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Executives

Debra Wasser - IR

John Peeler - CEO

Jack Rein - CFO

Analysts

Bill Ong - American Technology

Tim Arcuri - Citigroup

Matt Petkun - D.A. Davidson & Company

Joanne Feeney - FTN

Brett Hodess - Merrill Lynch

Jason Bernstein - Quattro

Veeco Instruments Inc. (VECO) Q3 2008 Earnings Call Transcript October 27, 2008 5:00 PM ET

Operator

Good day, everyone, and welcome to the Veeco Instruments third quarter 2008 earnings conference call. Today’s call is being recorded. For opening remarks and introductions, I would like to turn the conference over to the Senior Vice President of Corporate Communications and Investor Relations, Ms. Debra Wasser. Please go ahead.

Debra Wasser

Thank operator and thank you all for joining today's call. Joining me today are John Peeler, our Chief Executive Officer and Jack Rein, our Chief Financial Officer. Today's earnings release was distributed at 4:00p.m. this afternoon and is available on the Veeco website.

Also posted on our site is a PowerPoint overview of our third quarter financial results. The call is being recorded by Veeco Instruments and is a copyrighted material. It cannot be recorded or rebroadcast without Veeco's express permission. Your participation is by 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 made statements about the future; such statements are forward looking and are subject to a number of risks or 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 an annual report to shareholders and our subsequent quarterly report 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 to performance is available on our website. I would now like turn the call over to John for opening remarks.

John Peeler

Thanks, Deb and thank you all for joining us today. In the third quarter of 2008, Veeco again delivered strong top-line revenue growth and a significant recovery in EBITDA versus 2007. Our third quarter revenue was $116 million, up 18% compared to $98 million last year and in-line with our guidance. EBITDA was $8.3 million, compared to a loss of $1.7 million in 2007. Veeco’s earning's per share excluding certain items was $0.15, compared to a loss of $0.05 last year and was at the high end of our guidance.

In addition to the solid top-line performance versus last year, we continued to benefit from better management of our cost structure in 2008. I'm proud of the entire Veeco team for the significant progress we've made in refocusing our business, driving effective R&D, containing spending and improving the Company's overall performance. For the first nine months of 2008, revenue was up 12% to $333 million compared to $296 million last year. EBITDA has more than tripled to $22 million from $6.8 million last year. Our forecast for 2008 remains intact with revenue of approximately $400 million to $450 million, up approximately 10% from 2007 and in an increase in EBITDA from $10.8 million last year to approximately $30 million.

Third quarter bookings of $90.2 million were unfortunately below our guidance of $113 million to $118 million. While we had expected a sequential decline, bookings were below our expectations due to various factors. These included a sharp decline in MOCVD orders as the high brightness LED industry undergoes a capacity digestion period, a sequential decline in orders from our data storage customers after their strong first-half of 2008 capital investment and continued weak semiconductor CapEx. Compounding these factors, we believe the global economic slowdown and contained financing environment has impacted all Veeco end-markets. While the third quarter is historically our weakest bookings quarter, business conditions changed rapidly in the final weeks of September with customers delaying or foregoing capacity and technology purchases, particularly in our process equipment businesses.

By business segment, LED and solar process equipment delivered $41 million in revenue, up 29% compared with the prior year and representing 35% of Veeco revenue. Q3 EBITDA was $5.5 million, compared to $3.2 million last year. Orders were $26 million or 29% of Veeco's total; a significant decline compared to last year's Q3 orders of $49 million and $52 million in Q2, ' 08. While we had expected some fall-off in orders due to the significant MOCVD capacity build up in Taiwan, the decline was greater than we had originally anticipated. We believe that the current constrained financing environment -- we also believe that the current constrained financing environment had an impact on our solar bookings and in particular for our new web coder product line.

In data storage, we’ve reported revenues of $43 million in the third quarter, up 39% from last year with EBITDA of $6.7 million compared to a loss in the prior year. This business represented 37% of revenues. Data storage orders were $32 million or 36% of total, flat compared to last year's third quarter, but down 37% sequentially as our customers slowed their capacity investments after their strong first-half 2008 purchasing. We often see this pattern of strong first-half purchases in the data storage segment and had anticipated much of this decline when we provided our guidance for Q3. However, we are aware that key data storage customers are reevaluating their capacity investments and we’re concerned that this will have an adverse impact on Veeco in 2009.

In Metrology, revenues were $32 million, down 10% from the third quarter of last year and 3% sequentially. This business represented 28% of Veeco's revenues. As forecasted, Metrology reported a return to profitability in the third quarter due to cost cutting and restructuring activities, particularly in the nano, bio and automated AFM businesses. Metrology bookings were $32 million or 35% of total orders, declining 14% versus the prior year and 2% sequentially.

