you could look at our bookings displaced by one or two quarters, and project revenue.

I think that's still true.

So, basically $132 million and maybe slightly lower into the fourth quarter, still, would support a growth into the first quarter of next year?

Yes, it would be more specifically a growth mark for the '06 year.

You might start the '06 year with, you know, kind of another $100 million, $105 million revenue quarter.

Okay.

But we would expect bookings to increase and revenue to increase in the '06 timeframe.

And the other thing I would say is we are taking undertaking outsourcing in our Process Equipment group, and making some progress there.

So, some of our cycle times are down in that area.

Okay.

Yes, that's really a very good point.

You know, we will continue the gross margin improvement plan into '06, and it's not merely head count reduction.

We are beginning to see, you know, some very compelling positive results from outsourcing, and from the use of standard hardware and software platforms across all of Veeco.

So, some of the newer products, GanZilla II will be evident, a couple new edge products have cycle times that have been greatly reduced, because of common platform and outsourcing, and that will offset some of the pressure I spoke of longer revenue recognition for new products.

Is there any turns business among your products at this point?

Is that a factor at all?

Yes, there's always been -- if you look at us as kind of half equipment and half Metrology, in the equipment, big boxes, you know, there are no turns.

You go in with full backlog for the quarter.

In Metrology, about half of the sales in Metrology are 100,000, $150,000 desktop Metrology tools, where you have a very high turn rate in the quarter and we will continue to see that.

And then just one last question, Jack, can you give us an idea of the option expense in the current quarter that was just reported?

Our options are running about $500,000 a quarter.

Okay.

Currently.

Thank you.

We will take the next question today from David Duley, Merriman.

Yes, just one clarifying question.

The business that did not meet expectations on the order front was again?

If you go back to the guidance, the guidance for Q3, David, was $100 million.

And the actual bookings were $85 million.

So, if I go down by business segment -- let me do that for you.

Data storage was off about 5 or 6 million from the original guidance.

Semi was off 3 or $4 million.

And semi was clearly some orders that just moved into Q4.

LED was kind of right on.

We said $15 million it came in at exactly $15 million.

And scientific research was a little lighter.

We said $30 million and it came in at $25 million.

And I think that's kind of the summer effect of, you know, July and August, are vacation and shutdown periods across the world.

So, the real pushout, if you will, or delay in orders, was in data storage and semi.

Of your order guidance this quarter, how would you expect it to kind of break out?

What would be the disk drive bogey?

So, data storage was $34 million.

I would expect it to be between 40 and $45 million in the 95 to 105 guidance.

Semi was $11 million, I would expect it to come up to 13 to $15 million.

LED, I think, will stay at about that $15 million, maybe up $1 million, and Scientific Research always has a positive December quarter, because it's an end-of-year budget cycle, you know, might come up in the range of 28 to 30 million.

So, that's 95 to 105.

But you're in the middle.

Yes.

Okay, Dave?

Okay.

And going forward, what kind of, you know, I think you mentioned -- you gave specific guidance for gross margins in the fourth quarter, and I thought you mentioned in your prepared remarks what margins might do next year.

On a 10% increase in revenue, or whatever it is, that you're thinking your topline would grow, what can we expect gross margins to do throughout next year?

They should improve.

I would wait until the end of the quarter, Dave, to see, you know, what the linearity of the improvement is.

Let us finish the '06 plan.

But an important milestone in '05, was to end the year at a 46% gross margin and a 10% EBITA, and have delivered 2% margin improvement points each quarter.

In my prepared remarks, I said a similar data point for '06, would be to end the year with a 48% gross margin, and an 18 to 20% EBITA .

So, I think you will -- you know, one can expect to see, a 0.5 to 1% gross margin improvements continued through '06.

And what, besides revenue growth, is that -- have those programs already been put in place?

And you just need to put new products out and leverage less people? -- or it's the higher margins --

It's the new products with greater gross margins, it's greater use of common hardware and software platforms across the Company.

Greater use of outsourcing.

You know, we have probably a 10-point initiative to reduce the spending within Veeco.

And it's all of those things.

Thank you.

JoAnne Feeney, Punk Ziegel, is up next.

Good morning, folks.

I just had a couple of questions.

One on the Metrology and AFM business, I'm wondering if you can give us a breakdown of the Metrology sales to semi versus to research?

Well, the Metrology you pretty much could look at the Metrology sales, JoAnne, were $51 million in revenue in the quarter, and semi revenue in the quarter --

There's nothing else in semi revenue except Metrology --?

It's pretty much, you know, semi revenue was $12 million.

And you mentioned you expected 3 auto AFM orders for data storage by year-end.

Does that include any you've already told us about?

Yes, two are already booked.

There's one more to be booked this quarter.

But that's a significant data point because probably data storage, using auto AFM instead of fib sem, or CD sem, are probably capable of being users of two or three auto AFMs per wafer fab.

And are those, Ed, being used for primary research at this stage?

Or do you see that going into process control?

Those are all in Process Control.

They've always brought tabletop AFMs for research, but these are the high-end, sort of 1.6 million, 1.8 million tools that are being put right in manufacturing.

In wafer fab, looking at pole -- [palliative] recession and CD involved with higher aerial density, and eventually perpendicular recording.

So, right now in perpendicular, we're probably seeing them just use in research, is that correct?

Yes.

