II-VI F2Q08 (Qtr End 12/31/08) Earnings Call Transcript

Jan.21.09 | About: II-VI Incorporated (IIVI)

II-VI, Inc. (NASDAQ:IIVI)

F2Q08 (Qtr End 12/31/08) Earnings Call

January 21, 2009 09:00 a.m. ET

Executives

Craig A. Creaturo, Chief Financial Officer and Treasurer

Francis J. Kramer, President and Chief Executive Officer

Analysts

Mark Douglass - Longbow Research

Avinash Kant - D.A. Davidson & Company

Jiwon Lee - Sidoti & Company

Scott Blumenthal - Emerald Advisers

Chris McDonald - Kennedy Capital

Operator

Good morning. My name is Leslie, and I will be your conference operator today. At this time I’d like to welcome everyone to the II-VI Incorporated fiscal year 2009 second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions)

Now I would like to introduce your speaker for today, Chief Financial Officer and Treasurer, Mr. Creaturo. You may begin your conference.

Craig Creaturo

Thank you, Leslie, and good morning everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI Incorporated. Welcome to the second quarter fiscal year 2009 II-VI Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Wednesday, January 21, 2009.

The forward-looking statements we may make during this teleconference speak as of today, and we do not undertake any obligation to update these statements to reflect events or circumstances occurring after today.

Francis Kramer

Thank you, Craig. I'm Francis Kramer, President and CEO of II-VI Incorporated. The just completed second quarter was the most challenging and difficult quarter we have faced in many years. We entered the quarter with $121 million backlog, and we achieved our forecasted bookings in October.

However, the order rate decreased rapidly for the Infrared Optics segment and for the commercial portion of our Near-Infrared Optics segments in the latter half of the quarter in response to the worldwide economic problems.

The change in order rate for these segments was so sudden and of such a magnitude that we issued new guidance on December 2. We feel that today's guidance fairly represents our expectations for fiscal year 2009, as we anticipate considerable business changes as the year progresses. In my comments at the end of the first quarter, I indicated we were keeping a close eye on the bookings in all of our business segments. We did not expect the sudden change we encountered in November. However, we feel we reacted quickly and appropriately. We reduced costs quickly and were able to deliver a quarter with an 11% ROS and a 20% EBITDA margin despite a 15% decrease in sales versus the first quarter.

A strong performing business in the second quarter was our Exotic Electro-Optics business in the Military & Materials business segment. At the same time, within the Military & Materials business segment, our PRM business had results that were approximately 30% short of expectations. At Exotic, bookings and revenues exceeded forecasts. As guided on our October conference call, Exotic continues on a greater than 15% growth trajectory this year. Our sapphire-based products support Lockheed Martin's Advance Targeting Pod, named ATP Sniper, and the Electro-Optical targeting system on the Joint Strike Fighter aircraft.

Both of these programs continue to be prominent in the DOD's plans. In fact, the JSF is expected to be the next premier military fighter aircraft with production extending over many years. Orders for more ATP and JSF products should create strong third-quarter bookings. At PRM, bookings were lower than expected due to a reduction in the market prices for Selenium and Tellurium. Selenium and Tellurium are part of the minor metals market, and historically there has been significant price volatility.

These prices impact both the cost we pay for our raw material and our end-product selling prices. Worldwide slowdown in manufactured goods and the downturn of the Selenium metal market had a significant negative effect on our PRM second-quarter results. Bookings and revenues were lower than expectations due to the lack of demand for Selenium metal in the Chinese market, primarily related to reductions in steel and glass production.

PRM margins were lower than expected due to the lower sales volume and a greater than 35% drop in the market price of Selenium during the quarter. The decreased demand for Selenium was fundamental in this market price decline and required us to write down our selenium inventories to reflect the new market prices. We expect the market prices to stay at current levels through the remainder of fiscal year 2009.

Procurement of tellurium and selenium raw materials was at a level that met our second quarter expectations. However, we expect orders for selenium to be the largest challenge at PRM for the remainder of fiscal year 2009 and for the first half of 2010. Meanwhile, the overall demand for tellurium is expected to decrease slightly through the next 12 months as consumer goods manufacturing declines.

