FEI Company Q3 2008 Earnings Call Transcript

Executives

Fletcher Chamberlin – Treasurer and IR Director

Ray Link – EVP and CFO

Don Kania – President and CEO

Analysts

Satya Kumar – Credit Suisse

JoAnne Feeney – FTN

Steve O'Rourke – Deutsche Bank

John Harmon – Needham & Co.

Benjamin Pappas – D.A. Davidson

Nik Tishchenko – Soleil Securities

Owen McCloskey – Equity Value Ventures

Bill Dezellem – Tieton Capital Management

FEI Company (FEIC) Q3 2008 Earnings Call Transcript October 28, 2008 11:00 AM ET

Operator

Good afternoon, ladies and gentleman, thank you for standing by. Welcome to the FEI third quarter earnings conference call. (Operator instructions) This call is being recorded today October 28, 2008. I would now like to turn the conference over to Fletcher Chamberlin. Please go ahead, sir.

Fletcher Chamberlin

Good afternoon, ladies and gentlemen. As the operator said, I’m Fletcher Chamberlin FEI’s Treasurer and Communications Director. With me today at our headquarters in Oregon are Don Kania, President and CEO, and Ray Link, EVP and Chief Financial Officer.

Before we begin our presentation, we have to do the regular housekeeping matters. This call contains forward-looking statements to the extent that we discuss expectations of our future corporate performance and guidance, customer orders or revenue growth, performance by product and market, margin improvement, market developments and opportunities, the competitive landscape, product and technological developments, product introductions and shipment schedules, the effects of future movements and exchange rates, cost savings and restructuring, changes in our effective tax rate and other future events or plans. Those statements are considered forward-looking, subject to risks and uncertainties that could cause our actual results to differ from the forward-looking statements made.

These risk factors are cited in today’s press release and FEI’s most recent 10-K, 10-Q and 8-K documents and other filings with the SEC. Investors are urged to read these documents. Copies are available free of charge at the SEC’s website at www.sec.gov or our website or from FEI’s Investor Relations department at 503-726-7710. The company assumes no duty to update forward-looking statements set out in those documents or made on this call. This call is the property of FEI Company. It will be archived in the Investor Relations section of our corporate website at www.fei.com.

Ray and Don will review the details of our result in just a moment, but first we want to outline what you’re going to hear on the call. In summary, despite economic turmoil, FEI had a very positive quarter and our near term prospects are positive as well. We will discuss tow major things with some dept on today call. The first is the impact of changes in financial markets and particularly foreign exchange rates on FEI.

As a global company, the recent strengthening of the dollar affects us in many ways. Ultimately the weaker euro and stronger dollar is very good for FEI’s, bottom line and Ray will cover that in detail.

Second, Don will describe the prospects for FEI as we face the deteriorating global outlook. While electronics is an area of concern, the opportunity in the remainder of our business remains positive. I will now turn the call over to Ray.

Ray Link

Thanks, Fletcher, and good afternoon to everyone. Welcome to our third quarter call, I will go through the financial report and guidance in detail and then turn the call over to Don. Before I go into the numbers, I would like to comment on FEI’s strength in light of the recent financial turmoil.

We paid off and reduced our share count by 5.5 million shares by paying off $196 million of debt in the first half of the year and still have over $314 million in cash and investments at then end of the third quarter. We have over $127 million in short term investments above and beyond our operating cash requirements with much of that invested in U.S government money market funds.

Our only debt is a convertible note issue of a $115 million that is not due until 2013. We are generating cash and have no near term borrowing needs. We negotiated $100 million bank credit agreement on favorable terms last spring with a group of very strong banks, thus we are in good shape from a balance sheet and liquidity standpoint.

Don will talk in a moment about our markets and our outlooks, where customers are not immune from potential economic dislocation, the majority of our business comes from sources that are not subject to near term disruption though the difficult credit markets.