But for the GMR and TMR technology, they're putting those AFMs in manufacturing.

Okay, got it.

And in the LED space, and the Epi space, can you give us a sense of your installed base of the GaNzilla I products at the higher brightness LED manufacturers?

60.

60 just at the high brightness --

Well, 60 tools at different levels of brightness.

When I look at the potential universe for upgrade kits, it might be half of those 60.

Okay.

And -- and what kind of timing do you expect on the upgrades?

Fast!

You know, probably we would start with 4 or 5 per quarter.

[laughter] Okay, great.

Thanks.

Mark Mille, Hoefer Arnett has the next question.

You've had a good year in data storage sales, that's probably the start of this year and you're projecting even better for next year, I guess there are a couple of factors that worry me.

If you listen to CA's call last week, they're talking about increasing pricing pressures in the industry, and also the conversion of larger wafers, and plus we're going to a Femto slider conversion, both these conversions will put significantly more [hints] per wafer, which limits the number of machines that will be installed.

Have you factored this into your thinking?

Well, the -- you know, it's -- it's some of both, Mark, but the -- the Femto requires new lapping and dual spindled saws, that are the replacement of the existing installed base.

So, the dimensions required in Femto, meaning you can't use a lot of the installed base lapping and saws that exist.

Perpendicular, you can't make perpendicular heads on the same tools that you've been making GMR and TMR, and 200-millimeter requires a replacement to tool sets.

So, I think the CapEx level that data storage will experience over the next two or three years, won't decline because they have some rather significant technology advances to get into manufacturing.

Do you think the number of tools will go up, or remain static?

I think over time, this is, you can liken this to the 300-millimeter initiative in semiconductor.

At the end of the day, at the end of the cycle, there will be fewer tools that will produce more dye.

But to get to the fewer tools, you have to obsolete your 200-millimeters, to get to buy the 300 millimeter, and the same is true here.

So, yes, you're correct.

At the end of the day, you will have a higher revenue data storage industry that will be more efficient, and will have fewer total tools, but they have to buy that new toolset.

And you're not concerned, you know, from what you're hearing about, you know, CA's comments about tightening pricing pressures, and what that might lead to?

Well, I think there will be some pressures, and I think we will continue to see data storage revenue and bookings be lumpy.

But overall it will grow.

Quite literally it will grow in '06 and in '07, perhaps not at the dramatic rate that it's grown in '05.

Thank you.

We'll take the next question from Bob [Reitzes] of Bear, Stearns.

Yeah, hi.

It's Bob Reitzes.

I just wanted to ask you guys a question, two things.

One, I wasn't quite sure I heard the book-to-bill for the current quarter.

Could you repeat that?

Bob, I think it's like 0.85.

0.85.

Okay.

And the second thing is for next year you're -- you're talking about margins -- gross margins, maybe increasing from 42% from the first nine months to 48%.

Is that what I heard?

I said that they would increase for the year.

They would end the year at a 48 --

Oh, I see.

They will end the year at 48.

And probably will increase from -- on a year-over-year basis -- maybe just as they did this year, going from let's say 43% to 46%.

And with your stock down here at like -- it's down $1.80 right now, and you have a fair amount of cash, and you're generating positive cash flow.

You've always been acquisitive, why don't you buy your own stock, launch a major stock buyback, just optimistic about next year?

That's a consideration.

Thank you.

Thank you, Bob.

Operator, we will take one more question, if there is.

Absolutely.

The question will come from Ben Pang of Prudential.

Hi, a quick question on the AFM business.

So, that's their high gross margin business, and I guess you're generating substantially most of the revenue there on the scientific and nano side, is that right?

Yes, which is also a high gross margin business.

And are you facing increased competition over there?

We had very high market share, both in auto AFM and in research AFM, you know, above 60%.

There are -- you know, in research AFM, where we sell the lower priced tools, there are 5 or 10 small competitors, whose aggregate revenue is probably less than our total revenue, but there are 5 to 10 companies that have formed in research AFM.

And if the market share were to change that would be a long -- it takes a long time in this kind of area because you have so many customers, is that the way to think about it?

Yes, you know, we sell 100 research AFMs per quarter, it's a very deep customer base, it's across life science, material science, universities, government centers, a very stable, large customer base.

Okay.

And on the GaNzilla II, you shipped the first two tools, is that right?

That's correct.

We have shipped -- well, we've shipped the first three, and two have been accepted.

That was LG in Korea, and Huga in Taiwan.

We expect one more acceptance in the fourth quarter.

And in terms of the upgrade package, what's a status there in terms of the timing, and when will you know what your gross margins are on that type of business?

Well, we've already shipped two or three upgrade kits, and we expect them to be revenue in the fourth quarter, so we have a pretty good visibility, as to what the gross margin is.

Perfect.

Thank you very much.

That does conclude the question and answer session.

I will turn the conference back over to our speakers for any additional or closing remarks.

Thank you, operator.

I think we're pleased with the profit improvement performance improvement that we made in Q3.

We look forward to Q4, continuing that profit improvement performance, and we feel very strongly that there are growth opportunities for Veeco in 2006, and we will see increased revenue, as well as improved profitability.

Thank you for your comments and your questions, and we look forward to speaking with you at the close of Q4.

Thank you, operator.

And that does conclude today's conference.

We would like to thank you all for your participation and have a great day.