Veeco Instruments Inc (VECO) 2006 Q2 法說會逐字稿

Good day, everyone, and welcome to the second-quarter 2006 results conference call.

Today's call is being recorded.

For opening remarks and introductions, I would like to turn the call 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 today's second-quarter 2006 results conference call.

I am Debra Wasser, Veeco's Senior Vice President of Investor Relations.

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

Today's earnings release was distributed at 4:30 p.m. this afternoon.

If you have not yet received a copy, please visit the veeco.com website or call 516-677-0200, extension 1305, to get a copy.

For your additional information, we have updated our investor presentation to reflect second-quarter [2000] results and have posted this presentation on Veeco.com.

This call is being recorded by 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 that this call discusses expectations about marketing conditions, market acceptance and future sales of the Company's products, future disclosures, future earnings expectations or otherwise makes statements about the future, such statements are forward-looking and are 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 discussion and analysis sections of the Company's report on Form 10-K and annual 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 or 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The Company does not plan to update the information on this webcast once it has been archived.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 would now like to turn the call over to Ed.

Thank you, Deb, and good afternoon and welcome to our second-quarter financial conference call.

We are pleased to report strong second-quarter performance, including increased revenue, increased orders and EBITDA all exceeding prior year and all exceeding our guidance.

Our increased backlog supports our improved second-half 2006 revenue expectation.

To highlight the second quarter, revenue was $111.6 million, up 8% versus prior year, up 19% sequentially and above our guidance of $105 million to $110 million.

Orders of $143.2 million were up 21% year over year, up 13% sequentially and also above our $125 million to $130 million guidance.

Book-to-bill ratio was 1.28 to 1.

Gross margin of 44.5%, up 250 basis points from prior year, was on plan.

Our EBITDA of $9.6 million, up 58% year over year, and was also up 70% sequentially.

Net income of $3 million compared to a loss of $450,000 last year, and GAAP EPS of $0.10 per share and EPS excluding amortization of $0.18 per share.

Our continued focus on operational execution, cost control, gross margin improvement, cash generation, improved inventory turnover, outsourcing, implementation of SAP across all of Veeco and creation of standard hardware and software platforms on new Veeco products is proceeding.

We continue to strengthen our balance sheet, our cash and operational performance.

The second-quarter orders were strong across our three major core markets.

Another record data storage quarter of $71.4 million was up 18% year over year, up 2% sequentially.

High-brightness LED and wireless orders of $27.4 million were up 106% year over year and up 13% sequentially.

Semiconductor of $20 million in orders was up 6% year over year and up 98% sequentially.

Scientific research orders of $24.4 million, down 6% year over year but up 11% sequentially.

So again, our total Veeco orders of $143 million were up 21% year over year and up 13% sequentially.

Clearly, a strong booking quarter, driven by continued double-digit market growth in both data storage and high-brightness LED sectors, reflecting continued investment in consumer electronics and in perpendicular recording technology and the beginning of high-brightness LED backlighting of notebook and small area PCs.

We expect our 2006 year performance to benefit from continued double-digit year-over-year growth in both data storage and high-brightness LED wireless sectors, and our strong backlog for increased revenue in the second half of the year.

As such, we are raising our 2006 revenue expectation from the previously stated range of $440 million to $450 million to now be in the range of $455 million to $465 million, up 11% to 13% over 2005, again supported by strong first-half orders and increased backlog.

Six-month bookings of $270 million are up 24% year over year, with data storage at $142 million, up 34%, and high brightness LED at $52 million, up 90%.

So in the first-half orders, 70% of our business is growing in excess of 30% per year.

For the six months, semiconductor and scientific research orders were down 10% year over year.

Our outlook for the third quarter reflects continued strength in revenue and earnings, with a seasonal pause in orders in the September quarter, followed by our expectation for orders to grow again in the December quarter.

We expect Q3 increased revenue to be in the range of $125 million to $130 million, and increased GAAP Q3 earnings to be between $0.23 and $0.29 per share, and Q3 earnings excluding amortization to be increased to be between $0.25 and $0.30 per share.

Q3 bookings, influenced by normal third-quarter seasonality, to be between $115 million to $130 million, and to increase again in the fourth quarter.

For the year, we now expect 2006 revenue, as I have said, to be up between 11% and 13% over 2005, and earnings likely to double our 2005 results, as they have in the first six months.

As to the overall forward-looking market conditions, we see continued robust data storage and high-brightness LED markets.

We see our major customers in both data storage and high-brightness LED wireless continuing to plan technology and capacity investments tied to perpendicular recording, smaller format femto thin-film heads and the introduction of larger wafer sizes in manufacturing and data storage.

We see continued development of high-brightness LED for new high-growth backlighting applications, and overall we continue to see double-digit multiyear growth despite a reduced September booking quarter expectation.

I would remind us that the September quarter has been a decrease in bookings in four of the last five years, so that's the seasonality that we referred to.