The area where we are most affected by our recent market volatility is the foreign exchange markets. Here are the facts and the recent euro/dollar exchange rates. For the second quarter the average euro/dollar rate was 1.57 for the third quarter the average rate was 1.52 and the quarter end rate was 1.56. Today the rate is approximately 1.27, a 19% decline from only four months ago and the biggest movement ever in such a short time span.

FEI has more euro expenses than euro revenues, so the recent weakness in the euro and strength in the dollars has a positive impact at our margins and bottom line even as it reduces our revenue in bookings. As the dollar strengthens, expenses go down faster than revenue. This net positive impact of foreign exchange rates in the company had moderated in the short term by our hedging program which is designed to smooth out the impact of large fluctuations.

We are impacted to a degree by changing foreign exchange rates in the third quarter, a projected impact in the fourth quarter will be more pronounced at the current rate. Turning on to the returns of the third quarter, bookings of $175.3 million were above guidance and up 25% from the second quarter and up 14% from last year. That’s the highest quarterly total in our history. I’d like to point out that we revalue our backlog at the end of the quarter using quarter and exchange rates and the changes netted against quarters reported bookings.

The rate movement from the end of the second quarter to the end of the third quarter reduced the backlog by nearly $16 million. In other words, had the exchange rates been the same at the end of Q3 as they were at the end of Q2 we would have reported 191.1 million in books, up 36% over Q2. Even with the revaluation of the backlog at the end of the quarter was $329.5 million which is another record for the company.

Net sales in our seasonally slow third quarter of $141.7 3% were done 3% from last year’s third quarter and down 8% from the second quarter. About $2.5 million of the declines in the second quarter was due to changes in average currency rates. Without the currency impact we would have been in the range of our revenue guidance.

Research and industry revenue was down 7% from last year’s third quarter and 23% from a very strong second quarter. Life science however achieved record revenues and was up 68% from last year’s third quarter and up 20% from the second quarter of 2008, continued the growth we have seen recently.

Electronics revenue was down 26% from last year’s third quarter and 6% from the second quarter. In total electronics was less than 25% of revenue in the current quarter compared with 33% in last year’s third quarter. The gross margin increased from 38.1% in the second quarter to 40% in the third quarter.

A portion of the improvement was due to the strength in the dollar and the remainder was due to improvements in product mix, pricing, operations and service margins. Looking at our market segments, it is notable that our service and components gross margin improved for the third quarter in a row to 29.8%. This benefit is primarily operating improvement since this segment is to a large extent naturally hedged from a currency perspective.

Moving down to income statements, the sum of R&D and SG&A expenses was $48.9 million, down 4% from Q2. The bulk of the decline was due to seasonal factors, lower commission and the impact of expense control and restructuring programs with the portion of the climb coming from currency movements.

Amortization was purchase technology was $455,000 in the third quarter and we expect that level to continue barring any future acquisitions. Restructuring expense, $1.2 million we expect about the same in the fourth quarter. Operating income was $6.2 million compared to $4.9 million in the second quarter. Excluding restructuring expenses operating income would have been $7.4 million or 5.4% of sales, an improvement over Q2.

To low the operating income line, total other income was negative $591,000 compared to positive $1.5 million in the second quarter. Net interest income was lower because our cash balance was lower after we paid off our zero coupons notes in June and interest earnings were lower due to much lower market rates.

With the extreme volatility in foreign exchange rates our currency loss from balance sheet translation was higher in the quarter. Exchange rate volatility mix forecast in this line difficult we expect the total income line to show another loss of approximately 500,000 for the fourth quarter.

Tax rate for the quarter was 29.8%. We expect the rate to be around 25% in the forty quarter. All this leads to GAAP net income of $3.9 million or $0.11 per share for the third quarter above our guidance range. Restructuring expense accounted for $0.03 charge, so excluding restructuring expenses our EPS was also at the top end of our guidance range.

