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Operator
Good day, and welcome to the Komag, Incorporated, second quarter fiscal 2005 earnings conference call. Today's call is being recorded.
I would now like to turn the call over to the Chief Executive Officer of Komag, Mr. T.H. Tan.
Please go ahead, sir.
T.H. Tan - CEO
Thank you, Susan.
Good morning. I am T.H. Tan, CEO of Komag. With me on the call today are Dr. Russak -- Mike Russak, our President and CTO; Kathleen Bayless, our CFO; and other company officers.
We will ask Kathleen Bayless to discuss our financial performance for the second quarter of 2005, then Mike will discuss customer and market conditions, and I will discuss the second quarter's operations, our outlook for both the third and the second half of 2005 and make a few closing comments and then we will open it up to Q&A.
Kathy?
Kathleen Bayless - CFO
Thank you, T.H.
Before we begin today, I would like to remind our audience that we will be making forward-looking statements during this conference call such as the statements regarding our outlook for the third quarter and second half of 2005 and our expected capacity and capital spending for 2005. These forward-looking statements involve risks and uncertainties that could cause the actual results to differ materially from our forecast. These forward-looking statements speak as of today and you should not rely on them as representing Komag's views in the future. We undertake no obligation to update forward-looking statements to reflect events or circumstances after the date they were made.
In addition to the factors that may be discussed in this call, important factors that could cause the actual results to differ materially are contained in our press release today, announcing our second quarter results and in our recent SEC filing, including our annual report on Form 10-K for the year ended January 2, 2005, and subsequently filed quarterly reports on Form 10-Q. Copies of these documents may be obtained from the SEC's website or by visiting the Investor Relations portion of our website.
The press release describing our second quarter 2005 financial results is currently posted on our website at www.komag.com.
Now I will review our financial performance for the second quarter of 2005.
Net sales totaled 172.7 million in the second quarter of 2005 compared to 140.3 million in the first quarter and 101.1 million in the second quarter of 2004. This is a 23% increase from the prior quarter and a 71% increase from the year-ago quarter.
Finished unit shipments were a record level of 27.6 million in the second quarter, compared to 22.2 million in the prior quarter. Unit shipments in the year-ago quarter were 15.1 million.
Other disk revenue provided 20.1 million of revenue in the second quarter, compared to 17.4 million in the prior quarter and 13.4 million in the year-ago quarter.
Net income and earnings per share in the second quarter of 2005 were 29.9 million and $0.93 per share respectively, compared to 18.5 million and $0.59 per share in the prior quarter. Net income and diluted earnings per share in the year-ago quarter were 8.4 million and $0.28 per share.
Diluted shares outstanding were 32.7 million in the second quarter, 32.3 in the prior quarter, and 31.6 million a year ago.
Our income tax provision for the second quarter of 2005 was 1.5 million compared to .5 million in the prior quarter. The tax rate for the first half of 2005 was approximately 4%.
Net margin was approximately 17% in the second quarter of 2005. This included a one-time gain on the sale of an idle building in Eugene, Oregon, of $1 million. This compares to 13% net margin in the first quarter.
Operating expenses were approximately 10.8% of revenue, compared to 11.9% in the prior quarter. The dollar increase in the amount of spending in the second quarter was primarily related to variable incentive compensation and stock compensation and additional R&D spending to support new products.
On our balance sheet and cash flow, we ended the second quarter of 2005 with 145.9 million of cash, compared to 116.5 million at the end of the prior quarter. Our ending accounts receivable balance was 92.1 million, compared to 85.7 million in the first quarter of 2005. This higher AR balance reflected the higher sales in the second quarter.
Net inventory was 48.3 million compared to 42 million at the end of the prior quarter. The majority of the increase was for raw materials inventory to support production levels to meet continuing strong customer demand.
Finished disk inventory decreased by $3 million at the end of the second quarter as shipments exceeded production in the second quarter.
Depreciation was $10.6 million compared to 10.1 in the prior quarter.
Capital expenditures were approximately 27 million in the second quarter of 2005.