I will ask Jack to review second-quarter financials, and I will return with market comments and your questions.

Thank you, Ed.

For the three months ended June 30, 2006, sales were $111.6 million, an increase of 8% versus the 2005 second quarter.

The increase was due to a $6.2 million increase in Process Equipment sales attributable to growth in epitaxial products.

Metrology sales were $44.3 million, an increase of $2 million versus second quarter of 2005.

By market, sales were compared to the prior year by 32% in high-brightness LED wireless, 12% in data storage, 9% in research, but down 26% in semiconductor.

Sequentially, sales increased $17.7 million or 19%, primarily due to the $14.2 million increase in Process Equipment attributable to $10.1 million of increased Ion Beam and Mechanical sales and a $4.7 million increase in MOCVD, partially offset by a decline of $600,000 in MBE sales.

Second-quarter 2006 orders increased to $143.2 million or 21% from the second quarter of 2005, and were up 13% sequentially from the first quarter of 2006.

Gross profit was $49.7 million for the quarter or 44.5% of sales, compared to $43.4 million or 42% of sales for the second quarter of 2005.

Process Equipment margins improved to 40.3%, up from 36.7% in the second quarter of 2005, which reflects improvement in all Process Equipment product segments.

This 3.6% improvement was due to an 11.1% increase in epitaxial gross margin, resulting from increased sales volume and improved product mix, and a 2.7% increase in gross margin in Ion Beam and Mechanical sales to 45.4% as a result of improved mix due to new products and outsourcing.

We had a 51% gross margin in Metrology, compared to 49.7% in the second quarter of 2005, primarily due to higher volume and favorable product mix in the optical Metrology business.

The second quarter of 2006 mix of Process Equipment to Metrology sales tracked our previous guidance of 60% Equipment and 40% Metrology.

Sequentially, Process Equipment margins improved from 38% to 40.3%, which is important progress in achieving our gross margin goal.

Our third-quarter 2006 revenue forecast is a little richer in Equipment, 65% of revenues, versus Metrology, which represents 35% of revenues.

In addition, there are some products that will result in higher-than-normal revenue recognition bifurcations.

Accordingly, we are currently guiding for gross margins in the range of 43.5% to 44.5% in the third quarter of 2006.

We believe that gross margins will improve 2% to 3% in the fourth quarter of 2006 as we return to a more normalized mix of Equipment and Metrology, as well as improved gross margins within each segment, due to new product adoptions and recognition of revenue previously bifurcated.

SG&A was $24.9 million or 22.3% of sales, compared to $21.4 million or 20.7% of sales in the second quarter of 2005 and $21.5 million in the first quarter of 2006.

The increase from the second quarter of 2005 was principally due to a $2.3 million million rise in administrative expenses from incentive-related items including stock options, restricted shares, long-term cash incentives, bonus and profit-sharing, as well as severance and litigation-related costs.

Selling expense increased $1.2 million, due to expansion of field sales and marketing to support new product introductions and expansion of our Asia-Pacific operations.

R&D expense totaled $15.3 million, a decrease of $600,000 from the second quarter of 2005, largely due to the completion of certain new product developments in Research AFM and MOCVD.

As a percentage of sales, R&D was 13.7%, compared to 15.3% in the second quarter of 2005 and 15.5% in the first quarter of 2006.

Overall, operating expenses declined slightly as a percentage of sales to 35.9%, compared to 36.1% in the second quarter of 2005.

We expect that operating expenses will decline as a percentage of sales by 1% to 2% in each of the next two quarters.

Amortization expense totaled $4 million in the second quarter of 2006 and 2005.

Net interest expense totaled $1.1, million compared to $2 million in the comparable 2005 quarter.

The decrease in interest expense was attributable to the rise in interest rates on invested funds over the past year and repayment of $20 million on convertible notes in the first quarter of 2006.

Second-quarter operating profit before amortization or EBITDA totaled $9.6 million, compared with $6.1 million in the 2005 second quarter.

The improved EBITDA is primarily the result of strong performance in Process Equipment, resulting from both higher sales volumes and improved gross margin.

Veeco's second-quarter 2006 GAAP net income was $3 million or $0.10 per share, compared to a net loss of $400,000 or $0.02 per share in the second quarter of 2005.

EPS excluding amortization expense for the quarter was $0.18, compared to $0.09 for the second quarter of 2005, using a 35% tax rate.

For the six months of 2006, sales totaled $205.6 million or a 4% increase from 2005, due primarily to an increase of $9 million in Process Equipment sales.

Gross margin for the first six months of 2006 were 44.5% of sales, compared to 41% for the comparable 2005 period, primarily due to the increase in sales volume as well as cost reductions in improved supply chain management, which included outsourcing.

SG&A increased to $46.3 million, compared to $41.6 million in the first half of 2005, primarily due to higher selling and commission expense resulting from the increase in sales.

