Veeco Instruments Inc (VECO) 2010 Q3 法說會逐字稿

Good day, everyone and welcome to the Veeco third quarter 2010 earnings conference call.

Today's call is being recorded.

For opening remarks and introductions, I would like to turn the conference over to Senior Vice President of Corporate Communications, and Investor Relations, Ms.

Debra Wasser.

Please go ahead.

Thank you operator and thank you all for joining today's call.

Joining me today are CEO John Peeler and our CFO Dave Glass.

Today's earnings release is available on the Veeco website.

Please note that we have prepared a slide presentation to accompany today's meeting.

We encourage you to follow along with the slides on Veeco.com.

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

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

Your participation implies consent to our taping.

To the extent that 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 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 discussion and analysis section of the Company's report on Form 10-K and annual report to shareholders and in our subsequent quarterly reports on Form 10-Q, current reports on Form 8-K, and press releases.

Veeco does not undertake any obligation to update any forward-looking statements including those made on this call to reflect future events or circumstances after the date of such statements.

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.

Lastly, please note that all results presented today are for Veeco's continuing operations.

Excluding results of the former Metrology Business which was told to Bruker Corporation.

I'd now like to turn the call over to John for opening remarks.

Thanks, Deb and thank you all for joining us today.

We're calling you today from Seoul, Korea and we're excited to be here to celebrate LG's latest LED fab opening as well as to meet our key customers and employees.

As Deb mentioned, our third quarter results are adjusted to reflect the October 7 sale of our Metrology Business to Bruker.

We think that Bruker was the ideal purchaser of this business and we moved quickly to bring the transaction to a successful close.

We've now created a new Veeco focused on growth opportunities and LED & Solar and data storage.

Turning to our third quarter financial results which you can see on slide five, Veeco's revenue was $277 million, that's up 25% from Q2 and up 270% from last year.

Our strong revenue drove EBITDA to over $95 million and net income to $91 million.

GAAP EPS was $2.16 a share.

Non-GAAP EPS was $1.46.

Gross margins were 49% and that's up 4 points sequentially.

These are really exceptional results and represent record performance for us across-the-board.

I'm really proud of how our team has executed.

Turning to slide six, I'll review Q3 revenue by segment.

Veeco's Q3 LED & Solar revenue was $243 million, that's up 31% sequentially and over 350% compared to last year.

MOCVD revenue was $236 million.

We shipped over 100 systems and that's nearly five times the number of MOCVD systems we shipped in Q3 of 2009.

LED & Solar represented 88% of our Q3 revenue.

Data storage revenue was $34 million or 12% of our total, down slightly on a sequential basis but up 59% year-over-year.

EBITDA improved year-over-year in both of our businesses.

Slide seven shows our Q3 bookings performance by segment.

Q3 bookings were $278 million.

LED & Solar bookings were $243 million, that's down 7% sequentially, but up 36% year-over-year.

Data storage bookings were $35 million, that's down 30% sequentially but more than 100% year-over-year -- 100% up year-over-year.

Veeco's book-to-bill ratio for the quarter was 1-to-1 and our quarter ending backlog was $569 million.

Turning to slide eight, let me give you additional detail on our third quarter bookings.

In LED & Solar we booked $243 million and that was mostly MOCVD tools due to an unusually low level of bookings this quarter for our MBE products.

Our Turbo Disc K465i continues to win business as the best performing lowest cost-of-ownership tool in production today.

We received orders from 15 customers and saw continued strength in china.

Bookings included large multi-tool orders from Elec-Tech, Sanon, TsingHua TongFang and others.

In Taiwan, we received follow-on orders from Epistar, Arima, and GPI, and we penetrated [Lextar] for the first time .

This will be a key new account for veeco.

In data storage, we had an excellent quarter, we're winning in the market for hammer technology investments, including our new products for ruthenium CVD, DLC-X, and PVD.

These products are seeing strong adoption from multiple customers.

We also continue to be selected for eight inch wafer program expansions at key customers.

Turning to slide nine, I want to cover our plans to expand our service and support across Asia.

We're establishing three new state-of-the-art facilities in China, Korea, and Taiwan and plan to add over 50 new training and technical support personnel in the region.

We believe that this investment in infrastructure, equipment and people will help insure that our Asian customers successfully ramp production and accelerate the LED's industry in growth and penetration of general illumination.

