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Electro Scientific Industries, Inc. (NASDAQ:ESIO)

F2Q09 Earnings Call

October 22, 2008 5:00 pm ET

Executives

Brian Smith – Director of Investor Relations

Nicholas Konidaris – President, Chief Executive Officer & Director

Paul R. Oldham – Chief Financial Officer, Vice President Administration & Corporate Secretary

Analysts

Matt Petkun – D.A. Davidson & Company

Jim Ricchiuti – Needham & Company

[David Neuronberg – Neuronberg Investments]

Operator

Welcome to the ESI fiscal 2009 second quarter earnings release conference call. My name is Becky and I will be your coordinator for today. At this time all participants are in listen only mode. We will be facilitating a question and answer session towards the end of this conference. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call Mr. Brian Smith.

Brian Smith

My name is Brian Smith, Director of Investor Relations for ESI. With me today are Nick Konidaris, our CEO and Paul Oldham, our Chief Financial Officer. This conference call will cover our fiscal 2009 second quarter results. Before we go in to the details of the call I would like to remind you that some of what we say on this call will include forward-looking statements concerning customer orders, shipments, revenues, gross margins, expenses and earnings.

These statements are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include a number of risks and uncertainties that are discussed in more detail in today’s press release and our filings with the SEC. Actual results may differ materially from those forward-looking statements. This call also contains time sensitive information that we believe to be accurate as of today, October 22, 2008 and which could change in the future. This call is the property of ESI.

Now, I’ll turn the call over to our CEO, Nick Konidaris

Nicholas Konidaris

Q2 was a challenging but good quarter for ESI with solid financial results in a deteriorating marketing economic environment. Although sales were at the low end of our rage, non-GAAP earnings per share were at the high end of our range driven by improved gross margins and good executions. Orders however, fell to their lowest level in 13 quarters driven by a weakening economic environment and a further downturn in the semiconductor memory market.

As a result we took additional actions to reduce our overall cost structure and to lower our operating breakeven point. In this difficult environment we remain committed to our long term growth strategy and last week we announced a definitive merger agreement with Zygo. We believe this combination will create additional growth opportunities, increase the scale and profitability of the combined company and create a more diversified revenue stream going forward.

For the second quarter orders were $37.6 million, sales were $49.6 million and earnings per share were $0.05 on a non-GAAP basis. On a GAAP basis net loss was $0.02 per share reflecting both lower revenues and the expenses associated with reducing our cost structure. Broadly speaking the global financial crisis has put additional pressure on many of our markets. Weakening consumer demand for electronic products is reducing the capacity requirements of our customers particularly for memory repair driving down ASPs and further weighing off profitability and capital spending.

As a result, orders in our semiconductor segment were down both sequentially and year-over-year with record low orders for memory repair. Previously analysts estimated that DRAM chip prices had bottomed but during the quarter upward selling prices on 1 gigabyte DDR2 chips actually declined another 12% to 17% according to estimates. Last, memory prices for September fell more than predicted. In the near term this will result in continued over capacity, profitability constrains and lower capital spending for memory manufacturers.

However, longer term we see continued growth in demand for memory and we believe we are well positioned to capture an increasing share of that business when the market recovers. On the bright side, our LED wafers scribing and LCD repair segments were both strong. In fact, our new wave research division have strong orders and record quarterly revenues. Customer response to our new AccuScribe and Polaris products has been very favorable and our laser ablation products had a particularly strong quarter.

Looking forward the timing of the recovery in memory capital spending remains uncertain. Given the over capacity and profitability challenges in the memory market combined with the economic downturn we see activity in this segment being slow for the next several quarters. Our LED scribing and LCD repair business which are not related to the memory market should continue to remain strong but maybe affected somewhat by general economic slowing.

Turning to the interconnect and micro machining group, orders were down from Q1 but above the run rate of fiscal year 2008 which was a record year. We continue to win new micro machining applications and slow growth in our flex interconnect business. In addition, revenues for this quarter were a record high reflecting the shipment and acceptance in to production over large multi system order for our new model 5800 dual beam higher power micro machining system which were announced in June.

Looking forward, orders in this segment will continue to be lumpy driven by capacity expansion for customer specific applications. However, we expect this to be an area of overall growth for the company. In our passive components group orders were also down sequentially as the market did not experience its normal seasonal uptick in preparation for the holiday season. Capacity expansion in this market is paced by the demand for consumer electronics which has been impacted by the slowing of the global economy.

