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FEI Company (NASDAQ:FEIC)

The 31st Annual J.P. Morgan Healthcare Conference Call

January 9, 2013 7:30 PM ET

Executives

Don Kania – President and CEO

Analysts

Evan Lotus – JP Morgan

Evan Lotus – JP Morgan

Good afternoon. My name is Evan Lotus I work under the Life Science Tools and Diagnostics Team here at JP Morgan. Very excited to have Don Kania, who is President and CEO of FEI Company who’ll tell us a little bit about the company. The breakout will be afterwards in the Georgian Room, thank you.

Don Kania

Thanks Evan. Thank you very much and thanks for coming to listen to the story today. It’s actually very pleasure to be here, it’s our second year at the conference, let’s see if I can get the buttons right. Usual Safe Harbor stuff applies, so please pay attention. I’m going to give no new guidance or anything like that. And really highlight the strategy of the company, and the success that we’ve had to date.

So what investment thesis, this is an investment conference, why would you investment in FEI. We are a company that’s focused on technology leadership and workflow leadership as giving solutions to our customers, that’s led to market share leadership. It’s a growth opportunity as I hope to highlight to you we have a strategy to grow our served available market significantly and that doesn’t require a global economic growth, it requires that FEI produced better products in some of new competitors that way we would be coming up against. And we have tremendous geographic diversity which in particularly in the emerging economies which helps us also be quite robust in any kind of economic climate.

Our margins have been expanding I will show you some numbers on that over the past few years and we continue to have plans to continue to expand those margins both gross and operating margins. And we’ve generated a lot of cash and I think we’ve been more and more effective at deploying that cash, we’re doing some M&A, we’ve got our dividend in place, we’ve also done some opportunistic share buybacks.

So what do we do, we make as far as this audience is concerned ridiculously complicated microscopes that in their most sophisticated in body can see a single atom. But what you can do if technology like that is you can image things that are biologically relevant in three dimensions at the nanometer scale, you can image materials you can image transistors, you can tell people that are trying to produce new stills how to do it better and that’s really what it’s all about. So, we make something called the transmission electron microscope that’s the thing they can see single atoms. We make a tool called scanning electron microscope which looks at services at a very, very high resolution,

And we also make on the right you see something called a DualBeam or Helios, we additional capability that’s effectively on nano-scale machine tool, which can remove our add material so if you want to look under a service you can drill a hole and look inside that service to see what’s going on beneath the surface. And if you repeat that process remove material or look remove material, you can actually do a three dimensional reconstruction.

So, a big thread that we see overtime is more three dimensional information for customers or also capable given the fact that we use a electron sight the material, we can also do material discrimination, atomic discrimination by x-rays that they can get. So, we can tell you where the items are and what kind they are that’s what we do for a living.

Technology leadership and workflows we not only focus on the microscopy capabilities we also focus on what our customers need. Often times samples have to be prepared in special ways in life science for example typically there are cryogenic samples, there are living samples that are frozen that go into a microscope, they’re measured and then typically quite a large data sets are generated we provide the software capability to do the atomic sorting, to do the localization, to do the segmentation problems. So, that the customers can get to the information that they need very, very quickly.

So, our goal is to produce all encompassing solutions for the customers not just sell the microscopes. And with that we can preferential margins, we can get preferential position against our competition overall.

Just to capture how the company has been growing over the past few years of bookings perspective, the one on the left goes from 1998 to 2011, we’ve grown from the below $200 million level to approach $800 million level and should on a revenue basis get close than $900 million this year. And if we look on a one year term basis we’ve continued a pretty strong growth trend through the first quarter of ‘09 through the last quarter that we’ve reported. But I think, this is based on our strategy as I hope to elucidate further of let’s go grow our markets, grow our served available markets, find new customers and produce some notions for those customers using our advanced technology that gives some answers that are important to them.

If you look at the segmentation by geography which we think is actually great strength to the company you can see that the rest of the world that Asia is 42% of our business, China is 12% of our business, China is cabin a very, very fast growing region for us overall. USA and Canada about 30% and Europe about 30% of our business overall, that’s Europe plus that does include Middle East as well and parts of South America.