The fully diluted share count of 37.3 in the quarter down from 41.5 million shares due to the repayment of our zero coupon convertible notes in June, we expect the share count will grow only modestly in the next few quarters. That does not include 3.9 million shares attributable to our remaining 2% and 7% convertible notes because their inclusion would be any dilutive at the current income levels.

Turning to the balance sheet, our total cash and investment position at the end of the quarter including restricted cash and long term investments was $314 million up $23.2 million from the end of Q2. Operating cash flow was positive $32.2 million. Receivable days outstanding declined as did inventories and current liabilities. Capital spending in the third quarter was $2.5 million compared to deprecation expense of $4.2 million.

So now let’s turn to the details of our guidance. All of our guidance for Q4 assumes an average, quarter end euro rate 1.35, which is close to the average rate for October. This compares to an average rate of 1.52 in the third quarter. We expect revenue for Q4 to be in a range of $141 to $148 million.

This average foreign exchange rates in the fourth quarter was the same as the average rates in the third quarter, our revenue guidance would be approximately $7 million higher. In our current mix of sales by geographic region and currency, each $.01 strengthening of the dollar verses the euro reduces reported U.S dollar revenue by approximately $400,000.

At the same time our gross margins improve and operating expenses are reduced. Improvements in growth margin due to a stronger dollar will be mitigated over the next two to three quarters due to offsetting hedging losses. The continued long term stronger dollar will improve EFI’s results. For the fourth quarter, we expect gross margins to be above 40% even with the impact of hedging.

Operating expenses excluding restructuring are expected to remain below $50 million in the fourth quarter. GAAP earnings per share for the fourth quarter assuming a 25% tax rate are expected to be in the range of $0.11 to $0.17. Restructuring changes of approximately $1.2 million which are included in the GAAP guidance are estimated to reduce income in the quarter by approximately $.02 to $0.03 per share.

Now on to the bookings guidance, if we are to assume exchange rates stayed the same at the end of the third quarter to the end of the fourth quarter, our bookings guidance would be above $115 million, the same as the guidance was for the first quarter. That’s an indication of our overall outlook solid despite an expected fall off in electronics bookings that Don will talk about in a moment.

Using the same euro/dollar exchange rate of 1.35 that we use for revenue and EPS guidance, our guidance, as the gross books with will above $140 million or $10 million lower than the constant currency estimates. We will then revalue the existing backlog at the quarter end exchange rate and that could reduce reported bookings number by an additional 10milloin to 15 million.

So in summary we had a very good quarter with strong orders. Movements in foreign currency rate create a complex picture in our financial statements, but fundamental the stronger dollar and the weaker euro are good for FEI. Even if the top line growth is moderated, our margins at earnings are expected to improve by the strengthening of the U.S. Dollar. With that I will turn the call over to Don.

Don Kania

Thank you, Ray, and good afternoon everyone. Despite the turmoil in the global economy and changes in foreign currency markets that ray described, FEI had a very good third quarter. Bookings were the highest in our history as each of our market segments recorded sequential increases in bookings. The environment remained positive for our research and life sciences business and the electronics segments orders grew as we had anticipated.

As we announced in our press release today, the quarter included the largest single order in the companies history, from the King Abdullah University of Science and Technology in South Arabia or KAUST, where a substantial investment is being made to create a world class graduate level research university dedicated to inspiring a new age of scientific achievement in the South kingdom. We were honored to be chosen as a provider of TEM, SEM and dual beams for the University.

The tools will be dedicated to researching the life sciences and material science. We feel that this selection confirms FEI’s technology and market leadership. The order is for multiple tools including five Titan class TEMs totaling over EUR 20 million, with deliveries expected through the first three quarters of 2009.

This South investment in KAUST is a prime example of the infrastructure investment that is taking place across the globe. There is also another example of the inter-disciplinary multi-tool order opportunities that have expanded in recent years and which FEI had dominated.

Turning to our market segments, research and industry books in the third quarter were %68 million, our second highest quarterly total in history, up 19% from the second quarter and down 15% from the all time record in last year’s third quarter.