While our auto AFM business continues to be impacted by the weak semiconductor CapEx environment, we achieved two important milestones for our new insight product during Q2-Q3; the sign-off of our second beta tool by a major US customer and a new order from a key Korean customer. Our nano, bio and optical instruments businesses continue to be impacted by slow funding for government R&D, particularly in North America and Europe, a situation that we've been seeing for much of 2008.

Veeco's third quarter bookings indicate a significant deterioration in general business conditions. Clearly the world has changed. While we have a healthy prospect list for new orders in the current quarter, there are signs that the global economic climate may cause a broad slowdown in CapEx purchases, and we’re uncertain as to the depth or duration of the downturn. We anticipate that order rates will come under pressure for some time period. As stated in our press release, due to this limited visibility we’re unable to give an accurate estimate of fourth quarter orders which include both significant opportunity and downside risk.

In light of this new reality, we are taking corrective action to lower our cost structure with the goal of keeping Veeco profitable at the EBITDA line and cash flow positive in 2009 in what appears to be likely to be a down revenue year. Our management team is conducting a comprehensive review of our global work force and we’re planning reductions in the current quarter. We are evaluating several scenarios for next year with different levels of actions tied to them, and we’ll continue to monitor customer order patterns and be prepared to adjust our plans accordingly.

Our overall intent is to lower our spending while maintaining strategic investments in R&D, particularly in our LED and solar business. The reality of our third quarter bookings and the uncertain outlook made it imperative that we move quickly to take action while not abandoning our growth strategy and investments in our future. Before I comment further on our outlook, I’ll hand the call over to Jack for some additional financial commentary.

Jack Rein

Thank you, John. Sales for the third quarter of ' 08 were $115.7 million, up $18 million or 18% versus the third quarter of 2007. This increase was primarily due to process equipment customer technology and capacity requirements, and the data storage and LED and solar markets. Orders for the third quarter of 08 were $90.2 million, down $28.1 million or 24% from the third quarter of 2007 and $46.3 million or 34% from the second quarter of ' 08, primarily due to a slow down in the high brightness LED industry as a result of having to absorb the significant amount of new systems purchased during the last two years, as well as slower demand in the data storage semiconductor research and industrial markets. We believe that the global credit crisis has had an immediate impact and caused the customers across our various end-markets to delay or reassess capacity and technology purchases.

Veeco's book-to-bill ratio was 0.78 to 1 for the quarter. Veeco's backlog at September 30, 2008 was approximately $176million, down $35 million from the June 30, 2008 level. Third quarter 2008 backlog adjustments totaled $9.8 million, primarily as a result of order push outs from Asian customers for MOCVD tools. Overall, gross profit for the quarter was $46.1 million or 39.8% of sales, compared to $35.9 million or 36.7% of sales for the third quarter of 2007. Purchase accounting adjustments related to our acquisition of Mill Lane solar business adversely impacted gross profit by $900,000 and 80 basis points, compared to overall sales.

LED and solar gross margin improved to 36% versus 33.4% in the third quarter of ' 07, despite the Mill Lane purchasing accounting impact which was 230 basis points on this segment sales. This reduction was a result of purchase accounting which requires adjustments to capitalize inventories at fair value. Despite this charge, the third quarter '08 gross margin improvement was the result of increased volume, improved mix and favorable impact of outsourcing.

Data storage product equipment gross margin improved to 39.8%, due to an increased volume and favorable product mix and pricing. Metrology’s gross margins also increased to 44.9% from 42.6% and principally due to a richer product mix. Total Veeco gross margin declined to a 190 basis points, compared to 41.7% in the second quarter of ' 08 and was below our previous guidance while Metrology gross margin improved sequentially 110 basis points, principally as a result of favorable product mix. Metrology sales declined by 3.5%, adversely affecting the aggregate Company gross margin.

In addition, LED and solar gross margins declined sequentially by 540 basis points, principally as a result of lower volumes and the purchase accounting adjustment that I just mentioned. SG&A was $23.4 million or 20.2% of sales, compared to $22.5million or 23.1% of sales in the third quarter of ' 07 and $23.9 million or 20.9% of sales in the second quarter of ' 08. The dollar increased from the prior year quarter was primarily due to an increase in the bonus and profit-sharing as a result of increased earnings partially offset by a reduction in personnel related costs consistent with the Company's continuing initiatives to reduce spending.