If you look on the right hand side, our segmentation by markets that I will walk through we served the semiconductor business we call that electronics about a third of our business, we serve material science which is about a third of our business that’s mostly researches either in universities or at large companies doing research on fundamental research on material science. Life science is which varies between 10% and 15% of our business and then service which is our version of recurring revenue model it’s highly proprietary service on our tools is about 25% of our business overall.

If you look below you can see in the last quarter they kind of built up the growth that we’ve been seeing year-to-year from Q3 ‘12 that we’ve seen significant growth and that’s the bookings flow from year-to-year. So, we continue to have I think, pretty good traction in kind of medial for global economic climate of being able to continue to grow our business overall.

A big parts of that’s emerging market growth we do have a large global footprint, if we look in regions outside of Asia emerging regions like Eastern Europe, Middle East, Latin America, Africa the company growth rates has been almost 40% overall since 2003. And we look at China the growth rate there is been 22% since 2003 and lately accelerating to 46% since 2009. In the 2006-07 timeframe we started significant investments in China to guard that market, opened up a demonstration center in Shanghai, put a quality management team in place of local management team that understood how to grow the business which I stole from the last company I was at, I did the same thing there, really it’s proven to be quite successful for.

So, brand leadership in China, great recognition and I think tremendous continued opportunity for growth. In the areas that we serve we are less sensitive to the commercial world and more sensitive to the government investment role which absolutely immune from macroeconomic changes. So the Chinese have their five year plans of investments in science and technology, they stick with those five year plans and we are in the second year of their I think, eleventh five year plan right now.

And areas that we serve are fundamentally identified in those plans overall. So our strategy around that is how do we grow our served available market, we think the core marketplace grows about 7% per year. Our goal is to grow FEI to at least 12% per year, we don’t think market margins we think overall there is some opportunity there.

Generally it’s how do we go out and find new customers how do we create new markets for our great technology. And that’s to provide solutions for customers, I’m going to walk through some opportunities that we see. And in 2011, we set out a target for ourselves to double, our served available market from $2 billion to $4 billion by 2015 and I’m happy to report we’re on track to do that. I’ll highlight some of those things we’ve done. And I’ll especially those things we done in the LifeSciences off late.

But I want to clear, when you grow the served market, those new pieces that we enter, we’ll enter with zero market share. So this does not represent necessarily the growth rate for FEI which we’ve targeted at 12, we’re going to be growing the served available market at higher rate than that around 20%. So, that’s fine, we’ll have new competitors, we’ll have new opportunities, we entered with zero market share. But we’re confident that we know how to go win with taking great technology to two markets and you’ll see some examples of that in the next few slides.

So, let’s start with LifeSciences business, what we do is we have two segments here that we’ve been focusing on, so relatively new business for FEI, one is structural biology. So, what we can do with this powerful imaging capability is we can do effectively what the physicians do for you and your going to the hospital and get a CT scan, we can do CT at the nano scale. So, we can take interesting macro molecular structures, proteins, trans-membrane proteins, viruses and even three dimensions at nano meter and sub nano meter resolution.

And as many of you have certainly appreciate here, the shape and structure of macromolecular complexes is important to how they function, how they work, how disease works. And so, our goal has been to take that technology which has been adopted relatively successfully by people that use electron microscopy.

And now take it to the world where people use other technologies such as X-ray defraction or NMR to image molecules of interest to life. And we’ve partnered with NIH, where they have experts in all three disciplines, what we do – electron microscopy, NMR and XRD to show how those technologies can either work together to produce more information about the machinery of life, or how electron microscopy alone can identify certain classes of molecules that you just can’t image any other way.

And we’re seeing in the range of greater than say 100,000 150,000 kilo atoms that in fact we can provide very powerful imaging capability, a very exciting biologically relevant things. The way this market will progress, our prediction is, we get people like the NIH to publish, publish papers, papers bring attention to the technologies, capability, establishes that it is real and we’ll see the follow-on activity from penetration into customers that normally would evaluate their next major purchase in another technology like X DMR, and look at say, gee, really maybe I should get an electron microscope this time instead because I can look at these other things that I can’t image with these other technologies.

And I won’t go into all the details but there are some clear differentiations between the limitations of those other technologies and what we can do. But essentially we have arbitrary imaging capability because we are in direct imaging instrumentation we’re not an instrument that infers a structure from other types of information.