While these facilities and personnel will initially be LED-focused, they will be leveraged to solar and other clean tech markets as those businesses become more important to Veeco in the future.

I'd now like to turn the call over to Dave Glass for some additional financial

Thank you, John.

Let me now touch on a few of the important financial highlights starting on slide 11.

As John mentioned earlier, we set a new bar this quarter with record levels of revenue, gross profit and earnings.

GAAP income from continuing operations of $91 million was up from breakeven results in last year's third quarter and up over 80% from the second quarter of this year.

As a strong indicator of how Veeco leverages its outsourced manufacturing model and a very lean fixed cost base, we saw strong flow through this quarter as $56 million of additional revenue versus Q2 translated to $32 million of additional EBITDA.

Gross profit margins of 49% were very strong, up 4% from the second quarter.

Margins were helped this quarter by higher average selling prices, a growing number of final tool acceptances this quarter which increases our margins, and greater fixed cost absorption related to the higher volumes.

Turning to slide 12, John has already touched on revenue and bookings' performance by segment but let me spend a bit more time on EBITDA among the segments.

LED & Solar finished the quarter with $92 million EBITDA.

This is up 60% over second quarter and 31% higher sales, as a result of strong margins as well as controlled operating cost spending which didn't rise as rapidly as the sales did.

Data storage EBITDA of $9.4 million was just slightly below the $9.6 million reported last quarter on slightly lower sales.

Total EBITDA for the Company was $95.5 million or 34% of sales.

This represents a sequential EBITDA gain of 50% on 25% higher sales.

This quarter represents another outstanding performance for both of Veeco's continuing business segments.

Now let's turn our focus to the balance sheet on slide 13, recently one of my favorite subjects to talk about.

We finished the quarter with $467 million of cash and short-term investments which included $32 million in restricted cash.

Our cash balances are up by over $50 million in Q3, driven by $77 million of free cash flow and offset by $32 million of cash that used to buy back stock under our buyback program which was authorized in August.

The average cost of shares purchased under the buyback program was $34.

Accounts receivable and inventory were both well under control in the quarter and reflect the increased business growth.

Turning to slide 14, you can see that Veeco has had a fantastic run of positive cash generation over the last few quarters.

Making a few conservative assumptions and holding the impact of any further stock buyback activity aside for the moment, we expect to finish the year with cash and short-term investments of over $700 million of which about $55 million will be restricted.

Our substantial cash balance leaves us with more operational and strategic flexibility than Veeco has ever had before.

We plan to use this cash prudently to support strategic growth in Asia, to continue buying back shares as appropriate under our Board authorized buyback program and potentially for strategic acquisitions should the right opportunity present itself.

In Asia, we plan to invest about $25 million in CapEx during the next 18 months.

On slide 15, I'd like now to comment on the positive outlook for the fourth quarter.

We currently expect that Veeco bookings for the fourth quarter will be equal to or better than bookings in the third quarter.

In LED, we continue to see particular strength in China as deposits are coming in for large multi-tool orders -- purchases and we're quoting additional new customers.

In Taiwan, we see significant opportunities both at existing and new customers as we're increasing our historical market share.

And in data storage, overall market conditions remain healthy as customers continue technology investments.

In fact, we've already had a strong beginning to Q4 in data storage with some important customer wins earlier in the month.

For our fourth quarter revenue outlook, we're expecting sales of $285 million to $320 million.

As explained in our press release due to the recent strong order rate from China our current plan for Q4 revenue includes a significant amount of large multi-tool shipments to key Chinese customers, many of whom are building or expanding their facilities.

While we're confident these tools will ship over the next few months, revenue could shift into Q1 due to customer facility readiness.

On slide 16, based upon this revenue range of $285 million to $320 million, we expect gross profit margin to continue to climb slightly to 50% to 51% and we expect operating expenses in the range of 16% to 17% of sales.

These factors would result in EBITDA margins of between 34% and 36%.

Moving to slide 17 we expect Q4 GAAP EPS of between $1.96 and $2.35 per share or between $1.46 and $1.70 per share on a pro forma basis or non-GAAP basis.

We're on track to report a fifth consecutive quarter of record results in the fourth quarter.

Let me now turn the call back over to John.

Thanks, Dave.

Moving on to slide 18, let me make a few comments on the lighting market.