Now let me turn it over to Mike.
Mike Russak - President & CTO
Thank you, Kathy.
As previously stated, total finished disk shipments were 27.6 million disks in Q2 '05, a new record level, compared to 22.2 million disks in the prior quarter. Sales mixed by major customer was Maxtor at 30%, Hitachi Global Storage at 25%, Seagate at 21%, and Western Digital at 19%.
Shipments of 100 gigabyte per platter and above advanced disks increased to 20% of total finished unit shipments, which is 5.5 million, compared to 18% of disks shipped in the prior quarter, 4 million. These advanced disks are primarily targeted for multi-platter consumer electronic applications, including EVR and DVR applications, as well as nearline storage.
Enterprise disks shipments of 70-millimeter and 84-millimeter disks were 15,000 and 10,000 RPM, high-end server application, totaled 1.9 million disks in the second quarter compared to 1.2 million in the prior quarter.
Our blended average selling price was similar to the prior quarter. We expect stable to a slight upward bias in the blended average selling price during the second half of 2005, due to a slight product mix shift to higher capacity disks.
Substrate sales were 12% of total revenue and we expect a similar percentage in Q3 of '05.
We have made several process improvements and equipment upgrades to meet the more complex demands of advanced disk drives. In addition to improving our customers' drive yields and reducing PPPN (ph) levels, these changes have also improved our internal yields and overall factory output.
Our development efforts are focused primarily on qualification in our customers' next generation products and are proceeding on schedule. Additionally, we are shifting more resources to assure our readiness to produce perpendicular magnetic recording media for future products.
Komag is well-positioned to support both LMR and PMR media. However, based on our customer requirements, we would not expect to be producing significant volumes of PMR media until the second half of 2006. Komag's initial PMR product will most likely be an 80 gigabyte per platter, 65-millimeter disk utilizing a glass substrate.
We have been providing sample quantities of aluminum magnesium-based media for portable drive evaluations during Q2 of '05 and the initial reaction has been quite favorable. It is too early to tell when and if these products will achieve market acceptance.
Now T.H. will provide some further comments on the second quarter and our business outlook.
T.H.?
T.H. Tan - CEO
Thank you, Mike.
We are extremely pleased with our second quarter of 2005 financial performance. Second quarter 2005 finished disk shipments were a record 27.6 million units up 24% from the prior quarter. Our second quarter 2005 revenue and net income increased 23% and 62% over the prior quarter, and 71% and 25% over the second quarter of 2004, respectively.
In our manufacturing operations we increased finished media capacity to 27 million from 25 million in the prior quarter by upgrading equipment to increase equipment output, improve yields, and achieve excellence in overall factory productivity. These achievements we started in the increase in our gross margin to 28% from 25% in the prior quarter.
Due to the very strong market demand and the fact that we are now running at full capacity, we are increasing our capacity, our capital spending plan is now approximately 200 million for 2005. We have signed strategic supply agreements with several of our customers. These agreements call for Komag to add capacity to supply increasing volumes of disks to the customers. The customers will (inaudible) for the levels of this and provide Komag with certain prepayment for media. These prepayments are intended to mitigate the initial cash yields during the period while we are adding capacity, and combined with cash from operations are expected to allow Komag to remain relatively cash neutral while increasing capacity.
We believe that these agreements with our customers are a true win-win situation. It allows us to meet their increasing need for disks by increasing capacity in a prudent and responsible way. We believe this reflects true strategic relationships with our customers and we appreciate their support.
Our R&D and manufacturing operations are continuing to work very hard designing, qualifying, and shipping new advanced products with ever tighter product specifications, bring it up new capacity, ramping production volumes and controlling cost.
I would like to give special thanks to all our employees for the extraordinary efforts to increase capacity through excellent factory productivity and yield performance on new products as well as mature products, making the current results possible.
Outlook. Looking forward overall market demand remains very strong entering the normally seasonally stronger second half of the year. As we are currently running at full capacity of approximately 27 million disks per quarter, we expect total revenue to be similar to (inaudible) sequentially, assuming some improvement in the blended areas selling price due to an improved product mix to higher capacity disks.