Part two of this is cellular biology which is very, very new for us, we launched some products into this area, only in December at the American Society of biology show here in San Francisco. And what we’re doing here is bringing optical microscopy, high performance optical along with electron together. And combining those into a common work flow, where you can get the context for information that you get from the localization that you get from super resolution optical microscopy using fluorescent tags.

So you bring those together, so it’s Google Earth in some way where you know that the fluorescent thing moved to a certain place had some dynamics associated with it, which is interesting to the researcher. Now we can provide in a seamless way the total context is inside of membrane, next to a membrane, with a high resolution that you can get from electron microscopy, I’ll go into that a little bit more.

You see, we’ve been growing about 15% clip in this business. Since the ASPs are kind of high, it is kind of a granular business, it does have some quarter to quarter variations. And in the served market we think we can grow substantially at a very high rate, you can see in the lower right there at 41%.

So, why do science my correlated microscopy, it really is that ability to take large and small scale data and localization data and imaging data together and put it all into one place. So the fluorescent tells you where the action is and we tell you what is underneath that, what is the structures that are actively participating in the process, bringing those two together overall. So you can do lifestyle imaging, you can do a variety of high performance optical imaging technologies and put that together in a seamless way with high resolution sub nanometer resolution from electron microscopes.

And we really kind of talk about the two pieces here, light microscopy gives you dynamics, you can do fluorescent labeling, but in terms of true imaging the resolution is limited. In terms of localization, it’s really quite powerful, that as you can say something is at a location which you’re actually not imaging what’s going on. And that’s what we do is then now reintroduce the ability at the nanometer scale to also image while you localize the active regions. So that becomes, we believe quite a powerful new opportunity for LifeSciences researchers to carry their work horse of light microscopy into the nano realm with context as well as the chemistry that’s going on.

So, we introduced a product that combines both directly together. So, we take one of our high resolution imaging microscopes called the transmission electron microscope called the tech nine, and we stuck the con focal microscope, optical microscope right on the same platform. So you can nearly simultaneously do both fluorescent, con focal imaging or electron microscopy imaging at extremely high resolution, all the software, all the ease of use that goes with it.

So, on the right, you can see kind of a cartoon, essentially a real image of overlay of the images, the optical is telling you where a certain chemical activity is taking place, that’s the green regions. And you see that in a cellular context. You can zoom in further as you see in the little balloon, it’s attached to that. Now you’re getting down to the – I think that’s around the 10 nanometer scale of what substructure within the cells the actual fluorescent activity is taking part in.

And so, no one knows the context of the chemistry that you tag with the fluorescence. Another alternative approach that we’ve also introduced is to bring in a workflow, lot of people already own optical microscopes, have a variety of techniques that they prefer to use, we are also offering our own, where you can in a seamless way using a workflow and software that we provide go from a high performance optical microscope to any of our electron microscope based tools, so whether it’s one of those scanning tools or transmission tools or one of those machine tools if you want to do a 3-D structure, that you can do that in a way where you can maintain an understanding of the physical relationship, spatial relationship of the fluorescence images and the electron images.

Turns out it’s not a trivial thing to do at the nanometer scale, we’ve produced that and we have that available for customers. We see that overall when you look at that marketplace of high performance optical microscopy, it’s like $400 million a year, we’re newcomers to this space but we think we can garner a meaningful share of that over the next few years, it’s all – again said, let’s go grab some new markets, let’s go compete with optical microscope providers like Zeiss, Olympus and Nikon and show that electrons together with that really provide more value FEI has got all the technology that it needs to do that, part of the growth for us overall.

We’re going to switch gears now to one of our other businesses, which is material science. It’s been actually a really good growing business for us, this is college professors around the globe, researchers that are at companies like Dow chemical or major steel companies, it’s really any material, I mean it’s from potato chips and cosmetics to quantum dots and graphing, it’s a very broad world for us, but it’s the work horse tool in the material science space. You want to know where the atoms are, and you know which atoms are which, and that’s what we do for this class of customers.

The US has been a relatively muted market for us in this space, that’s been pretty slow over the past couple of years, what’s interesting to note if you combine life science and material science together and we look at the customer base of the country yields, China has been the number one purchaser, seven out of the eight last quarter, exceeding the United States, the US comes in second, Germany comes in third and France is also in the top five, which is interesting, people are worried about year up, we’ve seen that.