While there have been much reported about the current LED industry hiccup caused by flat-panel inventory correction, we think the demand for LEDs will remain strong and that continued backlighting penetration and LED lighting adoption will require the purchase of thousands of MOCVD tools over the next couple of years.

LEDs offer tremendous benefits over other forms of lighting, including energy efficiency, high performance, and long lifetime.

LEDs are smart and tunable lighting solutions and are good for the environment.

The LED industry continues on a pace to deliver 35% per year increase in light output and a 20% per year reduction in cost.

MOCVD will continue to play a critical role in achieving the industry's goal of a $5 light bulb.

There have been many forecasts for the LED industry in some of the most notable recent commentary coming from Phillips and GE, stating that LED lighting could represent 50% of their lighting sales within five years.

We strongly believe that the cost curves for LEDs will begin to climb rapidly and that Veeco, through new product introductions, help enable and accelerate a pace of change in the industry.

Moving to Slide 19, with another strong bookings quarter now underway, we'll enter 2011 with a large backlog in both LED & Solar and data storage.

We expect first half 2011 revenues to remain strong and well above the first half of 2010.

It's difficult to repredict MOCVD orders more than a quarter out as there are many moving pieces and for example, our Korean customers are digesting tools that they ordered from us last year and earlier in 2010.

It's unclear how long this digestion phase will last but we believe these customers are committed to full penetration of LEDs and TVs and the general illumination market.

In addition, Veeco continues to penetrate important accounts and we're in the game for many large deals.

Predicting the future is hard, particularly as to when or if there will be a decline in MOCVD business or whether there will be a more seamless transition from back lighting to general illumination.

So we're focused on the things we can control, such as accelerating our product road map, and continuing to deliver high quality products to our customers.

It's our goal to become the number one supplier of MOCVD systems.

In our other businesses, quoting is picking up for our CIGS solar deposition systems as we make progress advancing these tools process capabilities for high efficiency, low cost solar cells.

Our data storage business continues to perform exceptionally well with new products that are meeting customer technology challenges.

We expect continued momentum in data storage and revenue growth in 2011.

I'm really proud of the progress that Veeco has made in 2010 to achieve our record financial results and I am excited about our future outlook.

Our goal is to achieve revenues of over $1 billion dollars in 2011.

Thank you all for your participation.

We'll take questions at this point.

(Operator Instructions) Our first question comes from Christopher Blansett with JPMorgan.

Good morning everyone or good afternoon.

Quick question about the push out you're seeing and if you could quantify exactly where this is coming from, is it mainly tied to facilities readiness?

Or we were wondering if some of the push outs were tied to some of your customers wanting to build factories in China as opposed to Taiwan or Korea so they could access that subsidy there?

We have not seen any push outs in China.

We've seen a small number of push outs, about ten tools that are in our backlog, really in Korea and a little bit in Taiwan, but nothing in China.

Is this really just tied to the facilitization issues some of your customers are having?

I was just trying to see if you had some -- maybe some [thoughts] you can categorize the reasons that you know of at least?

No.

The push outs aren't tied to facilitization.

They are really tied to the slowing market in Korea, the digestion of the tools that we've shipped over the last year-and-a-half and really just taking a pause there as well as a few small number of tools in Taiwan and just adopting to the tools, I believe, of the LED flat-panel correction cycle.

I think China is a pretty different thing.

We're seeing absolutely no slowdown in China and but, there are huge facilities to be built and customers are either building new facilities or expanding existing ones.

And if they aren't done at the beginning of the quarter, you always have to assume there could be some risk there so that's a different situation than push outs.

All right.

And then I just had one follow-up related to the additional order -- the Epistar win and your view on share?

I wasn't -- although the competitor hasn't reported yet, could you give us an update on how you think your share is trending now with these additional penetrations into Taiwan?

I think our share continues to grow.

We've done very well in Taiwan and penetrated key new customers that if you looked at us a year ago, that were not customers a year ago, whether that's Lextar or Epistar.

We'll continue to penetrate new accounts and see our share as growing in Taiwan to more closely reflect the higher share that we have in other regions of the world.

Thanks guys.

I'll come back around for another question.

Thanks, Chris.

Our next question comes from Bill Ong with Merriman Curhan Ford & Co.

Yes, hi.

Congratulations on the record quarter.

Can you share first with us China's LED investment view for the next three years to five years and specifically why are they investing so much right now knowing that today's MOCVD tools will likely become more trailing edge in three years to five years and not competitive with the general lighting market?