Market research indicates the capacity utilization has fallen under 80%. As a result, we project that expansion in this market will not resume until calendar 2009 with a timing of recovery in line with the return to growth of consumer spending in general. In the meantime, our new model 3550 continues to be adopted by MLCC customers as the trend towards smaller size and high capacity persists.

At the company level, in response to the weakening market conditions we took additional actions during the quarter to reduce our cost structure and lower our breakeven point. These actions included continued acceleration of our offshore manufacturing initiative, streamlining of management positions and selective headcount reductions across the company. Although difficult we believe these actions will allow us to largely preserve the strategic investments necessary to position us for growth when market conditions improve.

Turning now to the overall outlook for ESI. Although visibility is very limited, we expect demand to bottom out around current levels as economic uncertainty and cautious capital spending continue to delay investments. As a result given our backlog position we expect shipments and revenue for the third quarter of $30 million to $40 million and a loss of $0.10 to $0.20 per share on a non-GAAP basis.

Although the timing of improvement in our markets is difficult to predict, we believe that the underlying demand drivers of miniaturization and complexity of technologies and devices remain intact. In the interim we will continue to focus on improving gross margins, managing our cost structure and making critical investments on new products and applications. Despite this difficult environment we remain committed to our long term growth strategy of leveraging our core competencies to expand our addressable markets.

Consistent with this strategy we announced last week a definitive merger agreement with Zygo Corporation. This merger positions us to become a premier photonic micro engineering and metrology solutions company with an innovative combination of complimentary core competencies. It greats a company of greater scale with a more diversified revenue stream and broadens both our range of capabilities and our addressable market.

This merger also enables Zygo’s growth strategy as ESI’s system expertise, customer knowledge and support infrastructure will further enable the integration of their world class technologies in to system solutions for high volume manufacturing applications. On a combined basis ESI and Zygo have pro forma revenues in calendar year 2007 of $458 million and EBITDA of $66 million. In addition, the combined company’s expected to have cash and investments of over $200 million after transaction costs.

This transaction is an important step forward in both of our strategies and will enable our combined company to access new growth opportunities, leverage economies of scale and improve profitability in the coming years. We also announced that our board of directors approved an increase to our share repurchase authorization to $100 million contingent upon the close of the merger.

This opportunistic repurchase program will reduce dilution from the transaction while retaining flexibility and liquidity in today’s uncertain markets. While we cannot forecast the timing of the economic upturn, we are taking all the right measures to create a strong more profitable company with expanded opportunities for growth as the market’s improve. Now, I’ll turn the call over to Paul for a detailed discussion of our results for the second quarter.

Paul R. Oldham

The following information includes results from our second quarter of fiscal 2009 which ended September 27, 2008. To improve comparability, we are also providing earnings per share and related income statement results on a non-GAAP basis excluding the impact of purchase accounting, equity compensation, restructuring expenses and non-recurring items.

Orders for the second quarter were $37.7 million down 37% from the prior quarter. Orders declined sequentially across all three businesses with weaknesses and semiconductor and passive components driven by continued over capacity in the industry aggravated by the financial crisis and the weakening economic environment. The demand for semiconductor memory and passive components were at the lowest levels seen in several years.

Orders for interconnected micromachining products also declined for the quarter due primarily to the timing of the introduction of the 5800 and the large multisystem order booked in Q1. However, underlying demand for both micromachining and flex circuit via drilling applications was strong. In addition, orders from NWR were strong driven by good demand for LCD repair, LED scribing and laser ablation applications.

Geographically orders declined in all three regions with Asia representing approximately 58% of total orders. Shipments in Q2 were $48.1 million down sequentially from $64 million in the prior quarter. Interconnected micro machining shipments were up slightly while shipments per passive components and semiconductor products declined consistent with the lower orders. Backlog at the end of the quarter was $28.6 million, down $9 million from last quarter largely due to the shipment of the micro machining orders received in Q1.

Deferred revenue is also down slightly but still consistent with historical levels. Revenue for the second quarter was $49.6 million down 23 % from the first quarter. Semiconductor revenue declined 40% sequentially and passive component revenue was down almost 50% both due to lower demand. Interconnected micro machining revenue improved 5% off of record revenues last quarter as a result of strong shipments of our new micro machining products.

Gross margin for the quarter was 42% including approximately $500,000 in purchase accounting and equity compensation reflected in cost of goods sold. On a non-GAAP basis margins were 43% up from 40% last quarter. The margin improvement on lower revenues reflected improved product mix and lower warranty costs. Operating expenses were $23.4 million down over $2 million sequentially.