The supply of tellurium has historically been tight. The tellurium market price is expected to be volatile, fluctuating as much as plus or minus 15% for the next six months. Tellurium demand for the photovoltaic markets that we serve is stable to growing. Additionally, we maintained low inventories of tellurium products and we feel we can manage the price variation risk. During the quarter, our VLOC near-infrared optics business continued to expand its non-UV filter military opportunities.

Year-over-year increases in non-UV filter military realated bookings and revenues were 67% and 40% respectively. This help to offset the decline in the commercial side of the business caused by economic conditions. It is anticipated that the non-UV military sergment of VLOC will remain strong for the remainder of the year with orders nearly doubling for the full year 2009.

Driving this growth is enhanced competencies in optical crystal component fabrication coding metrology and assemblies. These competencies include CNC controlled polishing, diamond turning and (inaudible) sputtered coatings. During the quarter, this resulted in key orders (inaudible) for crystal and optical sub assemblies for startegic ground base laser designator systems, range finder programs, target acquisition and long-range surveillance systems.

Near-Infrared Optics business continued to meet or exceed the required schedule for deliveries of UV filter assemblies to our primary customer. However, as we have been reporting, we have had a reduction in delivery rates for this product line. We will continue to adjust our production capacity as orders dictate, and we will continue to take appropriate cost-cutting measures.

During the quarter, the decline in the commercial business caused by economic conditions resulted in our fiscal year to date commercial bookings being down 25% and revenues were down over 10%. We project that at least this 25% reduction in commercial business at VLOC will carry through the rest of the fiscal year. Cost-cutting activities have been taken in our Near-Infrared Optics Asia and Florida operations in response to this downturn.

In fiscal year 2008, the Near-Infrared Optics segment had non-UV business that was two-thirds commercial and one-third defense and military. We now project that the commercial portion will decline to near 40% with the balance being in defense and military on the same dollar value of business. Most of the additional Near-Infrared Optics military work is in complex assemblies.

In the Wide Bandgap Materials business of the Compound Semiconductor Group, silicon carbide wafer orders and shipments were up significantly and met expectations for the quarter. The growth was due primarily to increased orders and shipments to Japanese OEM and US DoD customers.

The demand for 100 millimeter wafers increased markedly in the second quarter with shipments made to both Japanese and US OEMs and US DoD customers. We've already begun to receive repeat orders and expect the volume of 100 millimeter substrates to continue to grow.

Our manufacturing yield of 100 millimeter wafers continues to improve and is approaching the yield of smaller diameter substrates. In order to make the capacity to address the projected demand for 100 millimeter wafers, we continue to accelerate the conversion of existing growth stations to a new design capable of larger diameter and substantially increased output.

During this past quarter, we continued to make progress on the milestones and deliverables of our two DoD technology and manufacturing development contracts. The development activity in our 4H conducting substrate program has led to significantly reduced crystal defect densities, improved mechanical properties related to wafer flatness, and substantially increased process yields.

As a result, we have begun shipping three-inch diameter prime quality 4H n-type wafers to several commercial power customers, both in the US and Japan. In addition, feedback from customers on our newly released 100 millimeter 6H semi-insulating substrates continues to be favorable and development of our new 100 millimeter 4H n-type substrates remains on schedule for commercial release in the third quarter of fiscal year 2009.

Marlow Industries, in the Compound Semiconductor Group, revenues bookings and earnings in the second quarter were down sequentially. The bookings decline was due primarily to a delay in a major retail customer's anticipated follow-on order, a softening of the demand from our telecom customers, and a delay of one quarter in the anticipated startup of our new automotive business. The decline in the revenues was due to continued softness in demand from telecom customers and a push out in demand from some medical diagnostic customers not due to end-market demands, but rather due to supply chain issues at the customers' factories.