So are these tools being purchased largely by motivated by spending government's money or do the Chinese customers really believe this creates an install base that will be competitive with the some of the Tier 1 players?

Thanks.

I think that the Chinese government recognizes that they have a really major energy problem in the country and that they are really looking to alternatives for green energy both to save energy use within the country as well as to create an industry that connects forward to the rest of the world.

The purchases that are being made for MOCVD tools in China will eliminate the need to build huge numbers of new coal-fired power plants for example, so there is an urgency from the Chinese government to deal with an energy problem and they are addressing that both by subsidizing LED manufacturers to get started and to create an industry as well as creating a demand or creating a market for those same suppliers in the street lighting market.

So it's a double-sided strategy and I think they're working to solve an energy problem as well as create an industry as they've done in some other areas of clean tech.

Thanks, Bill.

Great.

Thanks so much and nice job, everyone.

We'll now hear from Daniel Amir with Lazard Capital Markets.

Thanks a lot.

Can you comment a bit what you're seeing right now in terms of lead times in the industry and a follow-up question is could you also comment about when do you expect your next generation tool to come out?

I mean is that soon and what should we be looking at there?

Thanks.

So thanks, Daniel.

The lead times are staying relatively the same.

I think we haven't really had a change there in that perspective.

As far as next generation tools, we've been working very hard on our product development.

We increased our investment starting a couple of years ago, launched the 465i in a state when it was really done and ready to go, so that's been a tremendously successful product for us because it hit the ground running and didn't have much in the way of start-up issues.

We're committed to launch a new generation every 12 months to 18 months.

We launched that product in January of last year so you get a feel of when you could expect the next one.

We've already launched a number of upgrades to the 465i so we do upgrade our current products as well as launch new generations and we have development for two generations going on at once, so that's actually a new -- a newer strategy that we adopted over the last two years at Veeco.

So that we can continue to gain momentum in our road map, so we think we have a very exciting product road map on the way and expect to do great things with that.

Thanks, Daniel.

Thanks.

We'll now hear from Krish Sankar with the Bank of America Merrill Lynch.

Yes, thanks for taking my question.

John, I wanted to find out in your view, exiting 2010, what do you think is an install base of MOCVD tools in China and where do you think that will be exiting 2011?

I don't think -- I don't really have a number for you on that.

I can tell you Q4 is a major installation quarter for us in China.

Q3 had some significant numbers of installs.

Q4 is large but we will also hit 2011 with a large backlog of additional equipment to ship into China and other regions of the world, so it's been a real uptick.

We saw the Korean orders starting about 15 months ago and playing out very heavily for three quarters or four quarters and then we saw China start to really ramp up and along the way, I think Taiwan has been steadily increasing.

Got it, and if you look into 2011, I'm not looking for any quantification but can you tell me regionally which segments will drive the strength for MOCVD and which segments will actually be -- which regions will be down next year?

Hard to -- it's hard to say, Krish, at this point.

I think we're expecting the Korean market order rate to be lower in the first half, the real challenge there is when does that start to turn back on.

I think it's got a couple of quarters before that happens.

It could come sooner, it could come later, backlighting is -- I think backlighting, we're going to near 100% penetration of backlighting over the next few years.

And all three major Korean customers have major general illumination programs so they are going after both of these markets and the timing of the net is hard to quantify.

What we know is the first half of 2011 will be strong because we're going to hit the period with a very strong backlog and we expect there to be continued growth in China, especially we don't see an order of slowdown.

Got it.

Just a final question for Dave.

You spoke about the cash on the balance sheet.

Seems like you have a little over $100 million debt coming due in a year-and-a-half.

Any plans to pay that off next year?

Thank you.

Ladies and gentlemen, please stand by.

Ladies and gentlemen, please stand by while I reconnect our speakers.

Hello?

And you are reconnected.

Thank you.

All right.

So we were disconnected during the answer to Krish's question.

Did we get most of that through?

Krish, are you still on?

Yes, can you hear me?

Yes.

How much of John's answer did you hear?

Yes, I heard it completely.

That was great.

I just had one final -- just to follow-up for Dave.

Dave, you spoke about exiting the other $700 million of cash in hand and it looks like you have $100 plus million debt coming due in a year-and-a-half.

What are your thoughts around it?

Thank you.