There were also higher personnel costs related to increased incentive expense resulting from improved profitability, stock options and long-time incentives as well as litigation (indiscernible).

R&D expense totaled 29.8 million, a decrease of $900,000 from 2005, primarily due to a completion of certain new products in the Research AFM and MOCVD product lines.

As a percentage of sales, R&D decreased from 15.6% in the first half of 2005 to 14.5% in the 2006 half.

Amortization expense totaled $8 million in the first six months of 2006 versus $8.5 million in the 2005 comparable period.

This decrease was the result of achieving full amortization of certain intangibles.

Net interest expense totaled $2.5 million, compared to $4.1 million in the comparable 2005 period, due to the increase in interest rates over the past year on investment funds, as well as the previously mentioned $20 million repayment of convertible notes.

EBITDA was $15.3 million, compared to $8.7 million in the first half of 2005, because six months 2006 GAAP net income was $2.8 million or $0.09 per share, compared to a net loss of $5.2 million or $0.17 loss per share in the first half of 2005. [2000] GAAP net income was impacted by the income tax expense of $2.3 million, primarily from foreign taxes, compared to $1.2 million in 2005.

Earnings per diluted share, excluding certain items for the first half of 2006, were $0.27 compared to $0.10 in the first half of 2005.

Backlog at June 30, 2006, was approximately $159 million.

[To describe] the guidance, we are currently forecasting third-quarter revenues in the range of $125 million to $130 million, earnings per share between $0.23 and $0.29 on a GAAP basis and earnings per share between $0.25 and $0.30 excluding amortization of $4 million, assuming a 35% tax rate.

As previously noted, gross margins are expected to be in the 43.5% to 44.5% range, and operating expense as a percentage of sales should improve by 1 to 2 percentage points.

On the balance sheet side, cash and equivalents totaled $116 million at June 30th.

We were pleased that we were able to reduce our debt by $20 million in the first half of 2006, while maintaining a cash balance of $116 million.

Accounts Receivable DSOs for the quarter were 71 days, down from 75 days at March 31, 2006.

Inventory increased $4 million to $96.1 million at June 30th from the first quarter, primarily due to the third-quarter planned increase in revenues.

Inventory turnover improved to 2.6 times from 2.3 times in the first quarter.

Capital expenditures were $6.1 million in the second quarter of 2006 and $9.6 million for the six-month period.

Depreciation expense totaled $3.3 million in the second quarter and $6.6 million for the first half.

Balance sheet and cash position of $116 million remains quite strong.

We will return to add some additional comments and your questions at this point.

Thank you, Jack.

Allow me to comment on market conditions, starting with a continued healthy data storage market.

We again achieved record orders in Q2, $71 million, up 18% over prior year, bringing our six-month orders to $142 million, up 34% from prior year.

We received multiple multi-million-dollar orders from almost all major thin-film head manufacturers in Q2, reflecting continued technology and capacity of investments in the proliferation of perpendicular head technology, still early in its transition and expected to be only 15% of 2006 head production, and expected to double next year in 2007.

Femto smaller form factor heads currently expecting to be 30% of slider production and to double in 2007.

Aerial density continues growing at 30% to 40% per year, so overall technology investments in these areas will continue through 2006, 2007, 2008 and 2009, as every head manufacturer has a funded multiyear perpendicular and femto head program, and we see strong acceptance of new Veeco etch deposition, new mechanical [sorters] and lapping tools and Veeco Metrology products in this sector.

Today, we announced a multi-million-dollar order for our new PVD multitarget sensor deposition tool, essential for achieving high aerial density, and our auto AFM continues to penetrate high-resolution data storage metrology PMR applications.

To move to larger wafer size, essential to avoid costly bricks and mortar expansion, is now at a prototype stage and will provide production system revenue in Veeco in the 2007, 2008, 2009 timeframe.

The drive industry continues reporting strong double-digit unit and dollar growth, recently reporting another quarter in excess of 100 million drives, led by consumer electronic applications expected to grow over 30% this year and mobile drives growing at 20%, while enterprise and desktop continues single-digit annual growth.

Our Q2 revenue in data storage of $53 million grew 33% sequentially, and our six-month revenue of $93 million is up 28% year over year.

We expect Veeco data storage revenue to be up between 25% and 30% this year, with a strong pipeline of new Veeco products allowing continued year-over-year Veeco growth in data storage at the 25% to 30% rate, similar to recent years.

In the LED wireless market, another strong -- our third strong quarter sequentially.

Q2 orders of $27.4 million were up 106% from prior year, and six-month orders of $51.7 million up 90% year over year.

This reflects continued success of our GaNzilla II MOCVD and our MBE tools, both up significantly.

We have continued multiple system orders from APAC, the combination of Korea, Taiwan and China.

High-brightness LED market opportunities are still in their infancy, as we progress beyond traffic lights and keypad toward small-area LCD backlighting, automotive applications, large-screen LCD TVs, architectural lighting and, in the future, general lighting applications.