Demand grew globally with over 80% of our bookings coming from outside the United States with a significant portion from the emerging markets. While we do not expect another order on the scale of KAUST in the fourth quarter, our outlook remains positive as our pipeline continues to grow for the research business. Life sciences had a record booking quarter $25.9 million, that’s up 20% from Q2 and over 130% from last year’s third quarter.

The latest quarter includes a portion of the KAUST order. As we have said before, bookings in this segment will be uneven, but we believe that the trend continues to be very good. The response to the Titan Krios continues to be positive as the pipeline for this product continues to build globally. Third quarter electronics bookings were very strong at $51.2 million, up 85% sequentially and 78% from the third quarter a year ago.

The total is driven by technologies buys from major semiconductor customers and a strong quarter from data storage. Semiconductor bookings remain roughly flat with the second quarter at just below $30 million.

In the fourth quarter we expect electronics bookings to decline due to a significant sequentially decrease in the data storage part of the business. We expect that continued technology investments by leading semiconductor customers are likely to keep that portion of the business flat to slightly down from the third quarter.

In summary, total bookings are at record levels for the company and life sciences for in the third quarter. We see this as a significant achievement. The fourth quarter total is likely down primarily due to a weaker electronics segment and the effects of exchange rate that Ray described earlier.

As we look at 2009, we along with many others expect the year to start with a restrained semiconductor capital spending environment. We believe our strategy of focusing on the lab and its strong technology content give us an advantage over other companies driven equipment company as the demand for our tools grows in lien has continued to shrink.

We also expect to expand our markets with our (inaudible) which continues to get positive customer reviews. We maintain our thesis that FEI will outperform the industry in electronics. The first half outlooks for research, life sciences and serves segments of our business which together make up over two thirds of our revenue is more robust.

Our pipeline continues to grow. Our research and life sciences businesses which are dominated by government and intrusions around the global tend to be cash based and have long buying cycles. Therefore we believe they are less likely to be affected by budget and credit constraints in the near term. In addition we believe our new products can expand FEI’s share of the largest life sciences equipment market.

We believe many countries are likely to continue their investments in FEI products, a clear benefit of our geographic diversity. I would also like to add a comment on our competitive environment and it is again related to foreign exchange markets.

In the last three months the Japanese yen had has appreciated by over 25% compared with the euro and over 10% compared with the dollar. That change will substantially improve FEI’s cost position relative to our Japanese competitors, both inside and outside of Japan.

So regardless of the uncertain environment we believe FEI will continue to prosper. We have technology leadership and will continue to aggressively press our advantage. Our product lines are stronger than ever and we are winning the vast majority of major orders around the globe. Our research and industry, life sciences and service business remain strong.

We have a clear strategy to outgrow the broader semiconductor capitol equipment market and will benefit from continued near term technology investment, the operating supply chain and manufacturing improvements for our restructuring program to lower our cost and create a natural currency hedge. For now the currency head winds that we have been facing for the last three years has turned into a tail wind enhancing the prospects for improved gross margins, operating margins and EPS. We remain excited about the long term outlook for FEI and are confident that we can do well in a difficult environment.

With that operator, we are ready for questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Satya Kumar from Credit Suisse. Please go ahead.

Satya Kumar – Credit Suisse

Third quarter order guidance, $175 million that is pretty strong, but can you just talk a little bit about your currency showing impacting the revenue guidance, but can you just talk a little bit about why your revenue guidance is significantly lower than your order guidance?

Ray Link

A couple quick points on that, our bookings of $175.3 million is an all-time record. A portion of that relates to the KAUST order which Don mentioned is in excess of EUR20 million. That order will not ship until 2009; it will be spread over several quarters in the first half of 2009, potentially even go into the third quarter.