Second quarter expenses included $300,000 in purchase accounting amortization, approximately $1 million in equity compensation and $1.2 million in expenses associated with the actions to reduce our cost structure. These actions should enable us to lower our non-GAAP operating breakeven point to around $50 million in revenue per quarter. Excluding the impact of these items, non-GAAP operating expenses were $20.9 million, more than $2 million below the prior quarter reflecting lower labor costs, discretionary spending and variable pay.

As a direct result of our cost reduction actions we expect non-GAAP operating expenses to be approximately $6 million per quarter lower than our exit run rate last fiscal year. Operating loss for the quarter was approximately $2.3 million compared to a loss of $200,000 in the prior quarter. Non-GAAP operating income was $600,000 or 1.3% of sales down from $2.7 million or 4.2% of sales in the prior quarter primarily due to the decline in overall revenue and related gross profit partially offset by lower spending and improved gross margins.

Second quarter interest and other income of $1.1 million was up by approximately $250,000 from the prior quarter primarily due to gains on foreign currency. Looking forward we expect to see interest and other income at approximately $900,000 with higher projected cash balances offset by lower yields on cash. Income tax for the quarter was a benefit of $500,000. On a non-GAAP basis the tax rate was 27% reflecting the implementation of our tax planning strategy associated with increased offshore manufacturing.

On a GAAP basis the second quarter net loss was $665,000 or $0.02 per share. Excluding the largely non-cash charges related to purchase accounting, equity compensation and restructuring expenses, non-GAAP net income was $1.3 million or $0.05 per diluted share down from $2.5 million or $0.09 per diluted share in the prior quarter. Turning now to the balance, sheet cash and investments were $166 million up $11 million from the prior quarter. Included in our investments is $14.1 million in auction rate securities.

Given the recent turmoil in the financial markets and the demise of Lehman Brothers late in the second quarter who had been our custodian for these securities, we continued to analyze the valuation of these instruments. Pending on the results of this ongoing analysis the value of the securities may change in the future however, we continue to receive interest payments on the securities and have the ability to hold them for an indefinite amount of time.

Inventories were largely unchanged in the quarter as ongoing reduction efforts were offset by lower demand. We continue to see this as an area of focus and we expect or inventory balance to decline over the next few quarters. Inventory turns were 1.2 times on the lower revenues. Accounts receivable decreased by $9.4 million, however DSO increased from 84 to 91 days largely reflecting the lower level of revenues.

During the quarter we spent $1.4 million to repurchase approximately 94,000 shares of stock at an average price of $14.65 as part of our ongoing program to offset dilatation. In addition, we spent approximately $1.1 million in capital expenditures. Operating cash flow totaled about $14 million for the second quarter driven primarily by reductions in working capital. Looking forward, for the third quarter we expect our shipments in revenue to be approximately $30 million to $40 million reflecting the continued weak environment.

Gross margin excluding the impact of purchase accounting and stock compensation is expected to be approximately 37%, down sequentially to lower revenues and less favorable product mix. Non-GAAP operating expenses are expected to be down approximately $1 million from the second quarter with the impact of cost reduction actions partially offset by higher engineering project related expenses. As a result, we expect a non-GAAP loss including stock compensation, purchase accounting, restructuring and other non-recurring items to be between $0.10 and $0.20 per share.

Associated with this loss we expect the non-GAAP tax benefit of approximately 40% reflecting our statutory tax rate and the tax credit associated with reinstatement of the R&D credit enacted by Congress earlier this month. Now, I’ll turn the call back to Nick for a brief summary.

Nicholas Konidaris

To summarize, although our markets remain weak, our commitment to long term growth and profitability remains strong. In the near term we will focus on increasing efficiencies and managing our cost structure while balancing strategic investments for the future with the particularly challenging revenue levels we’re seeing today. With the Zygo merger we are moving forward on our strategy creating a larger more diversified company with more complimentary technologies, cultures and competencies that will ensure both top line growth and faster earnings growth over time.

This concludes our prepared remarks. We’re ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Matt Petkun – D.A. Davidson & Company.

Matt Petkun – D.A. Davidson & Company

First, just given the obviously challenging macroeconomic climate I was wondering Paul or Nick if you could provide any commentary just about what this quarter, the October month, has looked like for you guys generally from an order perspective.

Nicholas Konidaris

I would say that it’s consistent with our guidance, no surprises one way or the other.

Matt Petkun – D.A. Davidson & Company

Then Paul, on the expense side did you say that you expected expenses op ex down about $1 million next quarter?

Paul R. Oldham

On a non-GAAP basis that is correct.