With this level of revenue in the third quarter and continuing excellent factory productivity we believe that net margin in the third quarter will be around 16% without any potential impact of exchange rates. We expect first new (ph) capacity at our existing manufactured disk should start adding to revenue in quarter four '05. But we expect to be up to a capacity of 31 million disks a quarter by the time we exit quarter one of 2006.
In addition, we plan on adding additional capacity during 2006 to meet the commitment we have to our customers and expect to exit (ph) 2006 with a total capacity of 14 million disks per quarter.
In July, 2005, Komag received an extension of our tax (inaudible) in Malaysia. This extension will continue our tax (inaudible) through 2016 through June 16.
In addition, on July 21, 2005 Malaysia removed its currency peg to the U.S. dollar in favor of a managed float system, pegged to a basket of currencies. As a result, a portion of the company's spending in Malaysia ringgit will be subject to exchange rate fluctuation.
We continue to be excited about the outlook for growing demand for disk drives and disks in both traditional computer-related markets as well as the expanding market for consumer electronic devices. We believe that we are well-positioned in the high-growth consumer applications market for PVR, DVR, HDTV, external storage, and other home entertainment devices.
In summary, we believe we have the right financial model. We are committed to maintaining our low-cost manufacturing structure, advancing technology, and strengthening our strategic customer relationships to grow our business and provide positive financial performance.
Now I'll turn it over to Susan to conduct Q&A.
Susan, please?
Operator
Thank you. The question and answer session will be conducted electronically.
(Operator instructions.)
We'll take our first question from Shebly Seyrafi with Merrill Lynch.
Shebly Seyrafi - Analyst
Thank you.
Good morning. Great quarter, by the way.
A few questions, if I may. Your net margin is guided to decline to 16% from 17%, yet revenues expect to be flat with potentially higher ASPs. I'm wondering, why are you guiding for this net margin decline sequentially?
Secondly, of the 40 million disk capacity that you're guiding to for the end of 2006, how much of that do you expect to be glass based?
T.H. Tan - CEO
Okay. Let me answer the second question. 2006 depends on our customers' requests. (Inaudible) in the second quarter -- the second half, the third quarter and the fourth quarter, and it's not going to be a huge amount on our total capacity. So our (inaudible) not below like 750,000 a quarter in the first quarter that we participate and we will see how it goes from there. Okay? So it's not (inaudible).
Regarding the fact that we guided our net down a little and revenue flat is because (inaudible) up because we are working at a richer mix of product. (Inaudible) again, we cannot count on all these things to happen, we are trying to be extremely cautious here, our problem is we have guided you before that second half would be a richer mix of 100 gig and up, I would hope (inaudible) would be from there.
Shebly Seyrafi - Analyst
So you're just being conservative on GAAP?
T.H. Tan - CEO
Being conservative (ph).
Shebly Seyrafi - Analyst
If I may, one last one, the Malaysian ringgit -- I guess I don't know much about that currency -- has it been, when it was managed, thought to be trading at a premium to the dollar and it's expected to fall? Or how should we think about this?
T.H. Tan - CEO
Well, you -- (inaudible) in talking about Chinese currency, but product managed is not (inaudible), so when we started to peg to our basket, our currency is more real. So it's going from a control to a more real.
But the key is manage, manage float. Malaysian government has stated in so many locations that they want to see stability. (Inaudible) there may have been undervaluing by the pegging to a U.S. dollar, but we want to (inaudible) -- we have seen what they have done the last four working days. Up till now we are just seeing about 1.5% appreciation.
Shebly Seyrafi - Analyst
Okay. Thank you.
T.H. Tan - CEO
Thank you.
Operator
We'll now hear from Mark Miller with Hoefer & Arnett.
Mark Miller - Analyst
Yeah. My congratulations to a wonderful quarter.