Demand in revenues from our defense and space market customers continues to increase. We are projecting the defense business to continue to grow for the remainder of the year, and we expect it will offset the slowdown in the telecom sector. The outlook from medical diagnostic customers has been positive and in line and stable with prior projections. While we expect that Marlow's market diversity will help to minimize the impact of the economic downturn on the overall business, we have, however, taken steps to accelerate cost reductions in response to decreases in the telecom and industrial markets. We are continuing to identify and develop a significant number of new opportunities.

We completed the relocation of our European office from the UK to Germany and expect to see an expansion in market share in Europe to have a positive impact on the second half of fiscal year 2009. We are taking steps to leverage the economic downturn to increase our market share worldwide in the thermoelectric market and we continue to view our Vietnam manufacturing operation as being strategic to that end.

We are continuing the process to sell the eV PRODUCTS x-ray and gamma-ray detection business with sales being led by Roth Capital Partners. Because of the sensitivity of the process, we're not able to articulate further details. EV PRODUCTS did receive a government contract during the second quarter in the amount of $1.5 million from the Defense Threat Reduction Agency. This first-tier award is part of a potential multi-year contract. The main goal is to develop a capability to detect special nuclear materials using the CZT-based detectors.

The final business to discuss is the Infrared Optics segment, where bookings decreased 15% in the second quarter versus the first quarter. This decrease happened in the last two months of the quarter as OEMs adjusted their production, consumed inventory and pushed out orders.

Bookings from high-powered OEMs in Japan and Europe declined 20% for the second quarter of fiscal year 2009 versus the second quarter of 2008. Our low-power OEMs have reduced orders a greater percentage as the laser marketing and engraving markets serving consumer products have stalled. The rate of order cancellation remained unchanged at its historically very low level.

The bellwether US aftermarket is doing relatively better than our OEM business. Orders decreased 7% versus the second quarter over last year and are down 2% year-to-date. In the zinc selenide and zinc sulfide materials sales business, sustained yield improvement and capacity expansion initiatives have allowed us to reduce our costs and to capture market share in the growing military and security markets.

In our outlook for the Infrared Optics business, we see that low-power OEMs that address marking, medical and via hole drilling have experienced declines of up to 50% in new machine production rates, which will remain this slow for at least the next six to 12 months. Sales of high-powered carbon dioxide lasers declined more than 30% in the second quarter and this lower demand is expected to persist for at least the next year.

The military and security markets continued strong. We will grow our business in these areas more than 25% and 100%, respectively, this fiscal year and expect that this will partially offset the declining demand resulting from the lower volume of new low and high-power laser machines.

Therefore, our outlook is determined by the carbon dioxide laser optic sales to the aftermarket. That demand is determined by utilization rates of the more than 50,000 high-power lasers deployed around the world doing work. 25% to 35% of our aftermarket sales come direct from the end user. The other 65% to 75% comes through the OEMs.

The difference in the rate of order decline from OEMs versus directly from end customers is strong, suggesting that OEMs are reducing their spare parts inventory. We expect a slight improvement in the OEM spare parts order rates to achieve the guidance we have given. There has been a drastic change in consumption of consumers and this will take considerable time to return laser material processing to its prior levels.

We believe that during the last 60 to 90 days, there has been a slight overreaction in reducing optics orders as OEMs work to rationalize the downturn they faced in their businesses. We are prepared to address this opportunity. Craig, that concludes my comments.

Craig Creaturo

Thank you, Fran. Here are the items I would like to highlight before we move into the question-and-answer portion of the call. As described by reportable segment in the press release, bookings from continuing operations for the quarter were $67.3 million. This decrease, when compared to both the prior quarter and the quarter ended September 30, 2007, was driven by the softness in non-military markets that we serve, which Fran described in his prepared comments.

This level of bookings combined with the revenues generated for the quarter produced the overall backlog from continuing operation at December 31, 2008 to $114 million, which was approximately the same backlog of the company as of March 31, 2008. The components of the December 31, 2008 backlogs from continuing operations were infrared optics at $35 million, near-infrared optics at $19.5 million, military & materials at $41 million, and compound semiconductor group at $18.5 million.