Yes, the debt is due in a year-and-a-half.

The window opens, however, where we could, at Veeco's discretion, choose to pay it off as early as April of 2011, so we haven't made any final decisions for that but obviously on that $700 million, we're reserving $103 million and that will be there for whatever we decide to extinguish the debt.

Thank you.

Thanks, Krish.

Our next question comes from CJ Muse from Barclays Capital.

Hi, this is Olga [Levinzon] calling in for CJ Muse.

Two questions.

First of all you talked about the potential for some of the Korean and Taiwanese tool shipments to be pushed into Q1 and the potential for China as well.

Given some of that as well as the potential for some of the CIGS revenue you have in backlog recognizing either in the next quarter or the quarter after that, how do you think about the revenue trajectory into the first quarter and second quarter beyond just the comments you made in your prepared remarks?

Well, first of all, we talked about some potential push out in Korea and Taiwan, actually some push outs into Q1 and those are accounted for in our revenue guidance and we also mentioned that there might be some facility start-up issues in China in terms of facility readiness, and we've done our best to incorporate those into our guidance.

So I think our guidance range includes the variability that happens based on these items, so I think we're going to have another record Q4 here in terms of the business and we're going to hit 2011 with a very strong backlog and so we're expecting a really good first half of 2011.

I think it's quite likely we'll have a very good second half and also we just can't predict that yet.

It's a bit early to predict Q1 revenues though.

Okay, got it.

And then assuming that the better first half of 2011 plays out, do you see gross margins being sustainable at the 50% plus range or how should we think about that going forward?

For the time being, we're assuming the gross margins will be in that 50% plus range.

Got it.

Thank you.

We'll now hear from Stephen Chin with UBS.

Great.

Hi John.

Thanks for taking my question.

Just a question on China.

Since you were in China last week, I was hoping you could share maybe a ballpark estimate of how many LED fabs in China you're tracking and how many you think likely need MOCVD equipment shipped going forward?

Well, so we had about nine customer sales into China last quarter and a number of those were really repeat customers that we've been selling to for a fair period of time, so the number of fabs is bigger than that.

It's bigger than ten, maybe 15 is a reasonable estimate.

It really depends on size though.

Some of the fabs are hundred-plus unit fabs and others are considerably smaller.

We think of the market in three categories -- large established companies that have been making LEDs in China for quite a while and clearly have the expertise to do that.

And then secondly, newer companies that are joint ventures between Chinese companies and Koreans or Taiwanese companies, usually well capitalized, and have some basis of intellectual property and know how to get up and running.

And then some smaller ones that are new start-ups and are looking to pull talent from somewhere else.

Most of our business comes from those first two categories of customers.

That is we're pretty confident they are going to be successful.

And then if I could ask a second question on the bookings guidance of fourth quarter being flat to up, do you get the sense that there could be some pent-up customer demand for orders again maybe in the first half of next year with customers waiting for the new Veeco MOCVD tools to become available.

Is that a possibility that's happening also?

It could be.

It certainly it could be.

We've had a lot of strong quarters in a row and I think our bookings guidance basically says look, we're going to have another one and the statement is that it would be equal or better than Q3 and I think that's a real positive thing.

We -- so there could be some pent-up demand though, some people waiting for the future but it's a healthy order rate and a healthy business.

Thanks, John.

Thank you.

We'll now hear from Andrew Wang with Sterne, Agee.

Thank you.

I guess the first question is can you give us a rough sense of how MOCVD ASPs in the backlog compared in Q2 versus Q3?

They're up.

I -- not thinking of it in terms of the backlog but generally, our ASPs are -- were up in the third quarter.

Okay.

And then, I guess --

Pricing has stayed very strong and our ASPs have done really well.

Our gross margin has gone up 4 points so that ought to give you a feel for it and clearly some of it's volume but there are -- Well part of the gross margin increase was definitely ASPs.

So when you say ASPs, it's a positive mix shift, correct?

Mixed as well as on average, the average selling prices on the mix that we're selling is up.

Right.

Great.

So if your backlog is down by about $28 million and if your bookings and revenue were both I guess $243 million does that mean that there were cancellations during the quarter?

There were no cancellations and book-to-bill and MOCVD was 1, so I think we have to look elsewhere for why the backlog was down.

Okay.

And then just one last question.

Do you have any commentary on shipments or bookings for six inch MOCVD tools?