R&D expense totaled $15.3 million, an increase of $300,000 and $200,000 from the third quarter of 2007 and the second quarter of 2008 respectively, due to research efforts related to MOCVD product enhancements and next generation tool development as well as investments in our new solar global web product line. In the third quarter of ''08, restructuring expense of $4.1 million as previously forecasted, related to $3.7 million of charges for the acceleration of equity awards and other severance costs resulting from the mutually agreed termination of the employment agreement of the Company's former CEO, $400,000 of severance and lease related charges in Metrology. $3 million of these charges are non-cash in nature.

Amortization expense totaled $3.1 million in the third quarter of 2008 , up by $1.2 million compared to the third quarter of 2007 as expected due to the additional amortization associated with the Mill Lane acquisition in the second quarter of 2008. Third quarter 2008 GAAP net loss was $1.7 million or a $0.05 loss per share, compared to $5.7 million loss or $0.18 per share loss in the third quarter of 2007. EPS excluding certain items and amortization expense using a 35% tax rate for the quarter was $0.15, in-line with the guidance of $0.10 to $0.15, compared to a $0.05 loss in the third quarter of 2007. GAAP EPS of $0.05 loss was also in the range of guidance of a $0.12 loss to a $0.03 loss.

For the first nine months of 2008, sales totaled $332.5 million, a 12% increase from 2007, primarily due to a $46 million increase in LED and solar process equipment for high brightness LED applications and customer acceptance of the Company's newest generation of MOCVD systems. Gross profit for the nine months ending September 30, 2008 was 41% compared to 41.2% in the comparable 2007 period. Strong performance in process equipment due primarily to an increase in sales volume was off set by unfavorable sales volume in Metrology.

LED and solar process equipment gross margin increased to 39.6% from 37% in the prior year period, primarily due to a significant overall increase in sales volume as well as favorable pricing on new MOCVD products and a favorable product mix in MBE products. The current year period includes a reduction in gross profit of $900,000, related to the acquisition of Mill Lane as I previously discussed. Data storage product equipment gross margin decreased to 38.9% from 39.5% in the prior year period, due to favorable warranty and pricing adjustments in the prior year period.

Metrology gross margins decreased to 45.2% from 45.6% in the prior year, principally due to lower sales volume offset by a reduction in spending and a favorable product mix. Operating expenses overall were flat for the nine month period compared to the nine month period of 2007, despite an increase in bonus and profit-sharing related to improved profitability. Reductions in travel and entertainment, consulting, insurance and other costs offset these variable incentives.

Veeco has aggressively focused on cost containment and reduction initiatives this year and we will continue to do so. Orders for the first nine months in 2008 of $336 million were flat compared to the same period in 2007. The book-to-bill ratio for the first nine months was 1.01 to 1.

Veeco's nine month 2008 GAAP net income was $900,000 or $0.03 per share, compared to a net loss of $8 million or $0.26 per share in the first nine months of 2007. EPS excluding certain items for the nine months of 2008 were $0.40, compared to $0.10 for the first nine months of 2007. The items excluded from these calculations are amortization expense, restructuring charges, the $900,000 purchase accounting adjustment and $300,000 asset impairment charge for 2008, and the gain on extinguishment of debt for 2007.

With respect to our balance sheet, cash and equivalents totaled $117.7 million as of September 30, 2008, an increase of $8.1 million during the quarter. Cash flow for the nine months was a positive $600,000 which included the $11 million purchase of Mill Lane. This result was ahead of our internal plan by approximately $5 million. We are pleased to be generating this positive level of cash in the current economic environment.

Accounts receivable declined by $4.5 million sequentially and day sales outstanding for the quarter were 56 days, down from 60 days at June 30, 2008 and well below the industry average of 74 days. During the quarter, inventory declined by $9.4 million to $105.7 million with a turnover of 2.6 times. Capital expenditures were $3.3 million and $10.4 million for the third quarter and nine month periods of 2008 respectively.

Depreciation expense totaled $3.1 million in the third quarter of ' 08 and $9.5 million for the first nine months. We expect to retire $25 million of our original convertible notes as they become due in the fourth quarter of 2008 and to existing cash balances because balance sheet remains healthy with the balance of our convertible notes not due into April of 2012.

With regards to outlook, Veeco currently forecast fourth quarter 2008 revenues to be in the range of $110 million to $118 million. Gross margin is currently forecasted to be in the 40% to 41% range. Fourth quarter operating expenses are currently forecasted to be approximately $40 million, up sequentially due to increased spending in LED and solar R&D, and variable compensation items in SG&A.

However, as previously noted, we are taking corrective actions to lower our cost structure in response to the severe economic climate which we believe will adversely impact our capital spending, are intended to lower spending in SG&A, direct labor, overhead and services while maintaining strategic investments in R&D particularly in our LED and solar businesses. There will be restructuring charges related to these cost reductions, but we are currently evaluating the extent and timing of these actions. As such, we are unable to estimate the amount of these charges at this time. These actions will obviously impact the spending rate leading into 2009.