Matt Petkun – D.A. Davidson & Company

But, another comment in the call you said that overall we’d be around $6 million below the exiting run rate that you saw at the end of last fiscal year which is just about $29 million. So, is that more towards the end of this year?

Paul R. Oldham

Again, on a non-GAAP basis I think our exit run rate was around $26 million. Then Nick, trying to sweep aside all the macro issues I was wondering if you could maybe update us on a couple of your new product offerings? Maybe the only good things we’re hearing out there in the semiconductor industry is that some manufacturers continue to look towards next generation technologies so wafer thinning and your silicone via drilling business, if you could update us on what’s going on in those two businesses? And, what you expect for them in the 2009 calendar year?

Nicholas Konidaris

The wafer thinning business, basically you’re referring to our ability of doing laser [singulation]. As you know, in this area we have received an order and we’re delivering a system to a customer. We have announced that some time ago. I think recently we announced that we’re opening a demonstration center in Korea. We have talked to all of the immediate target customers, we are very actively involved in demonstrations and evaluations on wafers, so examples and so forth.

This is an ongoing process that is going to take some time because you have to become a plan of record for the process point of view and that takes several steps. We are however focusing that market. We have a number of built on people that have been before in penetrating good markets from the company focusing on this market. We don’t expect a significant effect in fiscal year ’09 but we expect we’re going to see some of that effect this year but this is a longer term issue towards fiscal year ’10 and beyond.

Operator

Our next question comes from Jim Ricchiuti – Needham & Company.

Jim Ricchiuti – Needham & Company

Nick, it sounds like you see the memory repair and passive businesses kind of at a bottom here or am I reading too much in to that? Do you see much potential for further declines or has it really bottomed out?

Nicholas Konidaris

I think we are bottomed out. It’s not a flat bottom, it’s rocky but we are at the bottom.

Jim Ricchiuti – Needham & Company

Now, with respect to the NWR business, that appears to be performing a little better and I wonder if you could elaborate a little bit more on what you’re seeing there? Also, we’re hearing more signs of weakness now in the LCD market, how concerned are you by that and do you see the LED portion of the business holding up better?

Nicholas Konidaris

Over there the areas that we are closing well are the LED scribe, the LCD repair and again in LCD repair we provide the engine not the complete system. We have another product that basically it is the front end for ICPMS spectrometry that will [cull] laser ablation. All of these products are doing very well. As far as the LED scribing we believe that LED of course is going to be affected but we don’t think it’s going to be anything near to what is happening in memory. It’s going to be somewhat as I mentioned in my prepared remarks.

I think for the time being, the LCD market continues to be the same thing but that is also a cyclical market as you know and the cycles may or may not coincide with the semiconductor cycles. The ICPMS however business is much more diversified. It’s a number of labs, it’s from mining companies, security and so forth and I think the fact that it’s that diversified is going to be affected somewhat by general trends in the economy.

I’d like to add that that in each of these areas we have a new product and those products are received very well.

Jim Ricchiuti – Needham & Company

Can you give us any color just on the bookings in this area?

Nicholas Konidaris

These bookings are at the top level maybe even higher than what the bookings were for new wave research before [inaudible].

Jim Ricchiuti – Needham & Company

Just shifting over a little to the interconnect and micro machining portion of the business you talk a little bit about the strength in orders. Do you feel that’s sustainable and what’s driving that? Is that share gain do you think?

Nicholas Konidaris

No, I think if you look at the last two years, in fiscal year ’07 we had bookings of around $50 million, in fiscal year ’08 we had bookings around $60 million, we think we’re going to do better this year. Micro machining for us is two activities, one it is a set of activities that I would call PCB based activities, this addresses flex circuits and ICP packaging. The other is, let’s call it non PCB kinds of activities, general micro machining where we do a number of things on different materials for different industries.

At this point in time both branches are really doing okay especially the flex as well as the non-PCB let’s say general micro machining driven primarily by consumer demand.

Jim Ricchiuti – Needham & Company

Do you see that holding up a little better?

Nicholas Konidaris

Yes.

Jim Ricchiuti – Needham & Company

Finally, not to bring too much attention to it, you’re guiding to lower gross margins this quarter which clearly is understandable off of these revenues but I wonder if you could talk a little bit about the mix that might have contributed to the gross margins this past quarter?

Nicholas Konidaris

Well, we have as you know over the last couple of years introduced a number of new products in every product line. As a result of that introduction, the benefit that these products deliver to the customers we have improved the margins in almost all of our product lines and have tightened the distribution. So, basically at this point in time to the extent that we have a mix similar to this quarter we could have enjoyed better margins.