So that portion all gets deferred to 2009. So when you take that order out, our guidance was pretty much where we thought we would be basely in the 150 plus million range and that’s generally what we have been shipping and if you take our revenue guidance of 141 to 148 bring that to the same currency (inaudible) but it does have a pretty big impact because of their main change. We said that we would have about $7 million higher, but before the decline in currency. So that would put us right in line with a low $150 million or so revenue bookings. So our book to bill will be about one to one.

Satya Kumar – Credit Suisse

And then one quick question on your service books. Typically your service bookings for third quarter are flat quarter over quarter, but this time they are down about 11%. Can you just comment on that?

Don Kania

Sure, this is Don. If you really look back to Q2, we had slightly stronger bookings in that quarter. So if you look at Q2 and Q3 we are comfortable with the flow. So I think we just pulled some stuff into the second quarter. I asked quite specifically if there is any kind of trend here and they’ve response is no, so I think we are okay.

Satya Kumar – Credit Suisse

Thank you.

Operator

Thank you. Our next question comes from the line of JoAnne Feeney with FTN. Please ahead.

JoAnne Feeney – FTN

Couple of questions; First of all Ray, could you clarify perhaps the amount of your fourth quarter EPS guidance that’s due to anticipated losses for hedging?

Ray Link

Our hedging program is designed to protect our margin from huge swings and we are generally looking at a margin difference whether it is a gain or loss from quarter to quarter and the 1% to 2% range, so its not real significant in terms of total dollars impact, but we will have a bit of an impact from hedging losses, but the flip side is we will get significant gains and real cost and our cost will be lower. As you probably know a significant portion of our manufacturing is actually done in Europe and we do have a fairly significant portion of our sales that are dollar based. So we have dollar base revenue, euro base COGS. We’ve already booked the order in dollars and the COGS will go down in dollar terms because they are paid for in euros.

JoAnne Feeney – FTN

So we have then two effects. It sounds like mix is going improve with the electronics side plus the tail wins on the gross margin from the cogs reduction helping out in the fourth quarter, is that right?

Don Kania

Partly. I don’t think we are really expecting a mix improvement. We would expect our electronics revenue as a percent of total would be no greater and perhaps less in Q4 than it was in Q3.

JoAnne Feeney – FTN

So the strength that you’re seeing in semi conductor orders this quarter; are those expected to shift in the fourth quarter or does some of that spill over into Q1?

Don Kania

It’s a mixed bag. Some spills over into Q1.

JoAnne Feeney – FTN

And if I could, you referenced in the press release a comprehensive support package. Could you explain what that is? Does it generate ongoing revenues and is it in the bookings number or is that something that is coming later?

Don Kania

It’s included, but we didn't give the specific number of the highlight that we said greater than EUR 20 million, but it is included in the initial package. It includes applications and service for onsite specific number of people and we think that’s the right thing for two reasons; one it certainly insures the success of our product in putting it into place and it’s done at what we think are favorable margins.

JoAnne Feeney – FTN

So will that end up in the service line then going forward?

Don Kania

Correct. That would end up in the service line.

JoAnne Feeney – FTN

And if I could just one last question on your sort of fundamental business. You had been talking about gaining share in Asia and about your pipeline and that comment you made at the end about gaining traction relative to your Japanese competitors, because of the exchange and I’m wondering if you have seen further share gains there or anticipate them this quarter or in the first half of 2009.

Don Kania

There’s two comments along that line. One, it’s a little bit early to see those affects because they’ve only just now really become apparent to everyone, but we have highlighted that internally that it’s a good opportunity for us to punish our competitors with the advantages that the currency markets are finally giving us and number two is that we expect that we also have the opportunity to be more aggressive in Japan as a result of again the currency changes.

As you may remember we signed up Shimanju as a distributor a few months ago for our low end product and I will mention here that we will be highlighting very soon. Well we have a major order at a Japanese research institute in material science of the high end product. So, we feel it’s important to attack our competition on their home turf and this is a great opportunity for us to do that.