France, Germany and the Nordics have been quite strong in terms of continuing investments both France and Germany have long term investment strategies and university infrastructure. And Eastern Europe, particularly Poland, Romania, Czech Republic and some even the Baltic states have also been investing in infrastructure because they’re getting closer to the EU and they want to compete and they want to compete for scientific money that flow from the EU, they want to educate the work force that’s competitive on a global scale. So, we’ve seen significant ongoing investments there overall.

We opened an office in Brazil, we opened an office in Dubai, the Middle East has been a good investor in this area, and South America, particularly Brazil has just – we think that’s one of the next countries. Interesting frontiers coming to us in this space, we can tell which atoms are which, we can tell one atom is, the next is adding time resolution to the system, we can look at dynamics and that’s kind of the next frontier for us here. We think our newer products have the capability to get time resolution at a variety of interesting scales to people that similar to what the life science world once in terms of dynamic microscopy.

So, overall we see this as a great business, we’ve been growing at about 10% compound annual growth rate, overall we look out the next few years, we’ll probably go at high single digits. The globe is a wonderful place for this business overall. We have a natural resources business, which reports into and this is another one of our new segments, this didn’t exist a few years ago at FEI, what we did was try to identify some opportunities where we could specifically take our technology to a market place where we could talk to customers about return on investment.

And so what we developed via acquisition and internal development is the capability to do what’s called automated mineralogy. You put rock in the distribution of the minerals, it’s a 3D tool, you can understand whether you are drilling for oil, what the porosity and permeability of the rock might be, that is the ability for the store oil and have that oil move out whether it has clays, whether that is swelling or not swelling clays.

You can imagine if you’re drilling oil and you really want to know if you are drilling through a clay that when it wet, it’s going to pinch or it’s going to stay in place and turns out. These are multimillion dollar decisions and the information that we can give to the people either exploring for oil, drilling for oil or maximizing the yield of oil, it can be quite important.

Similar things are done today manually, it’s a billion dollar marketplace, people spend a billion dollars measuring the rocks at oil wells. So, we’ve produced an automated system that works at the well site for embedded test around the globe. We think we have an opportunity here to raise the technical level of the measurements as well as make it more automated then it exist today overall.

Another piece of the about the share, it’s just kind of exciting right this the whole share business. This is the wild west of technology when it comes to oil and gas we’ve every major oil company in the world acquire our instruments to try to understand the physics of the rocks. How you can fracture them, again how much oil could you store in it, it can be oil or gas move around porosity and permeability and fracturability, people want to measure those systems, we can give that to them in an automated way, we can do it in the lab, we can do it at the site.

So small business for us right now but it’s been growing at a 50% annual growth rate, it’s our highest gross margin business as a standalone business, it’s software dominated the value comes from our interpretation of the data, not the production of the data overall. But it’s an example of how FEI has taken its core technology putting in new business in growing that business up overall.

Electronics and semiconductor every major semiconductor manufacture in the world is a significant customer of FEI. We don’t have a lot of customer concentration as a company, our top customer a year 6% that will probably either Intel or Samsung. These are used to develop process, control processes as one ramps production in a factory, we are not capacity related we are more technology related.

I know, many investors in this world get a little concerned about the cyclicality of the business, we characterize ourselves as cyclical growth in this area. There is a little chart there on the right but take away message if we look cycle-to-cycle in semiconductor, FEI’s business grew 36%. The capital spending in the industry was flat. So, we’ve been able to introduce our technology, get adoption to get people to see the value and they’re seeing as transistor elements gets smaller and that’s more as law that there is a greater and greater need for what FEI provides, where are the items, what kind of items are they and do look make my transistors work or not.

It’s a great business, we love the business, it’s about our third and we are happy with it about a third of it, yeah.

So some financial stuff if we look retrospectively, part of the FEI teams ability to really grow this business we were growing about 11% in the revenue but more importantly I think, get a lot of leverage on the profitability of the company moving gross margins on 6, 7 points over that from 2008 to 2011 that’s a compound growth rates over that period. We kept R&D high we like that 10%, 11% is right for us, operating incomes growing at a 60% clip as a result and accelerate the margins, you get operating income to move the diluted EPS is growing significantly and we’ve been good with the cash flows. So, I think, financially we’ve made a better company while we’ve penetrated these new markets, made these investments in the future overall.