Excluding these potential charges, $600,000 of additional purchase accounting charges, amortization of $3.3 million and utilizing a fully tax 35% rate, Veeco's fourth quarter earnings per share are currently forecasted to be between $0.08 and $0.15 on a non-GAAP basis. I’ll now turn the call back over to John

John Peeler

Thanks, Jack. I'd now like to talk for a few minutes about our key initiatives by business which we believe will help Veeco weather this storm and emerge in a strong position. In our LED and solar businesses, we’ll remain focused on growing a profitable equipment business in green technologies.

We’ll continue to make strategic investments in R&D that are critical to our future success in what we believe is our highest growth opportunity. In MOCVD, we’ll maintain our investments in order to develop next generation solutions that will drive success in solid state lighting and three five multi-junction solar cells. We believe the high brightness LED end market drivers for more efficient and cost effective lighting remain intact and will drive a large multiyear growth opportunity for MOCVD equipment. We've made significant progress in gaining customer acceptance of our latest generation systems, due to ongoing uniformity improvements and their compelling cost of ownership model. And our goal is to emerge from this cyclical pause with a stronger product line-up that continues to help LED manufacturers improve their performance.

We're also making significant investments in our new CIGS solar business and engaging potential new customers. Veeco has a strong opportunity to become a leading supplier of integrated vacuum deposition equipment for CIGS solar cells due to our superior thin film deposition technologies and our ability to develop low cost of ownership solutions. While financing of CIGS companies could be challenged in the short-term, we believe there is a several hundred million dollars equipment opportunity in CIGS vacuum deposition equipment. This estimate is based on the number of potential customers and their capacity expansion plans in the coming years.

In data storage, we made progress this year in refocusing resources, lowering our quarterly break-even to below $30 million through reductions in sites and people, and focusing on higher margin products where we have leading market share. Our data storage business has more than tripled its EBITDA in the first nine months of the year. Going forward, we're positioning Veeco to maximize our growth opportunities as our customers capital spending moves from capacity to technology buys. We’ll continue to offer state-of-the-art products that provide lower cost solutions such as our PVD high rate product and products focused on new thin film material sets that our customers are currently developing.

As we head into challenging times for this business, We're exploring additional cost savings, manufacturing synergies and operational improvements. As a key step to continuing to maximize the performance of our data storage business, we've selected an Asian outsource partner to manufacture our slider products. The first units manufactured by this partner will be shipped to customers in the first quarter of 2009 and we’ll make corresponding reductions in our US manufacturing site for this product line in mid 2009. In addition to the slider product line, We're also working on plans to outsource additional IMB products next year. We have hired a new VP of Operations for process equipment to help drive initiatives such as overseas material sourcing and consolidated purchasing. We believe these activities will drive several million dollars in additional savings and gross margin improvements in 2009.

In Metrology, we've made investments in leadership that include a head of sales, focused on our nano, bio, AFM and optical instrumentation businesses and a new channel partner leader to expand rep sales and coverage. While Metrology has struggled with challenging end-markets this year, we've seen some good customer response to new product introductions. We continue to receive strong customer poll in our nano bio business for the new harmonics, AFM Mode that was introduced in Q2. Our optical business continued to expand its penetration into solar manufacturing with the adoption of our optical profiling technology for improving solar manufacturing efficiencies and yield performance.

Also related to yield enhancement in Q3, we booked our first tool for defect characterization into printable plastic electronics manufacturing area. And lastly, we introduced a new in motion platform for wafer level testing and characterization of MEMS devices. Our Metrology leadership team continues to focus on operational excellence, and is making great progress in quality improvements, material cost reduction and contract manufacturing, and supply chain management; all with the goal to reduce our fixed costs.

In our nano bio AFM business, We're rationalizing and repositioning our product line to improve profitability and gain share. In our optical business, we see expansion opportunities in industrial markets and have improved the strength of our APAC sales channel and marketing efforts. We're also driving product development in these businesses into higher volume QAQC production applications.

So in summary, while we're obviously concerned about the current business climate and are taking rapid actions to lower our cost structure, we will continue to invest in our high growth technologies to capitalize on significant and exciting market opportunities ahead of Veeco. It's our intent to emerge from the present environment in a strong position to enable future revenue and profit growth.

Thank you for your patience during our remarks. Operator, we would like to now start with the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Bill Ong with American Technology.

Bill Ong - American Technology

If I -- good afternoon. When you look at your LED customer list, what percentage of your customers or revenue, whatever is easier, is primarily capacity buys? I would surmise that the balance would be more share gains and technology buys and within that, how much is capacity buys and tech buys? What I'm trying to get at is that would give you a baseline type of spending needed to sustain LED manufacturing globally.