I'd like to talk about capacity. You basically, by the end of 2006, are going to be doubling your capacity. There's a lot of capacity at other substrate and media manufacturers that's coming online. I'm just wondering, when you're estimating that we going to be in better balance between media supply and demand, a lot of people think it will be by the end of this year.
T.H. Tan - CEO
Well, Mark, (inaudible) with due respect, the number is not exactly doubling because you look at what we have done up till now, we have reached 27 million as of second quarter. So we're adding 13 million, just about, less than 50% increase by another -- in another 18 months. So 18 months to grow 50%, again, is not a lot of capacity --
Mark Miller - Analyst
No, I was actually speaking over the last year-and-a-half.
T.H. Tan - CEO
Okay. Yeah, when you go back that far, yes.
But there is another thing that happens, we (inaudible) discounted (ph) a lot of customers' forecast because we already had gone through the bad times before and we are -- we see that the numbers that we put in are extremely conservative gate (ph). A lot of customers say is that if they are only half their succession (ph) as their projection, what we are not (putting) is not enough for them. So there goes the whole process we have been in putting this capacity in place.
Mark Miller - Analyst
The agreements you have with prepayments where you're adding capacity, do these customers also guarantee, once you put in the capacity, they're going to be using a certain percentage of the added capacity?
T.H. Tan - CEO
You know, Mark, you know there's no such thing as (inaudible). Well, first your problem of (inaudible). We have to get back the cost. Okay? Then, of course, the prepayment helps because there's good incentive for customers to draw from our (inaudible). Again, get everything in equal. So we are (inaudible) continue to do so. Okay? I don't think a prepayment arrangement -- yeah, we enjoy some tactical (ph) advantage.
Mark Miller - Analyst
And finally, I just wonder what you're estimate is for the total industry shipments of the percentage of perpendicular media as the percentage of total ships in 2007. I've heard fairly aggressive estimates. I'm just wondering what's your shame (ph) in terms of what percent of total drive ships will be perpendicular in 2007.
T.H. Tan - CEO
A lot of people had (inaudible) perpendicular in the last 25 years, you know how that division has become. We're not going to add to that. Mark, I just cannot give you a position (inaudible) will be given by so many factors. Okay? And our customers, the size, those are the heads designs. So I would like to defer that question (inaudible) as we see a better picture.
Mark Miller - Analyst
Okay.
T.H. Tan - CEO
Thanks, Mark.
Mark Miller - Analyst
Thank you.
Operator
And once again, if you do have a question, please press star one at this time.
Now we'll move on to Les Santiago with Piper Jaffray.
Les Santiago - Analyst
Yes. Great quarter.
Could you give us a number for your current substrate capacity, that's my first question. Then I have a follow up.
T.H. Tan - CEO
Very sorry, we couldn't tell you this information because it is -- well, we both (inaudible) in media (inaudible) our competition as well as to our customers, (inaudible) supply. They are very complex and very mixed (inaudible) and the (inaudible) capacity of soft shades (ph) are a very good tablet secret. Sorry we couldn't answer.
Les Santiago - Analyst
Okay.
Secondly, just trying to figure out how exactly capacity will be added over the third quarter. Are you saying that you will not see any incremental capacity in the third quarter at all? You'll only start seeing incremental capacity in the fourth quarter?
T.H. Tan - CEO
If we get any increased capacity through our efficiency improvement, which we had a fantastic second quarter. Again, we improved yield, improved utilization and we got a big increase from the prior quarter.
I always felt that manufacturing is one area that once you have a customer that's pulling strongly and you (inaudible) you are bidding (ph) maybe too much to one customer than to others, when all four customers are joined strongly, then the (inaudible) can run and run and run. Efficiency is part of that, better yields, better utilization. So -- but we're not going to do (inaudible) given. So our guidance is set (inaudible) and we are (inaudible) efficiency, efficiency do what it does and continue to improve. Although you cannot expect (inaudible) increase, what, maybe little bit of improvement we can squeeze out of this operation.