Each LED generation requires new, higher-brightness MOCVD tools.

LEDs are now penetrating new laptop mobile PCs that are slimmer, lighter weight, more energy-efficient and capable of a fuller spectrum of color resolution.

30-inch and 40-inch TV backlighting applications are probably a year away.

LED unit growth for the combination of red, orange, yellow, blue, green continues at 23% per year growth in units.

Industry, government awareness and increased spending associated with solid-state lighting is a response to LED's ability to reduce lighting electrical consumption by 50%, reduce worldwide mercury and carbon pollution levels associated both with fluorescent lamps and building more power plants.

The increased use of LEDs will reduce the need for the number of new carbon-emitting power plants worldwide.

In China, where electrical power shortages are severe and highly-polluting new power plants and high-priced oil are a major concern, some new, modern cities are planned to be LED-lit.

This year's expectation continues to be a revenue increase of 25% to 30% to around $80 million for Veeco in this sector, with MOCVD gross margins increasing to 30% by Q4 from 15% a year ago and to a goal of 40% gross margin by mid-2007.

Q2 was a 22% gross margin, right on track with our previously announced margin improvement plans.

This LED sector is potentially a multi-hundred-million market for Veeco in future years.

In the semiconductor market, which is primarily our auto AFM metrology tool, Q2 orders were $20 million, up 6% year over year, up 98% sequentially from Q1.

For the six months, orders were $30 million, down 10% from prior year.

Today, we announced a record auto AFM bookings quarter in the second quarter of $17 million in orders in auto AFM.

We continue to see progress in penetration of 90-nm, 65-nm and the development of 45-nm semiconductor applications, where the AFM provides unique high-resolution capability for CMP, for etch and for litho and mask applications, and continues to be a fab-based reference metrology tool, compared and often replacing TEM -- ideal for measurement of line edge roughness and line width variations, so new applications.

And now, auto AFM increasingly being used in data storage fabs for 3-D imaging of challenging nanoscale perpendicular head structures.

Overall, we expect 2006 semiconductor revenue to be flat for the year, although auto AFM orders are up 20% in the first half, some of that being data storage applications.

In scientific research, our orders were 24.4 million, down 6% year over year, up 11% sequentially.

Six-month orders were $46 million, down 10% year over year, due in part to our late introduction of our bio AFM and other new Metrology products that are now slated for the second half of the year introduction.

We expect 2007 growth in this sector, based on our strength in AFM and optical interferometry and breadth of applications in material science and life science.

Lastly, separate from the Q2 financial release this evening, we announced an organizational change today, reporting that Don Kania, our President and COO, will be leaving Veeco to become the President and CEO of FEI.

We thank Don for his years of service at Veeco, and we wish him every future success.

At present, Veeco will not replace the President/COO position, as we have recently strengthened the key operating executive positions in both Equipment and Metrology.

Those general managers will report directly to me, and can be expected to continue producing the strong operating results that we are reporting today.

Operator, we would be pleased to take questions.

(OPERATOR INSTRUCTIONS).

Timothy Arcuri, Citigroup.

I have in my notes a quarter ago you were talking about gross margin companywide being 48% exiting 2006.

It seems like now you are guiding to something like 46.5% to 47%.

Is that the right read there, that there has been a downtick in that?

No, the guidance for the fourth quarter remains in the 46% to 48% range, influenced largely by the content of Equipment and Metrology.

We have a pretty good feeling now for [slot plans] and backlog that goes into the fourth quarter, and I think we'll be comfortably in the 46% to 48% range, really no change from the previous guidance, which lets us end the year at a total 12 months of 45% gross margin.

Did I hear you correctly say that LED -- that compound semi wireless would be roughly $60 million this year?

I thought that you had previously said it would be something like $85 million.

No, it will be $80 million to $85 million.

Okay, I just misheard that.

Can you help me better understand what the margins were in LED?

I heard that epi margins were up 11%, but I'm not sure if I heard that right.

The MOCVD margins were 22%, up from 15%, on their way to 31% at the end of the year.

Brett Hodess, Merrill Lynch.

I'm wondering if you could talk a little bit more about the mix that you see going toward year end, because your comment is that 4Q orders will pick up again.

Will that start to be more heavily weighted towards the HB-LED at that point?

Or do you think data storage will start to pick up?

If not, will data storage start to pick up again in the latter part of next year?

And also, your commentary on how you see the semiconductor orders shaping up?

In data storage, obviously we have had two very strong quarters, two $70 million booking quarters.

That's a hard rate to maintain.

I would expect data storage to be down in Q3 and back up in Q4, and to end the year at about $250 million, a very nice increase compared to prior year.

LED -- this is our third strong LED quarter, and it's still not including LCD large-area TV; it's still laptop and small-area, LED backlighting on LCDs.

So I think you're right.

I would expect it to pick up in Q3 and Q4.