The company experienced foreign currency losses during adjustment for the quarter. These losses were driven by the three factors that were described in the press release, and these factors were as follows. First, the movement of US dollar denominated funds out of Asian countries and into European countries was done to maximize cash and tax planning alternatives. We used US dollar funds between the US dollar bank accounts, so we did not have any realized losses of funds.

However, the timing of when these funds were moved in December and the changes in the exchange rates between the US dollar and the euro for the remainder of that month, combined with our movement of these funds to a subsidiary where the functional currency is not the US dollar, caused the need to recognize approximately $900,000 of losses during the quarter. Again, I want to emphasize that even though we recognized the loss for financial statement purposes, the cash that we used stayed in US funds and we did not have a loss of cash.

Second, the company is consistently long and in the end -- with a long end position due to its significant presence in Japan and sales in that country that are denominated in yen, combined with a lack of significant yen-denominated expenses. Because of this situation, the company enters into foreign exchange contracts to sell this yen position between the points of time that we received an order from the customer and when we collect payment from the customer.

During the just completed quarter, the 14% strengthening of the yen against the US dollar generated realized losses when these contracts were settled. These losses totaled approximately $600,000. These four contracts are non-speculative in nature. While a strong yen had a short-term negative impact on our operations for the quarter, when you take a longer-term view, a strong yen is slightly helpful to the company because of the significant sales we have into Japan.

Third, the various US dollar denominated obligations and receivables of our foreign sales and marketing subsidiaries are remeasured each period, and, based on the applicable balances and exchange rates, new measurement gains and losses are recorded even though they are unrealized. During the quarter, based on exchange rate movements, especially those of the Yen, British Pound and Swiss Frank, more than $1 million of foreign currency losses were recorded.

The area of foreign currency exchange rate was not the only area of volatility we experienced during the quarter. Some of the critical raw materials that we have utilized have seen recent reductions in pricing, specifically for II-VI and our PRM business and in the Philippines, the market pricing for selenium dropped $220 per pound by December 31, 2008 from just over $30 per pound at September 30, 2008. Because of this price decline, PRM wrote down their inventory of selenium, one of the two materials that they refine themselves.

The impact of the inventory write-down during the quarter was approximately $700,000 and impacted both the gross and operating margin performance of this business, which is part of the Military & Materials segment. The updated guidance contained in today's press release gives our current view of the expected financial performance for the quarter ending March 31, 2009 and the fiscal year ending June 30, 2009.

In general terms, it is comparable with the guidance we had from the December 2, 2008 release with the full fiscal year guidance being a little less optimistic on the upside potential of revenues and EPS than the prior guidance. With our backlog decreasing, our visibility into the future is not as clear as usual. Historically, we had released our first guidance for the subsequent fiscal year as part of the April earnings release. It is unlikely this year that we will be able to do so.

The press release noted that we have taken several actions to reduce our operating costs. These have included layoffs at our domestic and foreign locations since November. These manpower actions along with adjustments in levels of overtime are expected to lower our annual operating expenses in excess of $5 million. We have also made significant changes to our planned capital spending. Our quarterly run rate for capital spending for the last six quarters has been $4.5 million, which is similar to the run rate we had and adjusting for the quarter.

We will be completing open capital projects that were started in the first half of fiscal year 2009 and expect our capital spending to start to ramp down in the fourth quarter of fiscal 2009 and into fiscal year 2010. Our early look at fiscal year 2010 planned capital spending looks like it will range from $10 million to $12 million. Despite the recent macro challenges to our business, our cash balance remain strong at over $68 million as of December 31, 2008.

We ended the just completed quarter with $5 million drawn on our line of credit facility, which was a direct result of completing our most recent stock repurchase program that was completed back in November 2008. The interest rate on this debt at December 31, 2008 was LIBOR based and was less than 1%. The balance of our credit facility can be used for acquisitions or other permitted purposes, such as share repurchase programs. Francis, this concludes my prepared remarks.

Before we begin the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements, which are based on current expectations. Actual results could differ materially. For information about factors that could cause the actual results to differ materially, please refer to the 'Risk Factors' section of our Form 10-K for the fiscal year ended June 30, 2008.