Les Santiago - Analyst
Okay. Then and lastly, just to follow up on Shebly's comment, your net margin in the first quarter -- rather this quarter were -- I'm sorry, in the second quarter of '05 were 17%, it's going to 16%. How much of that is -- I guess I could do the math myself -- but how much of that is the one-time gain in the second quarter of '05?
T.H. Tan - CEO
Okay. Let me ask Kathy to answer it.
Kathleen Bayless - CFO
Hi, Les, this is Kathy.
Yeah, the -- basically, the second, we had the one-time gain. There was gain on sale of about $1.3 million in total. 1 million of that was for the sale of an idle facility. So the net margin of 17% included that one-time gain in Q2. So we're not expecting to have a similar gain in Q3.
Les Santiago - Analyst
Okay. Wonderful. Thank you.
Operator
As a final reminder, if you would like to ask a question today, please press star one on your telephone key pad.
We'll now hear from Christian Schwab with Craig-Hallum.
Christian Schwab - Analyst
Great quarter, guys.
Regarding the additional capacity going from 27 million to 31 million, has that equipment been ordered?
T.H. Tan - CEO
Yes.
Christian Schwab - Analyst
Have we received it?
T.H. Tan - CEO
Part of them, because we are talking about a whole spectrum of equipment.
Christian Schwab - Analyst
Okay. So then the typical 8 to 10-week period to install and qualify equipment is what we're assuming is going to be happening in the back half of this quarter and going into next quarter to give us the added capacity? Is that the way we should be thinking about that?
T.H. Tan - CEO
Well, as you know, our customer qualifications, too.
Christian Schwab - Analyst
Right. They're all taking time --
T.H. Tan - CEO
(Inaudible) 200% from our side.
Christian Schwab - Analyst
Right.
Maybe I'm just being too fearful, but we seem -- and congratulations on working perfectly here -- but as we add new equipment and bring in new processes, typically, of course, it never goes as smoothly as everybody would like. Is there risk that, as we're adding this capacity in the back half of the year and the first half of 2006, that we could see some hiccups in there? Are you pretty confident that we'll maintain perfection?
T.H. Tan - CEO
Well, you (inaudible)? You have seen our record for the last five years, okay? I'll get my watch, we'll move the (inaudible) from one part ocean to another part and we've brought in new machines from overseas. We've done everything -- have you ever heard of army (ph) hiccup?
Christian Schwab - Analyst
I hear you.
Will you need a new building to go to 40 million?
T.H. Tan - CEO
We are (inaudible) we have our own now. We just extended our building here and there, so that's just a little more economically or more efficient. We have a flow back there, so we put a little bit of extra space and then (inaudible) a building and then we also (inaudible) arrangement on our equipment. Yeah, we do our own (inaudible).
Christian Schwab - Analyst
Okay. I have just two quick other questions. We saw 38% sequential growth in our higher capacity platters, but yet we still saw ASPs decline by approximately 1%, the way I'm modeling it. What kind of mix should we assume that we need as far as finished good unit shipments, to see ASPs head up?
T.H. Tan - CEO
In the first or second quarter I think we guided you guys in the first quarter (inaudible) spending. We see the increase of AR volume would normally come from the 80 gig. It is something the customer wants. Just (inaudible) you want (inaudible). There are several reasons why 80 (ph)and we want to have them, so we give them a lot of 80 (ph).
We predicted second quarter to be about the same as first quarter. But we have seen the maturity of this product are coming to a very mature state. So second half we are seeing 100 gig, 120 gig to be increasing. So we are not giving any different guidance today than six months ago as we saw this coming.
Christian Schwab - Analyst
Fantastic.
Then my last question regarding customer concentration on the sequential basis, it looks like Western Digital and Maxtor -- well, it looks like Hitachi and Seagate got the lion's share of the increased revenue mix. Should we imply from that they're your largest customers of substrate media and some finished goods? Or should we not make that assumption?
T.H. Tan - CEO
First of all, I want to correct your when you say that we have three customers.
Christian Schwab - Analyst
Four customers.