And semi -- I would expect semi to be -- it was $22 million and then $24 million in Q2 in orders -- I'm sorry, $10 million and $20 million, came up very nicely in the second quarter, so $30 million for the six months.

I would expect it to be higher than $30 million in Q3 and Q4.

When you look at the fact that the Metrology area had a strong booking performance as well, and you talked about the timing of the margin in the second half, so in the fourth quarter, we should see a higher mix of Metrology along with the revenue recognition things that Jack talked about driving the margins back up?

Exactly.

So when Jack talks about the range of margins in Q3 being 43.5% to 44.5%, that is because in that particular quarter, the third quarter, the Equipment mix is quite high.

The backlog for Equipment and Metrology gives us a more normalized mix, something more similar to 60/40 or 62/38, and gives us higher margin for the fourth quarter.

Robert Maire, Needham.

Congratulations on nice numbers.

In terms of capacity, capacity utilization of your tools, particularly in the high-brightness area, can you tell us a little more detail of where that is at, given that a while back we had a case of perhaps overaggressive buying in this market segment?

Do you think we're seeing more conservative buying patterns as we have evidenced in the semiconductor side of the market?

If you could give us a little more color on that?

I think clearly we are not seeing, as we did some years ago in wireless, very high multiple ordering.

We are not seeing that.

So compound semiconductor, even though we're seeing an uptick in each of the last three quarters, the multiple buys that we see are two to three systems per property.

What we're seeing is still a lot of binning and sorting as they look for higher-brightness LEDs.

So we're seeing a bidding and sorting cost that probably equals their epi costs.

So, as we can introduce new tools with higher levels of brightness and uniformity, better yields, those tools will pay for themselves very quickly, due to the elimination of this extensive binning and sorting that is now going on.

Where would you say -- would you say we're at relatively full utilization, or can you give us a little detail on that?

And also, similar comments for the data storage side of the business?

The utilization in LED for high-brightness for the newer applications is very high.

They are selling every high-brightness LED they can manufacture, and they would eagerly buy more tools like the GaNzilla III and the GaNzilla IV that we are going to introduce that will have improved levels of uniformity and brightness.

In the older applications, they probably have enough capacity, but for the high-brightness blue and green and whites, there's not enough capacity.

I think in data storage, there has been some relaxation in utilization from the 90% level probably to the 70% or 80% level, but still very heavy investment in perpendicular and femto heads.

And current expectation in terms of order rates for the data storage side are relatively steady going forward in the near term?

Well, I think not steady compared to the $140 million first half.

I think that in the forecast, we are giving the midpoint is something like $122 million compared to the $143 million.

Probably data storage comes down $10 million from Q2 to Q3.

Matt Petkun, D.A. Davidson.

You guys have made a very solid improvement in earnings year over year, part of that obviously coming from better end markets, but a lot of it coming from the internal changes you've made.

I'm wondering -- and I know this is a hard thing to do -- if you guys can talk about your breakeven.

Obviously, your guidance suggests you are very far away from that.

But I think at this point, the market is wondering what type of changes you have made for when times are a little bit slower.

So I was just wondering (technical difficulty).

Well, we show that in our presentation, in our financial model, what we call a trough quarter that is probably not so different from Q1 of this year, where at about $94 million in revenue, we had a 6% EBITDA, compared to a peak quarter which hopefully will resemble Q3/Q4, where at something between $125 million and $135 million, we produced 16% EBITDA.

So breakeven, Jack should comment, is probably 80 -- depending on the mix of equipment and ecology, is probably in the 80's.

High 80's, yes.

Yes, I would say that's probably true, $88 million on a quarterly basis.

I think the important point that -- what we are trying to change is obviously our equipment business is more cyclical.

What we have done this focus on outsourcing there, so that we can be more proactive in terms of reducing our breakeven, if and when business turns down.

So that's an important element of our plan.

Backing Jack's point, even in the second quarter, to support his thoughts, equipment had a 40% gross margin, compared to 36.7% gross margin at almost the same revenue a year ago.

So the outsourcing and the new products, higher ASPs, more efficient efficiency is certainly helping.

Then, the gross margin on the epi side of the business, I think you said was 22%.

Is that correct?

On MOCVD.

MBE margins are close to 40% in the same quarter, but --

So the combined margin for that group would be --

It's probably be like 30%, Jack?

Yes.

But a lot of focus has gone onto the MOCVD, because that's where the historic problem was a couple of years ago.

There, clearly, we're seeing this dramatic -- in MOCVD, dramatic gross margin increase from 15% in Q1, 22% in the second quarter and expected 30% in the fourth quarter and reaching mid -- reach 40% in mid-2007.

But the numbers you have given in the past were just on the -- you combined both MBE and MOCVD.

Is that correct?

Yes, I think we have given both, yes.

Can you kind of tell us, did the GaNzilla ship and recognize as revenue in Q2, GaNzilla II?

Yes.

That is seeing the margins you wanted to see?

Yes.

Great, nice quarter.