John Peeler

Thanks, Bill. I don't think we have the information to give you that split at this point, but I would tell you that our customers continue to buy products that offer improvements in productivity and uniformity and LED brightness so we have seen an ongoing desire to move to new systems and the over capacity situation seems primarily focused on Taiwan and China at this point.

Bill Ong - American Technology

Okay well given that your bookings dropped in half, do you have a sense of -- qualitatively how much more will it drop modestly or more substantial drop and that will also give me a sense of the baseline type of spending in LEDs.

John Peeler

Bill, it's hard to tell at this point. The last time the market fell off was 2005. I think that the downturn lasted six to nine months. LEDs were in a lot less applications at that point. There is continuing growth of new applications as we go forward so if you look at DELL, for instance -- all of their new laptops are moving to LED back lights and it clearly takes time to get the new laptops into production but the change is happening and it's difficult to tell whether this is a flat spot or a downturn and we are all interested to let some time go by. There is a lot of prospects out there.

We are looking on a lot of deals, but it's a very volatile market so it's hard to tell how quickly it's going to dry up -- or if it is going to dry up or just go flat so very uncertain at this time and we’re monitoring it carefully.

Bill Ong - American Technology

Okay yeah I realize it's a difficult question. My second follow-up question is since you do have a distinctive set of customers -- the LED makers dealing with all the orders, the disc drive makers dealing with weak, demand, and then you have your research guys dealing with the long-term budget plans. Maybe you can give me some insight of how they are they looking at a recovery in the business and can you also rank which of the three segments will recover first?

John Peeler

Well I think, first of all, let me start off with I think that Metrology has some different dynamics than process equipment, because less of the purchases-- more of the purchases were based on research or product development or new technologies and there is less direct impact of a change and need for capacity buys so I don't believe the Metrology business will see the same level of downturn as the process equipment businesses.

In the process equipment business, we clearly expect there to be more focus on technology buys then and not a lot of focus on capacity buys, especially in data storage. But there are new technologies and we are delivering products, and we are delivering compelling products in those areas.

As far as how long it might last, I don't believe that from the customers I have spoken with -- they don't know. I don't think anybody has a good feel for what the length or depth of the economic situation is. So, we’re just going to prepare ourselves that this is not a one or two quarter event, but that this is a longer downturn and we will take quick action to keep the Company healthy during that downturn and at the same time, not throw out our future. So, we are focused on our key strategic moves and our development programs. We have done a lot of work over the last year on operational improvement and work to change cost structures across each of these businesses and that’s actually helping us now.

Because we’re delivering some operational performance improvements that if we had to start now, we couldn't get there. But, anyway, I hope it will be over a year from now, but I don't think anyone can predict whether that’s accurate or not.

Bill Ong - American Technology

Let's hope for better times. Thank you very much.

John Peeler

Thanks, Bill.

Operator

(Operators Instructions). We will hear next from Tim Arcuri with Citigroup.

Tim Arcuri - Citigroup

Hi, guys a couple of things. First of all, I saw even if you strip out the impact from Mill Lane, it looked like the margins in the LED, solar business were still down about 200 to 250 basis points and I was wondering what that was from.

Jack Rein

I don't think that that’s quite true -- for our second quarter gross margin was 41.4%. We had a 230 basis point impact of this Mill Lane thing. That would put us at 40.6%. So, we would be down about eight-tenths of a percent or 80 basis points sequentially.

The biggest impact really was a sequential quarterly decline in our MOCVD sales and it was down by $5 million quarter-over-quarter. So, Q3 -- Q2 sales were $45 million and $40.9 million in the third quarter. So, that was the major impact.

Tim Arcuri - Citigroup

Okay I guess John, can you go through then maybe how you see breakeven if you kind of look at it on an apples-to-apples basis, a fully taxed basis including amortization -- how you see breakeven in December and how it might progress in the first half of next year -- what your targets look like.

John Peeler

Well we are not at this point -- obviously we are not giving targets out because we are still working on our expense structures. And frankly, we're still trying to assess the top line revenue as to where that’s going to be. I would say though that the guidance that we gave said that we were somewhere between a $0.03 loss and an $0.08 profit on a GAAP basis in the fourth quarter and that was at the range of $110 million to $118 million. So you can figure that right now before we take these quickest actions, I guess our GAAP break even is somewhere in and about $112 million or $113 million range on a quarterly basis.

Tim Arcuri - Citigroup

Okay and then I guess just last thing, John, you had mentioned that it looks like next year’s going be a down revenue year.