JoAnne Feeney – FTN

Okay. That is all for me. Thanks.

Operator

And our next question comes from Steven O'Rourke with Deutsche bank. Please go ahead.

Steve O'Rourke – Deutsche Bank

Thank you, good afternoon. First, how big was the data storage portion of the electronics bookings this past quarter and can you be a bit more specific about what drove it?

Don Kania

The data store is about half of the total bookings in the quarter; primarily technology driven. There was a little bit of capacity under it in filling in some spaces on some of our other products, but primarily technology.

Steve O'Rourke – Deutsche Bank

Okay and last quarter on the call, I think you talked a bit about optimism you saw in emerging market places like Russia, China, India and it contrasted with the pessimism which seems to be pervasive here, financially driven of course. With the events of the past six weeks or so have you seen any change in that?

Don Kania

I think the best way to think about FEI in that context is the semi connector business, the electronics business as we describe it has its dynamic and that’s driven by the cycle of that business at this point in time, which is further dampened by those macro economic effects going on.

If we look at our research, biology and service business, they seem to be less sensitive at this point in time. I’ve checked with the sales force, we have scrubbed the pipeline pretty hard and we believe that’s due to the view in the emerging world which is part of our diversity, but this is infrastructure development which leads to education, job growth and development of industry and that applies pretty universally. Again more cash based and very it will credit, practically no credit involved, so we don't seem to see that effect as well. It gives us a belief that we will continue have robust business in that 2/3 of our business and we’ve been pretty clear about the semiconductor side of the business.

Steve O'Rourke – Deutsche Bank

Fair enough. Thank you.

Operator

Thank you and our next question comes from the line of John Harmon with Needham & Co. Please go ahead.

John Harmon – Needham & Co.

A couple of questions for you; back to the data storage orders, what do you think the delta would be between Q3 and Q4 and is this business generally lumpy like this or why was there such surge in orders?

Don Kania

I’ve been around this business for a lot of years and it is extremely lumpy and opportunistic in nature. This is a relatively small number of customers spending compared to semi conductor a relatively limited amount of capital dollars. This is not unusual for us to see a significant investment and then a very small investment for another quarter or two and then another significant investment, the nature of the beast.

We are hardened that our customers saw us as another technology buy and they invested in the quarter. We expect it to fall significantly in the next quarter, but that’s just not unusual, that’s part of the game.

John Harmon – Needham & Co.

Thanks and how did your manufacturing transfer from Europe to other places and did you see any benefits in Q3?

Don Kania

In terms of manufacturing movements, we are early for that. I think the benefit we’ve seen to date in terms of what we call our restructuring program has been on the head count side. If you note our head counts come down from last quarter. Those effects and we have told the world you really won't see those until the late latter part of 2009, because it takes a fair amount of time and effort to make that happen.

John Harmon – Needham & Co.

Thank you.

Operator

Thank you and our next question comes from the line of Benjamin Pappas with D.A. Davidson; please go ahead.

Benjamin Pappas – D.A. Davidson

Hi guys, nice quarter; thanks for taking my call. Just real quick, I wanted to ask you about the month of October if you would like to talk about it at all. Have you seen any substantial changes from the end of the quarter to date in the end market behavior? If you could talk about that at all that would be great and also an update on fee nom if possible. I haven’t heard anything about that in a while.

Don Kania

We did just recently complete a business review and I think every CEO and management team in the world is grilling their sales force about what do they see and what are the initial trends. So, that was part of the information we used to build our guidance up with. We are using the most recent information that we can garner to give you that guidance.

On the fee nom front we don't give specifics, so we’ve been making good progress there; we’re in that distribution building mode for that product and that is pretty much all we’re going to say until it becomes a more substantial part of FEI’s business.

Benjamin Pappas – D.A. Davidson

Okay. Thanks.

Operator

Thank you. (Operator instructions) Our next question comes from the line of Nik Tishchenko with Soleil Securities. Please go ahead.