If the mix is going to be a bit dissimilar this quarter the margins are going to be affected. But, the main issue about the margins of course is the lower level of business and the lesser capabilities of our [structure].

Operator

Our next question comes from [David Neuronberg – Neuronberg Investments].

[David Neuronberg – Neuronberg Investments]

I just wanted to note that the last trough that I was able to identify between one and two o’clock this afternoon was the quarter ended March 2, 2002 when revenues were as low as $36.4 million and the operating loss was $4.9 million.

It looks like in the same revenue range you’re going to produce a non-GAAP result slightly better than that but I guess the point I wanted to make was looking back to 6.5 years ago are that a) even in an environment of pervasive doom and gloom and when the market falls 500 points your business will come back. And b) that at trough times like this, as you have just demonstrated in the quarter just ended it’s a time when you have the potential to generate and enormous amount of cash out of receivables and inventory.

Nicholas Konidaris

Dave that’s right and clearly we’re going to come back. I think that we mentioned that although the near term business conditions are very difficult, long term underlying demand drivers remain intact. We are very, very positive and bullish about those demand drivers and we are working very hard on our growth strategy.

Operator

Our next question comes from Jim Ricchiuti – Needham & Company.

Jim Ricchiuti – Needham & Company

I’m just wondering in light of the deteriorating credit conditions that have been experienced how aggressively are your customers pressing you either in terms on pricing or extended terms? I’d just be curious if you’re also seeing any areas of pricing pressures within the various business units?

Nicholas Konidaris

Let me give you a brief answer and then I’ll ask Paul to enter in to this thing. What we see is what I would say very typical and very customary for this kind of a situation. We don’t see anything that is abnormal. We have a deep and strong relationships with our customers, both of us want to do the right thing for each other and I think whatever we do is on a very mutual basis.

Paul R. Oldham

As a practical matter, we haven’t seen a lot of pressure on either terms or pricing to date. There has certainly been some and it’s more customer specific than across the board but I expect we’ll see a little bit. But historically, even in our previous downturns we had not seen sort of pervasive pressure on terms or pricing.

When our customers do order these systems they tend to need them right away and they are also critical to their ability to manufacture products so they delivery quite a lot of value. As a result we haven’t seen as much pressure on terms and pricing has perhaps as other industries.

Jim Ricchiuti – Needham & Company

What is the current headcount at the moment?

Paul R. Oldham

The current headcount at the end of the quarter was 701 employees.

Jim Ricchiuti – Needham & Company

As you go through this period of very weak demand can you give us any sense as to whether you’re looking to do shift any or make any changes in your manufacturing? Perhaps shift more to Asia based manufacturing? Any changes that you’re looking at in this current environment.

Nicholas Konidaris

We are looking at opportunities through globalization to whoever better the current involvement. We started as you may know something like two years ago manufacturing and I think this year we will be probably half of our shipments are going to be out of our activities in Singapore. So, this is well in place and we continue to be looking for opportunities to really do manufacturing that allows us to be closer to the customers and more beneficial to [inaudible].

Operator

Our next question comes from Matt Petkun – D.A. Davidson & Company.

Matt Petkun – D.A. Davidson & Company

Just a quick question on the merger agreement, what were the specific collars surrounding the deal?

Paul R. Oldham

There’s no collar on the deal, it’s a fixed exchange ratio of 1.0233 shares of ESI stock for every share of Zygo stock.

Matt Petkun – D.A. Davidson & Company

Then, Paul on the interest income would you expect that to be fairly consistent for the next couple of quarters before you really start to use that cash to buy back the stock?

Paul R. Oldham

That’s right. We won’t be buying back any stock until after the merger is closed because we’re prohibited from repurchasing shares at the same time we’re going through a registration process to issues shares. So once the merger is closed then based on the authorization that was made by our board and based on market conditions we would certainly look to be more aggressive in our share repurchase program at that time.

Operator

I’m showing that you have no further questions at this time.

Nicholas Konidaris

To reiterate we’ll face near term challenges as capital spending in our markets remains short. Despite the market challenges we’re executing on our market strategy to expand in to new products and applications which should enable the company to emerge from this period positioned for growth. In the near term our focus on continuing to create a lean operating model should allow us to maximize return even at lower business levels and allow faster earnings growth as market conditions improve.

Thank you very much for joining us. You are welcome to call Paul, Brian or me if you have further questions. This concludes our call. Thanks for your interest in ESI.

Operator

Thank you again for your participation in today’s conference. This concludes your presentation.

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Source: Electro Scientific Industries, Inc. F2Q09 (Quarter End 9/27/08) Earnings Call Transcript
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