John Peeler

Yes.

Tim Arcuri - Citigroup

And you have a lot of revenue kind of in, in arrears, if you will given that you booked -- you have been over booking relative to what you have been revenuing for the last several quarters. So, you have like $10 million, $15 million, $20 million sitting out there. So, for you to have a down revenue year next year, you would have to see given the kind of six month lag times here, you would have to see bookings in December. I mean, they would have to fall off quite a bit. They’ll have to be $50 million to $60 million, something in that range for you to have a down revenue year next year. Is that what you are looking at?

John Peeler

I don't think they have to fall off that much for us to have a down revenue year. It’s a little hard to predict on one quarter, but we did have a $90 million quarter in Q3. We have a high level of uncertainty in Q4 with a very broad range.

So, we didn't feel that it was useful to provide bookings guidance and that's an unusual situation for us. But the fact is, is that we maintain a significant amount of backlog and when we exit -- a number of our products have fairly significant lead times. So, as we exit 2009, we will have to have a significant backlog.

Tim Arcuri - Citigroup

Let me --

John Peeler

It’s also the other thing is uncertain is whether we’ll see push outs in the backlog and whether some of the things that are in the backlog will be delayed. And we are just going to give it a little more time to get a better understanding of our customers' CapEx plans. If we look at some of the CapEx plans so far that have been announced in the data storage industry, for instance, they don't look too terrible. But it’s very hard to predict at this point. And we want to make sure that we make some assumptions here that are not overly optimistic and get our cost structure adjusted for that. So, we are planning to deal with a down year next year.

Tim Arcuri - Citigroup

Okay John thanks.

Operator

(Operators Instructions). Our next question comes from Matt Petkun with D.A. Davidson and Company.

Matt Petkun - D.A. Davidson & Company

Hi, good afternoon, following up a little bit, John, about your original comments. In the solar market, you said you had seen orders slowdown there. Really primarily, Mill Lane was enjoying one customer. I know we don't know very much about the order outlook overall, but what can we say about may be new customers engaging with you guys about looking at your CIGS technology with the expectation that nobody knows about when they can place orders in this environment?

John Peeler

Right so, on the web coating products, we’ve have made a lot of progress since we bought Mill Lane. We have developed the product significantly. We have quoted. We have a large number of quotes out to customers. Customer feedback has been very positive as far as the features and capability, technology, ownership model for the product.

So, we have a lot of quotes out there. We haven't been losing quotes. We haven't lost anything where we showed up in time for the bid process to work. And what we think -- we feel good about the product and the prospects there. A fair number of these customers already have a substantial amount of capital raised and have a substantial amount of money in the bank.

So, we believe that if there are deals flowing that we will win some of them and do well at that. But people have to place orders and there is some lead time on these. So, these have a six-month or more lead time in delivering the products. So, there will be some lag between when we get an order and when it turns into revenue.

Matt Petkun - D.A. Davidson & Company

Okay and then you obviously, have other equipment outside of Mill Lane that’s targeted at other elements of the solar market. But I was wondering in particular with Mill Lane if you are working on any other new product opportunities that wouldn't be intended for roll cutting -- flexible substraights or is that really the primarily IP that you bought from those guys was the web coating technology?

John Peeler

What we -- we bought a web coater product line and that did a couple of the steps to make a CIGS solar cell. We have been working with our thermal deposition technology to make the product able to do some of the other steps in CIGS fabrication on web base or flexible substrates. So, that is where we are focused. We are clearly looking at opportunities in glass and other places.

But our focus is on the web coating at this time. And we have taken what we have got with the Mill Lane purchase and added on our thermal deposition technologies, which is one of the real benefits of this. We think we have the technology to take this product to a whole other level. So, predominantly web coating at this point.

Matt Petkun - D.A. Davidson & Company

Okay and then just finally, back to the gross margin. Do you anticipate -- I know your overall margin expectations are for next quarter. The process equipment, does it actually see an improvement in gross margin despite what looks like -- down the pipeline, and obviously not for Q4, but into future periods a real decline in revenues from that business?

Jack Rein

Depending on -- next quarter we will probably won't see a gross margin improvement, but future gross margin improvement obviously is going to be largely impacted by the sales level and the volumes that we have.

Matt Petkun - D.A. Davidson & Company

Okay maybe the better way to ask it, Jack, is just looking at the margins that you have experienced this quarter and the revenue levels, I think we would like to see margins near to these levels even if revenues drop to -- obviously not too far but -- I guess my question is how can we see better margins out of that business overall?