Daniel Berenbaum, Susquehanna.

A question on your thoughts on working capital and free cash flow.

I have in my notes that you made a comment that you expected inventory to be down over the course of the full year.

Obviously, it picked up in time for this revenue ramp.

How do you think about what inventories are going to do for the rest of the year, and how do you think about where free cash flow should be for the year?

Well, we're planning and targeting a reduction in inventories in the second half of the year despite increased revenues.

We would like to see inventories go down somewhere between 5% and 7% in the second half of the year.

On a free cash flow basis, for the first half of the year, we were positive $7 million -- $7.2 million, and we probably would like to see that in the $20 million range in the second half of the year.

So then, for the inventory reduction, is that a benefit of the outsourcing, or is that just better internal controls?

Both, I would say.

Outsourcing plays a big role in it, though, for sure.

Then, a quick question on the AFM and the mix shift in the third quarter.

Since the mix is shifting away from Metrology, is that mix shift occurring more in semiconductors, in data storage?

Can you maybe give us a little more color of where that mix shift is recurring?

You mean the mix shift within Metrology?

The mix shift between Equipment and Metrology overall?

Between Equipment and Metrology overall.

As data storage and high-brightness LED continued to grow double digits and scientific research continues and semiconductor continues to grow single digits, you are going to have higher Equipment content in those quarters.

So, where our normal plan is kind of 60/40 Equipment to Metrology, you run through a couple of quarters that maybe are as high as 65/35 Equipment over Metrology, driven by the very high growth in LED and data storage, which have a Metrology content but not as high as Equipment.

Merriman, David Duley.

Nice operational results this quarter.

I was trying to get this from your prepared comments, but you have upped your guidance for the year on the top line.

Could you break down the three segments for us really briefly, how the growth rates changed in -- I think you changed it in hard disk drive and LED and in semi, but I just wanted to make sure I got it right.

So if you own the page of multiyear growth that led to previously describe the $450 million (indiscernible), that model, when you next see it or you look on the web page, is a $460 million model.

It reflects some of the comments many of you have made these last couple of months, that hard drive will have a 25% to 30% growth.

Let me find the older sheet.

So that growth which previously -- $450 million that was described as 15% to 20% growth is now 25% to 35% growth.

High-brightness LED, which was described as 20% to 30%, is now described as 25% to 35%.

So both of those have been increased a bit.

Semi is now thought of as being sort of flat to down 5% and scientific research flat.

So the total is up 10% to 13%, instead of what was previously described as up 10%.

So we changed the model from the midpoint of $450 million to now $460 million, really due to better performance in data storage and LED.

As far as operational expense guidance, Jack, could you just review where we should see total operating expenses in Q3 and in Q4 as either dollars or percentages?

Because it seems like what I heard was percentages are coming down.

But I just wanted to make sure I got this right.

Yes, what I said is it's going to come down 1 to 2 points per quarter.

We are currently running at about 35.9% this current quarter, in Q2.

So 1 to 2 points per quarter decline each successive quarter.

The driver behind kind of the lower operating expenses in total by -- if you take the midpoint, we're going to go from 35.9% and exit the year at maybe 32.9%.

What will be the driver of that 300 basis point reduction?

Well, I guess one part of it, obviously, is increasing revenue.

The other part is that we have kind of got our operating expenses fixed.

The only variable really at this point is the variable portion of compensation, bonus and that sort of thing.

You mentioned about moving to outsourcing.

Is there a plan?

If you were to take a majority of your manufacturing and outsource it someplace else, what kind of overall margin improvements would we be looking at from where we're supposed to hit this quarter or (multiple speakers) however you want to phrase it?

That is probably a multiyear initiative to say most of our products will be outsourced.

But if you take a look at our Ion Beam Equipment business, which last year had $25 million in the first-quarter revenue and a 40% gross margin and then 39.5% to 45.7%, we have increased those margins this year in the first quarter, 45.9% and 48.5% on sort of comparable revenues, slightly up revenues.

Really, a big portion of that is due to outsourcing.

We've probably got 20% of our Ion Beam Equipment now outsourced.

But also, that contributes to the difference between the 45% gross margin that we'll be reporting this year and the 48% gross margin in terms of how do you model further outsourcing.

It contributes significantly, not totally but significantly, to the fact that Equipment gross margins will go from 40% this year to 45% next year in our model, and Metrology goes from 53% to 54%.

So the next gain in margin, total Veeco, is a result of continued outsourcing standard platforms, which has the same potential impact on 2007 as it has in 2006, being improved against 2005.

This year, Equipment went from 35% to 40% gross margin and Metrology will have gone up 2 percentage points, from 51% to 53%.

So you could do that same kind of improvement on a model basis in the 2007 year, because of just a continuation of those initiatives.

What are the plans?

Is there a certain amount of the volume by the end of next year that you want to have outsourced?

Who is your primary outsource partner now?

I think we are still formulating those plans, to be honest about it.