The -- our tools are really wafer size agnostic.

They run a two, four, six, or eight inch and you don't have to change the machine to do that, so it's not really -- we don't make a machine for six inch or four inch.

What I can tell you is going on in the industry is that ultimately, industry will move to six inch but right now, six inch is very expensive on the wafer side for the sapphire wafer.

You use a lot more sapphire and have to be thicker and so most of the market if we look at it is running at two inches and four inches, and six inches more trial-based at this point with people looking to move at some time in the future as sapphire -- as the sapphire wafer industry catches up.

Got it.

Okay, thanks for the color.

Thank you.

And Mark Miller from Noble Financial Group has our next question.

Congratulations on another great quarter.

Can you just provide, I know it might be difficult but in terms of the orders you've received in the second and third quarter would it be fair to say that compared to your competitor that you've got at least 50% of those orders?

Well, our competitor hasn't reported yet, so I know in the second quarter we had over 50% of the overall market quarter so we have a couple of competitors, one big one and a couple of little ones, but I think we clearly booked 50% of the marketplace in Q2.

I think we had another strong quarter from a market share basis and if you look at our revenue market share, it's been increasing every quarter for the last year.

So I think we're happy about our market share and we're -- I think there's some good signs in there that we're penetrating new key customers and you see new customers that weren't really Veeco accounts in the past becoming Veeco customers.

As you continue to sell systems into the global LED market and say you get up to around a thousand tools installed base, can you give an estimate in terms of revenues from spares, replacement and service?

It should really move up.

It's well under 10% in the MOCVD business at this point with a large shipments over the last year.

Most of those tools are still in warranty, so it's -- that really holds it down as a percentage of our install base but as this goes up, it should increase.

This is an industry where it might not be as high as some other industries due to customers' desire to keep their recipes confidential and that thing, but I can tell you in our data storage business, it's 30% of the overall business and it's a very healthy part of the business.

As we move forward, we expect it to be a larger and larger part of our sales in the MOCVD area and we have a number of new programs to really give customers added value in this area, so it's a good opportunity for us.

And just one final one.

Are you pleased with how you're being competed against Xtrons new [G5] system?

We're very pleased.

Thank you.

Our next question comes from Ahmar Zamian with Piper Jaffray.

Hi, this is Sean [Wieland] calling in for Ahmar.

I was wondering if you guys could tell us what percentage of your bookings are now dependent on government subsidy?

I don't have a figure for you on that, I think and that's a little bit of an illusive number to get to.

I think China is the market where there are government subsidies and they do vary by province and you have to try to predict what those bookings will go to if those subsidies are eliminated but China is clearly our largest growth market at this stage, so subsidies are an important factor.

Thanks, and I was wondering if the Epistar orders that were announced today were already included in this quarter's bookings?

Yes.

Okay.

And some recent commentary from some LED peers suggest a slowdown in the Chinese lighting market.

What impact do you expect this to have on the LED bookings going forward?

We haven't -- I know Cree reported a slowdown in the Chinese market but we have seen no slowdown and we're a very different type of Company than Cree.

Cree is a Company selling components into the Chinese market against the Chinese companies.

We're a Company that's selling equipment into the Chinese market, helping them to build an industry, so I think it's apples and oranges comparing a slowdown of component shipments into China versus equipment shipments into China.

Thanks, Shawn.

Thank you.

Our next question comes from David Duley with Steelhead Securities.

Congratulations on a nice quarter.

Couple questions from me.

Why are you so confident about the order rates in the fourth quarter and the LED business being flat when you're seeing push outs in the third quarter?

We're confident because what's in the funnel, orders that we already received, POs for where deposits are coming in, pressure from our customers to get product, so it's all of those things.

Remember, we don't put an order on the books from China for instance without having received a really large deposit so in a number of these cases, we have the orders.

They're just not booked in the backlog because we didn't get the deposits yet but general demand situation and funnel and orders from other regions other than China tells us that it should be a good quarter, and it should be a good quarter in multiple markets, not just MOCVD.

It should be a good quarter in MOCVD and MBE and data storage, so I think it's -- there's a lot of good things going on.

And on the gross margin front, I think the drop rate on incremental revenue this quarter was about 90%.

You gave us a bunch of reasons.

I'm assuming that, that number is so high because of the ASP increases.

With the drop rate going forward what range should we expect?

Not sure how to answer that going forward.