T.H. Tan - CEO
We have four customers, (inaudible). We have four customers, together they form more than 90%. The 90% (inaudible). We have four customers. And it depends on how these customers want their products shipped. We (inaudible) you see (inaudible) probably you'll see some increase in some customers. I know some decrease. This problem would be temporary. (Inaudible) beauty of having your top four customers making up 90% of the market, because if someone new started (inaudible) like their orders, some of the other three will pick up and vice versa.
Christian Schwab - Analyst
Fantastic. Thank you.
T.H. Tan - CEO
Thanks.
Operator
And Dan Renouard with Robert W. Baird has our next question.
Dan Renouard - Analyst
Thanks. My question, it just seems like you've got more visibility now maybe than you've had in many years. Maybe this goes back a quarter or two, but with the prepaid agreements and everything else, what would you expect ASPs and maybe like the like ASPs to look like in '06 versus '05?
T.H. Tan - CEO
Do you want me to be so fearless as to go that far? I'm not going to do that. This is not a business that you can predict one year out. So I can't tell you that. Sorry.
Dan Renouard - Analyst
But what would you expect -- let me ask it a little closer. Then what are you expecting a like for like ASPs in the third and fourth quarter?
T.H. Tan - CEO
I'll tell you we know that high end mix of more than 80 gig or 100 gig would be definitely a view (ph). But I'm just going to tell you that one specifically. This was our result, (inaudible) come to this meeting. Okay?
Dan Renouard - Analyst
Okay. Thank you.
T.H. Tan - CEO
Thanks.
Operator
Now we have a follow up from Shebly Seyrafi with Merrill Lynch.
Shebly Seyrafi - Analyst
Yeah. Thank you. A few more.
Just to be picky on you, I guess, that you just shipped 27.6 million disks, so I guess your current capacity is closer to 28 million; is that correct?
T.H. Tan - CEO
Well, we just told you that we actually shipped some (inaudible). Okay? We ship a few hundred thousand out (inaudible) customers (inaudible). So whatever we have in the shop, we get -- pull out. So (inaudible) should be more than your production capacity is (inaudible).
Shebly Seyrafi - Analyst
Okay. The finished disk side --
T.H. Tan - CEO
Yeah. Our finished disks.
Shebly Seyrafi - Analyst
Right. And also, can you give us an update on the mobile disk shipment timing for you?
T.H. Tan - CEO
Well, we (inaudible) and our we are participating second half of 2006.
Shebly Seyrafi - Analyst
Okay. And of the 13 million increase in capacity, between now and the end of 2006, is that all based on firm commitments? Or what portion of that's based on firm commitment?
T.H. Tan - CEO
Like I'll say again we just told our customers forecast (inaudible). If we ship more than 40 million, we are still doing lovely, everybody happy.
Shebly Seyrafi - Analyst
Okay. So actually, firm commitments would imply more than 40 million?
T.H. Tan - CEO
Well, whatever (inaudible) first of all. (Inaudible) probably think it's prudent that we install at the time that people really need product. So we are having a time, okay? And the customers were not happy, they would say they want maybe little bit more. But we have room to be growing at this pace because of the (inaudible) industry. So there's definitely some commitment (inaudible). The problem is that (inaudible) No. 1, biggest factor your disk (inaudible) to be first in class. Okay? Best in class.
Then we come to the customers selection of who they will approve. And the (inaudible) advantage we are meet there, but nothing is firm. Okay?
Shebly Seyrafi - Analyst
Finally, from me, what's the chance that you'll land any new customers any time soon?
T.H. Tan - CEO
We're to a five-month capacity. I don't know how to -- we are not really giving our forecast and that's what you wanted. What you want you want (inaudible). We have delivered that. Again you see (inaudible) makes sense or not.
Shebly Seyrafi - Analyst
Thank you.
T.H. Tan - CEO
Thank you.
Operator
It appears there are no further questions at this time.
Mr. Tan, I'd like to turn the conference back over to you for any additional or closing remarks.
T.H. Tan - CEO
Okay. I want to thank you all for joining us today and we are along two months we meet. Thank you very much.
Operator
And that concludes today's conference. Thank you for your participation.