We've got a couple of outsource partners in Brooks and Precision Flow Technologies.

We're identifying other partners.

So it's a little premature to give a multiyear plan publicly.

We're still developing it internally.

Michael O'Brien, Bear Stearns.

Just a quick question on the confidence level in fourth quarter being up.

Given data storage, it's notoriously short leadtimes and pretty dynamic on them changing their opinion.

What are you hearing from your customers that give you the confidence that business will bounce -- that orders will bounce back in the fourth quarter?

It's really the two or three programs that they seem committed to are perpendicular reporting.

They are so early in the total proliferation of perpendicular being only 15% of all the heads they manufacture, and all of them have said that the industry wants to be at 30% next year.

And femto heads, which is 30% this year, will double again next year.

So those are two technology investment areas that they really can't deny.

They could move spending around from quarter to quarter, but they can't significantly impact those programs an annual basis.

And larger wafer size, which this year will just be a prototype investment and a production investment next year.

So even if their seasonality and capacity relaxes a little bit, I think they still have to make second-half investments in technology.

Is that just that you have to do it in the December quarter to be ready for the ramp midyear or something of next year?

Yes, they have to do it for end of the year, and they have to do it to compete with each other in high aerial density.

There's a big win here for these higher aerial densities, because they get to more single-platter, single or dual-head drives with a lower bill of materials, compared to the older technology, which will require the continuation of more platters and more heads.

Maybe I just keep beating on this, and it does sound like they are going to move forward.

But why December and -- I guess, as opposed to March?

Is there something that they just wouldn't be able to get it ramped up in time?

I just want to understand the --

They describe more flexibility in their capacity spending than they described in technology investment, that they really need to compete with each other in higher aerial density.

They dare not face the market without an increase in the number of perpendicular heads they have put into products.

The same is true for femto and larger wafer size.

So our current plan calls for a modest second half of the year compared to the first half of the year in orders, but still ends up with $250 million in orders coming from data storage compared to $167 million last year.

Thanks, and nice quarter.

Mark Miller, Brean Murray, Carret.

My congratulations not just for good operation results but for another strong quarter for orders.

One thing -- did I miss the backlog number?

Yes, you did. $159 million.

You mentioned -- just explain a little to me -- that every next-generation of MOCVD requires new tools.

Is that because of material contamination or design or layer structure?

It's layer structure and brightness.

They really need to -- brightness and uniformity.

They still are struggling with very poor yields, where they have been in [source] to get these higher blue and green LEDs.

They would be very, very accepting of new systems that give them uniformity across the entire platter for high-brightness blue and green.

So it's high-brightness and better uniformity.

Finally, there was a good deal of discussion about everything but this in the fourth quarter.

Typically, the fourth quarter has always been a stronger quarter here because of science and research.

That is not unusual for Veeco, but for a lot of firms who have higher percentages.

You're not seeing anything to make you believe that it won't be another stronger quarter for science and research orders and revenues in the fourth?

That's correct, and that's part of the reason we feel that the $120-ish million midpoint third quarter improved in orders in the fourth quarter.

Thanks and congratulations again.

JoAnne Feeney, FTN Midwest Securities.

Congratulations.

Just some odds and ends, really, questions.

The backlog currently -- what is the tilt in that?

How much of that do you see coming out next quarter or the fourth quarter?

How much is longer?

Of the $159 million, we have $120 million in Process Equipment and about $39 million in Metrology.

So most of the Metrology business will turn in the next quarter and, I guess, split on the -- it really is third quarter and fourth quarter for the Process Equipment balance.

So your conservative outlook on Q3 regarding orders and revenues -- is that merely a reflection of your own history, which typically does see a week third quarter?

Or, as people have been talking, are you seeing a definite weakness in data storage in Q3 here?

No, it's the former.

In four of the last five years, despite the fact that our customers predicted a more robust September quarter, with vacations and shutdowns and the September quarter seasonality, we had a decrease of 15% or 15% to 20% in orders in the September quarter.

So that conservatism has influenced our forecast.

But we increased our backlog by $64 million in the first half of the year.

If you take the midpoint of our -- what you're calling conservative guidance for Q3, $122 million in orders and $127 million in revenue, that's a $5 million decrease to the backlog, followed by an increase in the backlog in the fourth quarter.

So we expect to end the year with a pretty strong backlog.

The current backlog -- in terms of systems, all of the revenue in Q3 is in backlog.

All of the systems revenue is in backlog.

There are some turns in Metrology tools.

I would say about half of the fourth quarter in systems is in backlog.

So the revenue is -- you could, I guess, correctly describe our revenue forecast as conservative, because it's really covered largely by backlog.

Right.

It's all relative.

Yes.

So, regarding the shift in mix from Process Equipment to Metrology, and also tie that with the research outlook for the year, which is largely flat, you were saying --

Right.

Do you see the shift out of Metrology as a permanent trend for Veeco?

And is that tied, perhaps, to research being flat?