I don't know.

Dave, when you mean drop rate, you mean the flow through on the bottom line, how much more?

Well revenue, gross margin dollars were up almost as much as the revenue was up so the incremental dollars on the revenue front produce very strong gross margins.

And I'm just wondering are we to a tipping point where that's going to continue, not dollar for dollar but because that's theoretically impossible but --

One of the things that drove that condition is we had a lot of acceptances, more acceptances in the third quarter than we did in the second quarter.

And fourth quarter we'll see also a lot of acceptances as we're moving things out of backlog into revenue.

Okay.

So Yes.

And just final question for me is you gave guidance that accounted for the push outs or the movement in the backlog that you've seen recently.

Without those push outs, I'm assuming your revenue guidance would have been about $25 million higher because you said there was ten tools involved in this.

Is that a good assumption?

Yes, it could be.

Okay, thanks and congrats on a nice quarter.

Thank you David.

Our next question comes from Jed Dorsheimer with Canaccord Genuity.

Hi, thanks and congratulations on a great quarter here guys.

First question, John, is on the cost structure, you've very efficiently expanded your capacity.

I was wondering are there any commitments tied to that increase now that you're at 120 and maybe to ask the question a little bit differently, will the costs look similar to when you had 50 tools or type of quarterly capacity or are there any additional costs incurred as you know at 120 if utilization was to drop off to the 50 level?

Well, we ramped our manufacturing up to 120 units and we have the ability to ramp that up and down.

We didn't add a lot of fixed costs to do that.

There is some additional fixed costs as you have more test bays or things that require it but it's still largely a variable cost and we're getting benefit in that and our gross margin at this point and it can scale up and down.

So it may take a quarter or two to drop it down as we change our manpower that are applied to certain areas of it because we do the final test ourselves at all of these facilities.

So largely variable and but really we designed it that way because we know all equipment -- process equipment industries are inherently cyclical, so we've built an organization that will scale up and down.

Dave, do you want to add to that --

No, I guess, I mean just a little bit more color.

Since the ramp of the last 18-plus months, just to give you an example, we've increased our fixed cost base of roughly about 35% when the top line has grown 2.5X.

So that 35%, as John said, it's given time it can be scaled back but it's most of the increase that we've seen is variable.

That's really helpful, thank you.

And then just Dave maybe for you, on the restricted cash, is that the deposit money or where are the deposits showing up?

No, no.

The restricted cash is money that we keep in China -- that is related to our Chinese deposits.

We give a bank guarantee to assure that the money that's held on deposit will eventually, that it's safe from a customer standpoint.

That's essentially what the bank guarantees are.

So where are the deposits showing up then on the balance sheet and then I wasn't able to find them on the cash flow.

What are they being classified under in cash flow?

The deposits are, it's a change in working capital.

It's in the other assets.

Okay, and then what about on the cash flow?

The other assets?

I'm sorry, other assets and liabilities.

It's in other.

All right, great.

Thank you.

Operator, I think we'll take one more question.

Thank you.

Our last question today will come from Patrick Ho with Stifel Nicolaus.

Thanks a lot and most of my questions have been answered.

Just wanted to get a little more clarification as you look forward to 2011, as you build-out the infrastructure.

I assume that the operating expenses are going to go up as you put this in.

Now, it will go up in absolute dollars.

Is it also going to track revenues on a percentage basis or will you be able to manage OpEx as it relates to the revenue trends as you look going forward?

We're going to pace the OpEx the same as we've been saying for a long time.

We're going to pace the OpEx to be no more than the higher teens or 20% range, so we'll allow the OpEx increase proportionate to the sales.

Okay, that's great.

That's helpful and final question for me.

In terms of the Chinese MOCVD market, credit to you guys for taking advantage of that market first, how has the competitive environment been to date?

Are you seeing increased pressures?

Would you see potential ASP squeezes as your competitors enter that market as well?

We've been doing very well in the Chinese market.

ASPs have held up very well.

We believe we're booking well over 50% of the business, a little too early to quantify that yet but we think we've got the best product and the best product for that market, so there has been no -- certainly no negative ASP impact.

And we don't expect it.

Great.

Thank you very much.

Okay.

All right, well thank you all for joining us today.

We are really happy about our performance and expect to do it again next quarter.

Thanks.

Ladies and gentlemen, that does conclude today's conference call and we thank you for your participation.