Leslie, we're ready to begin the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Mark Douglass of Longbow Research. Your line is open.

Mark Douglass - Longbow Research

Good morning, gentlemen.

Craig Creaturo

Good morning

Mark Douglass - Longbow Research

First question is the workforce reductions, what kind of costs are you incurring? And what kind of savings might you expect? And then also the timing of incurring the costs and when those savings might come down the pike?

Craig Creaturo

Mark, the action that we've taken through the end of December, we expect to have annualized savings. We also include near the overtime reductions that we made, roughly about $5 million per year. We have taken all of the related severance costs for that during this current quarter, during the December quarter. And really those are the manpower changes at least through the end of December that were really needed based on the downturns in our business.

Mark Douglass - Longbow Research

Okay. Can you talk some about what you are seeing from the OEMs? Again, some of the differences regionally, as well as some of the higher versus lower power, can you go into that again?

Craig Creaturo

Okay. The lower power business has really stalled, and I think I indicated in my comments that that business was off 50%. That's new OEM laser builds and I think that's rather accurate. It does not have a trail yet to show that it's going to start to turn up. It is in the marking, engraving, many consumer-related product processing functions are done with it. So that will have to turn up as consumer confidence returns and I cannot predict that.

Mark Douglass - Longbow Research

And that's across CO2 versus solid-state, all of the above?

Craig Creaturo

Yes, that's a good point. Solid-state, yes. And it's across all continents too, so it's not preferential to the US or Europe or Asia or Japan; all the way across. So then head into high-power OEMs, I would say this is a judgment of myself and some of our people at our company, that high-power, CO2, 5500 such machines are -- have been -- being built each year. That number is probably going to be more like 3000 in the next 12 months. And that's not by any source. Nobody will come out with such a number. I'm trying to set the stage correctly, but that's an important number. I believe the business for us that depends on that out of our high-power portion of our business. About 5%, 7% of our sales for high-power are to that assembly line. The remaining 95% of our high-power sales are into the aftermarket, whether direct through the OEMs or direct to the end customer. So the part that the OEMs play is they are supplying these machine tools to industrial material processing users. And their visibility to what people are going to spend in capital for automotive or steel or brown goods, what the job shops are going to need for new capital, is quite limited now. Their short-term view, the next quarter or so is not good. So we're not able to tell you how much that aftermarket business which goes direct and flows through the OEMs, where it is going to pan out because those are really dependent on utilization rates of how the end-users are running their machines and if they have a need to replace that machine or take it out of service and put in a more highly productive machine. That data is really cloudy, much more cloudy than it's been. September and October, when we reported, I think they still had reasonably good visibility or if they had the visibility to the downturn, they were not talking it up too much. Now I think it's out in the open that that's really confusing everybody in the marketplace and the high-power CO2 field is adjusting. But on the other hand, it's a great product. There are going to be opportunities and we will adjust. I'm just trying to give you the clarity to what we know over the next 90 days, shall we say.

Mark Douglass - Longbow Research

And then, let me clarify. You believe that you have some opportunity here in the next quarter at least to maybe gain some share in the aftermarket sales through your direct sales force? Was that a correct understanding?

Craig Creaturo

Yes. Exactly.

Mark Douglass - Longbow Research

Okay. And then finally, can you discuss the profitability in your IR segment, and even your near-infrared. Is that a positive effect of the price declines in selenium, a combination of factors? Can you discuss your much improved profitability?

Craig Creaturo

Yes, I think, Mark, we've all been focused on kind of the top-line changes or the demand in the changes in the business. But I think what we can highlight to that end is that the operating performance, especially the infrared optics business, is really continuing to improve. Fran mentioned in his comments about kind of improving the yields and throughput and that's really evident -- very evident in the infrared optics business. So some of the yield challenges that we were having and problems that were plaguing us several quarters ago, we really made it through that. We are starting to sense that a little bit from lower-cost selenium, but I think that's more of a -- we will get a longer-term benefit. That's not really the direct impact in this quarter. From a profitability standpoint, our segment earnings -- our infrared optics business bears a lot of the additional costs that are not allocated out to the other three business units. So things such as performance-based bonuses and stock option expensing, things like that are things that were down pretty significantly during the quarter; a lot of that benefit ends up accruing, if you would, to the infrared optics unit. So I think it's a combination of, despite the lower sales, being able to execute and perform well plus also not bearing as much as those allocations as they have in the past.