No, I think the medium-term expectation in Metrology, with bio AFM and life science and some new products that are in the pipeline, is for the higher Metrology content than we are now seeing, and more like 7%, 8% growth in Metrology every year.

So I would expect that to be evident in the next couple of quarters, and I would expect with a little relaxation from data storage that we are talking about, that has a big impact in the mix of Equipment to Metrology within Veeco.

I think that helps.

So a little growth in Metrology, a little relaxation in data storage, and you kind of get back to a 60/40 Equipment/Metrology mix in Veeco.

You mentioned the GaNzilla III and IV.

Any timeline on when we should expect those?

Yes.

Well, the GaNzilla III -- we have not make any product announcements, but if I look in our pipeline, our R&D [product] -- and we are funding that pipeline because we see the need for higher-brightness tools.

They are sort of early to mid 2007 product launches.

[Nihal Chomsky], University of Rochester.

Congratulations on an excellent quarter.

I wanted to ask a bit of a more mid-term sort of range question, especially with regards to the acquisition strategy that Veeco holds.

In the coming year, 2006 and 2007, do you have any sort of range of dollar value acquisitions that you anticipate Veeco making?

Close to zero.

I'm being a little glib, but we have previously said that the -- and we are staying on this course.

After some significant acquisitions over the last 10 years, we now see an R&D pipeline within Veeco that is producing $150 million, $250 million of new products a year.

So there really is not a need -- other than some gaps in our roadmap, there is not a need for acquisitions going forward.

We can grow the Company this year to nearly $500 million, and we can see the next couple of hundred million of revenue within Veeco coming from internally-funded R&D programs.

So we are only likely to reach out for pockets of technology that are missing from the roadmap.

This year, we did a little startup in Massachusetts on alumina deposition that probably will cost us a couple of million dollars, and that is the size -- certainly, under $10 million or $20 million technology investments are all that is required to grow Veeco itself to a $600 million, $700 million size.

That's great to hear.

A follow-up to that, though, is that -- is there any desire to move into -- most of your products are at the front end of the fab.

Is there any desire to move towards the back end of the fab, or doing some testing, things like that?

Likely not.

I think we really see semiconductor as a difficult place to have double-digit growth this year, compared to data storage and LED that are in more of an emerging phase and will continue to have double-digit growth.

We have said previously that life science interests us, that we think biologists and life scientists are reaching for high-resolution metrology tools that are built around Veeco's AFM and optical intrerferometry skill.

So life science might be an area that we expand in.

You guys have talked about having slots for your current capacity without needing to (technical difficulty).

What capacity are you guys actually operating at right now with current revenue streams?

Well, because of outsourcing and because of the number of plants that we have, we pretty much could double our current revenue size without adding any bricks and mortar.

Excellent.

Timothy Arcuri.

I am still trying to connect the dots here a little bit.

Maybe I misheard you, but you're saying that storage orders are going to be down about $10 million in Q3?

Is that what you said?

Yes, I mean, we don't give forecasts by market sector for the [outcoming] quarters.

But yes, I said that if you are looking at the total orders that we just delivered that are $143 million, and you take the midpoint of our forecast that's about $122 million, down $20 million, you could have $10 million to $20 million of that could be within data storage alone, because data storage has just had two enormously robust quarters, $140 million in the first half of the year.

Even if it fell to $110 million in the second half of the year, you would be up $250 million compared to $167 million last year.

Sure, yes.

I'm just trying to take that relative to your comments also that orders in semis will be about $30 million.

If that's the case, if you're down $50 million or $60 million in data storage and you are $30 million in semis, you have to see a big decline in the LED business and in the research and industrial business to keep orders within your guidance?

No, not true.

LED, which grew $27 million this quarter -- I expect them to be up a little in Q3 and then up again in Q4. four.

So $60 million in the second half of the year, compared to sort of $51 million in the first half of the year.

It's just difficult to keep bookings where you are guiding them.

But okay, we can talk about it off-line.

I think an important part -- and you should get back to us -- is we are not -- as I look through these numbers, I see no change from previous conference calls, in terms of our gross margin expectation for the year or our gross margin expectation in the fourth quarter, and certainly no change in the expectation that I think orders for the year will be up about 25% to 30% for Veeco, somewhere around $520 million compared to $405 million last year.

Very strong order performance for the year, despite an expectation that Q3 will be seasonally down.

But I would be happy to take this off-line to go further with you.

Operator, thank you.

I think my last comment sort of sums up where we are.

We feel our major markets are quite robust, despite a September seasonality that seems to have always been with us in the last five years.

We think there is continued strength going into the 2007 year in our core markets, and we think that the operational excellence steps we have taken is showing up in gross margin and EBITDA.

EBITDA will again very nearly double from prior year, so we feel very good about the current market conditions.

We look forward to talking with you further and supporting our September quarter.

Thank you all.

That does conclude today's conference.

We do thank you for your participation.