Jack Rein

Well I think that there is certainly new products that are coming out that have higher margins. And I think that that's going to certainly have a favorable impact as we continue some of the cost -- I should say out sourcing and global sourcing and cost reductions in our initiatives -- various initiatives that we have, we should see the margins come up in those areas. So we will continue to work on initiatives, that will improve the gross margin irrespective of volume levels.

Matt Petkun - D.A. Davidson & Company

Okay. Thank you so much.

Jack Rein

Thanks.

Operator

Next, we will hear from Joanne Feeney with FTN.

Joanne Feeney - FTN

Hi here hi folks. A few questions. I’m back to the gross margin that you were just talking about, it seems like there were a few things that will be changing. One is that data storage and LED shrink in the share of the business your mix is improving, so that should push up gross margin.

John Peeler

Yes.

Joanne Feeney - FTN

But the volume effect looks like a lower gross margin, and then you've got the restructuring, like the ion beam outsourcing. I'm wondering if you could may be help us sort out the relative importance of those three effects and the timing. May be give us the relative sense of what a trough gross margin might look like.

Jack Rein

Well and frankly Joanne we have -- without understanding the timing ourselves of the volume impact, et cetera, it’s kind of difficult to do that. But I would say that certainly, you are right. Our average gross margin in Metrology is in the mid-40s at this point and our trailing nine month gross margin in equipment is a bit below 40%. So obviously that is about a 5 point favorable differential that would impact us as we go forward, depending on the relative volumes of Metrology and process equipment. So, we haven't given any top line guidance or modeling guidance really post the fourth quarter. So, it’s kind of difficult to give you the trough gross margin without weighting it with the appropriate revenue levels.

Joanne Feeney - FTN

So, if I were to -- so let's just take this as a benchmark. Suppose that the year were flat in 2009, if revenue level was flat, your volume is flat, the only thing that’s changing then is the mix and the mix is moving in a way to improve your gross margin. Is that at least the right way to think of that one benchmark? Or is I am missing something?

Jack Rein

Yeah, if revenue were to be flat and that’s not something that we are commenting on or speculating on at this point -- we would expect gross margin improvement, because all the initiatives that we outlined.

Joanne Feeney - FTN

Okay. And so that restructuring you talked about with ion beam, that's actually the timing I was wondering about. When do you think that might help on the gross margin line?

Jack Rein

I think we were referring to data storage product element that we are outsourcing. We talked about outsourcing of our --

Joanne Feeney - FTN

That’s sorry. That's what I meant. First of the guidance point --

John Peeler

Yes there are two areas to this. There is the saws and lappers which we expect to have outsourced in the first half of the year and I expect it to be completed in that timeframe. And then on the ion beam side, so I’ve -- we don't have as good a timeframe on that yet. It’s going to happen throughout the year, and it is a number of ion beam legacy products that we think we can outsource. So, that one’s going to be more phased throughout the year.

One of them is well along the path then we are in the final stages. But when you go to outsourcing a product line like this, we have to ramp up an outsourcing partner while maintaining the internal manufacturing. We actually end up with some overlapping costs at the beginning and as we move through the year, that will go away.

Joanne Feeney - FTN

That makes sense.

John Peeler

So, our objective on process equipment is to continually move more and more of our process equipment to a variable cost model. And the reason is the process equipment has such distinct up and down revenue swings. And it’s much more painful if you have a high degree of fixed cost. So, we have outsourced all of our MOCVD production at this point or virtually all of it. And we are looking to move more and more of our products to that model and we are looking to move all of our newer products to that model. We also expect to get our web coaters into that model as the business matures a little bit.

Joanne Feeney - FTN

So, then could you give us a sense may be of how protected gross margin is, maybe using LED or MOCVD as an example? So suppose that MOCVD unit sales went down say 10%. Given that it’s mostly outsourced, what would gross margin of the MOCVD systems do, do you think?

Jack Rein

Down 10% -- depending upon the product mix, I would say that we might be off half a point or something like that.

Joanne Feeney - FTN

That’s helpful. It gives us a sense of thing. If I could on Metrology, you are doing some restructuring there. Revenue was off slightly quarter-over-quarter. I'm wondering if, as you are thinking about the restructuring and initiatives you are working on, should we think about those initiatives as streamlining the product line in Metrology in a way that might increase gross margin? Or are you thinking more along the lines of expanding the product line to increase your share of available market maybe at the expense of gross margin?

John Peeler

You should think of it as on one hand streamlining, on one hand repositioning some of the products. We are introducing new products on an ongoing basis. And we have more new products coming in 2009 that we think will improve our competitiveness of the overall product line. So, most of these are not expanding the served available market though. They are still in the basic space.