We’ve done acquisitions with the use of cash, small tuck ins, TILL Photonics when we realized we wanted to have an optical correlated solution FEI realized it needed its own so we went out and we bought a small $10 million revenue high performance optical company located in (inaudible) called TILL Photonics, within less than a year we produced that correlated product with them. So, that’s TILL Technology on the upper side, electronic technologies and we stuck it together and the guys did a great job, within less than a year.

New product, new market, all new stuff for us, we bought aspects in the first in January of 2012, they make raged industrial sense, they were our partner for that oil and gas business that I talked about, we take electron microscopes and we put them in popular in the middle of nowhere and they have to work and they have to work without a lot of touch. Because it’s hard to get a service guy to popular in short notice.

They were our partner, that’s what their expertise, they decided to sell the company, we bought the company. They’ve introduced the whole new product express in the meantime which is we’ve been tearing, we’ve been segmenting their marketplace to high performance, mid performance, got a whole new platform there less than a year.

AP Tech is our create agent, Samsung is a big customer, you got to be a close to your big customers, so we decided to buy our agent and the service business that went with it. If you listen to be a little bit restore here 3D a lot and real hard worked company, FEI grew up as a hard worked company. Software we can talk to talk mean the software and we realized we needed more expertise in pure software particularly in 3D and 3D visualization in large data sets, we then bought that capability with visual science’s group that was in august we’re still in the integration phase on that but that will touch every market, every product that FEI produces with highly differentiated proprietary algorithms for understanding what the data means, what they value that 3D information that we image and presented to our customers in the value added way.

They’ve been accretive and moving forward to balance sheet, we’ve been good with the cash flow, I think the per share numbers I still look at how we’ve tracked that since 2005 going from $0.25 to almost 2.5 bucks in ‘11. I think, it just speaks of, we’ve done a good job by running the company while we have done all these investments and created more value for the shareholders. We do have a fair amount of cash in the balance sheet, net cash is $7 and shareholder’s equity is about $800 million.

But we do have a distinct strategy for effective use of cash, acquisition was $4 I showed, we paid about $117 million for those I think you can see how they all fit into the story. In addition, we are going to invest this year in the new manufacturing facility. Our largest manufacturing centers in the Czech Republic, that’s a great place for a couple of reasons, one taxes incentives, great work force, it’s the former Soviet Union center for electron microscopy there is tremendous skill set there, we do R&D and the bulk of our manufacturing there.

We grew organically and hap hazard so we have a very inefficient multi building complex right now which we’re going to convert into a single building complex with a $35 million investment. We did launch a dividend this last year $0.08 per quarter, our thoughts over time to accelerate that, we have done opportunistic repurchases a couple of millions shares at the about $30 a share, we’re trading $55, $57 right now, so rate might see if all looks like a genius in that process, but we are emphasize, we are opportunistic in that, we’re not trying to reduce solution, it’s when we have – we’re clearly undervalued relative to what we see we’re going to buy back shares, but the dividend will rank above that overall.

We have a convertible debt that converse this year but it’s already in the share count, converts at 29, given where we’re trading right now, but I’ll just go forward. The business model as we look forward, I think you can see the third quarter results but in mid 2015, we’ve targeted moving gross profit margins from around 47 which we’ve reported in the last quarter to 50%, another three point move.

Keep SG&A a little bit better but really we want to continue investing our channel globally I think that’s really important. We will keep R&D to relatively the levels 10% and 11% and then operating income we should move from around 17 more until the low 20s our target overall.

With that just remind you the investment thesis at FEI, we are technology leadership we focus on work flows, we focused on finding new customers and providing them real answers using our great technology, the diversified geographies really helped us getting and we don’t worry about the USA in our fund, that’s okay, it’s China there is Poland, there is other places in the world that are doing well and investing in FEI products. And we’ve generated a lot of cash and we are using that cash to help continue to grow the company investing in acquisitions, we are turning some of the shareholders either via buybacks or the dividend.

With that I think I will stop. Thank you all very much for your attention, I appreciate it very much.

Question-and-Answer Session

[No Q&A session for this event]

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