There may be new applications where we are not competitive or not playing a major role at this time. But most of them are strengthening the product line and addressing what we see as new growth applications. In the optical area, we’ve moved -- we are trying to increase our penetration in industrial applications. And we do really well in research and we think there are opportunities that we are not getting to in the industrial side either from a channel perspective where we are not -- we don't have the feet on the street or the channel partner to reach them. So, we are working on what we see as good growth opportunities from the channel perspective, in addition to the product development.

Joanne Feeney - FTN

Okay. Thanks very much.

John Peeler

Thanks Joanne.

Operator

(Operators Instructions) We’ll hear next from Brett Hodess with Merrill Lynch.

Brett Hodess - Merrill Lynch

Hi, good afternoon. I know you don't want to get nailed down to a breakeven point right now. But I guess if you look across the spectrum of all the stuff you have outsourced so far and what you have to continue to outsource, can you give us some feel for just -- between now and when you get done with it, how much more you would take your cost structure down at I don’t know the kind of run rates you are at now?

John Peeler

So, Brett, it is John here. We have been working on cost reduction since -- I'm going to say early September before the world -- of course, we have been working on it all year. But we turned it up our sense of urgency late in the summer as we saw the overall economic conditions deteriorating. But what happened is it has been hard to produce what we think is a solid top line revenue estimate and we have a lot of initiatives in place.

We didn't want to come out with a new model, and a new breakeven that is half baked here. So, we need some more time. We are implementing cost reduction immediately and we hope to be back to you with more information later this quarter on actions taken and some of the changes. So, that would be our objective.

Brett Hodess - Merrill Lynch

Okay and then Jack on the Metrology side of the business, do you think in this tough market environment, you will still see a little bit of the normal seasonal pattern where you get a sort of a fourth quarter budget flush and a dip in 1Q. And so Therefore is that part of the reason why margins are a little better in 4Q and then might we look for them a little weaker again in 1Q?

John Peeler

Well I hope that we will get the budget flushed. We've always seen it before. We have always seen an up-tick in Q4. What’s hard to tell is how much of that might be offset by just general tightening of the belt and people trying to hold onto their cash.

So, we are going to drive the business and try to get whatever money we can get there that’s available. But it would be hard for me to confidently say we expect an up-tick in Q4 here. It is just too volatile. I will let Jack address the gross margin comment there.

Jack Rein

Right there I think that John is right. We are -- it is very hard in this environment. But I think we have given you our best guidance, based upon we do have a backlog that we are looking at. We do have a mix -- our mix and process equipment business is particularly sensitive to the amount of parts, the components that we sell and the amount of final acceptances that we sign off on. So, what we’ve reflected is our best thinking at this point.

Brett Hodess - Merrill Lynch

Okay and just a final [question] can you give us qualitatively some feeling -- when you look at your MOCVD customers -- HD LED area, are their utilization rates high? Have they started to see a slowdown in their business that causes the utilization rates to drop? Or can you give any comments, color on that side of things?

John Peeler

There have been a lot of new suppliers come online over the last year because there have been a lot of purchases. There has been a lot of ramp up of production particularly in Taiwan and China. And so, their utilization rates of some of the customers are going down. On the other hand, there are others that are still buying for capacity and managing a ramp up of new factories for their particular application. So, it’s kind of a mixed bag which makes it hard to predict in aggregate.

Brett Hodess - Merrill Lynch

Thank you.

John Peeler

Thanks, Brett.

Operator

And our next question will come from Jason Bernstein with Quattro.

Jason Bernstein - Quattro

Alright thanks for taking the question. An update on the capital structure with the markets the way they are, have you contemplated buying back any debt in the market and also if you can talk about any divestitures?

Jack Rein

Well, with regard to buying back debt, as I mentioned in my earlier remarks, we are buying back $25 million of our original convert that is actually is due in December of 2008. So, we will be utilizing $25 million of our cash for that purpose. With regard to other aspects of capital structure, we feel that we have adequate cash at this point.

However, we are heading into some difficult times. And so, I think we have no plans at this point to buy back any other portions of the convert, but certainly we will keep our eyes on the market and see what's out there. But our key mantra today is preservation of cash and cash generation. And second part of your question, I'm not sure. Divestitures, I don't know. We have no plans for divestitures at this point. We are evaluating -- we always evaluate from a strategic perspective, the sit of the various businesses. And right now, we are comfortable with the businesses that we have.

Jason Bernstein - Quattro

Great, thank you.

Operator

And we have no further questions in the queue at this time. I would like to turn the conference back to the speakers for additional or closing remarks.

John Peeler

I want to thank you all for joining us today. And operator, that concludes our call.

Operator

Thank you, very much. That does conclude today's conference. And thank you for your participation.

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Source: Veeco Instruments Inc., Q3 2008 Earnings Call Transcript
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