Francis Kramer

I'd add also, Mark, that the lower cost selenium has not flowed through to the zinc selenide material. The zinc selenide that's in our process around the world was built at a higher cost and it remains at that.

Mark Douglass - Longbow Research

Thank you.

Craig Creaturo

You’re welcome.

Operator

Thank you. Our next question comes from the line of Avinash Kant of D.A. Davidson & Company. Your line if open.

Avinash Kant - D.A. Davidson & Company

Good morning Fran and Craig.

Craig Creaturo

Good morning.

Avinash Kant - D.A. Davidson & Company

A few housekeeping questions first. Did you give your estimate of the CapEx for fiscal year '09?

Craig Creaturo

Avinash, we said that we will start to ramp that down in beginning -- we will start to see some noticeable changes to that beginning in our fourth quarter, so our June quarter. We ran at about $4.5 million. We will run probably roughly around that level in the third quarter as we finish out projects that we had started; we think it will tick down from there. So the full year run rate, if you add it all up, it will be showed in today's press release that the total for the nine months, we were at about $9.3 million in CapEx. We think we will finish the fiscal year probably around $15 million to $16 million, somewhere in that range.

Avinash Kant - D.A. Davidson & Company

$15 million to $16 million, right. And that, you expect to go down again in fiscal year '10, right?

Craig A. Creaturo

That is correct. And our early look at that, which obviously is getting revised and as we get closer to FY '10, we will come out with more focused update on that, but our early look says it will be more like $10 million to $12 million FY '10.

Avinash Kant - D.A. Davidson & Company

And the deduction in costs, you talked about roughly $5 million per year run rate, right. But that should start to take effect maybe from the third quarter onwards, for the March quarter?

Craig A. Creaturo

That's exactly right Avinash. A lot of those cost actions were taken in the month of December. We really didn't see a significant benefit from that with probably one exception. Obviously turning down the higher levels of overtime that we ran in the early part of -- well, all of Q1 and the early part of Q2. We did get some benefit from that. But to your point, most of that, we'll start to see some of that benefit beginning in this current quarter.

Avinash Kant - D.A. Davidson & Company

That will be pretty linear going forward, right, roughly?

Craig A. Creaturo

That is correct. That's right.

Avinash Kant - D.A. Davidson & Company

And now in terms of bookings that you talked about, bookings have come down some. On a monthly basis or from what you see up until in this quarter, in the March quarter, do you see some sort of stabilization? Or do you see continued dropping of bookings here, especially in the non-military side, I'm talking?

Craig A. Creaturo

I'll maybe start and let Franc kind of add to it. I think kind of what we saw was October being very, very strong and then November weakness and then slightly continued downward there from December, which was inconsistent with what we had anticipated. I would say that what we are expecting is kind of that continued softness in general and running at those November/December type run rates. Fran, do you want to add to that?

Francis J. Kramer

I would agree. That might be the January/February early period. We have a little bit of uptick that we think will come through the end of this year as the overreaction to the OEMs pruning their spare parts inventory or they realize they've cleaned out their pipeline and they need it. We think there will be a little bit of a tick-up and we've projected that in our guidance.

Our other business is the infrared -- that's what I was commenting upon, was infrared. Remember we've guided you before on Near-Infrared, that one product line there that's moving downward and that affects us in the third and fourth quarter, is our UV filter business. So that one will be seeing a little slowing down, so that's always been in our projections. That continues to be there. I think our other two business segments Military & Material and our Compound Semiconductor Group, they look good. They look steady and there might be a tick-up. It depends upon how the bigger orders we're looking for, which are defense and space, how they come in.

Avinash Kant - D.A. Davidson & Company

So the tick-up you're talking about, Fran, is it end of fiscal year or calendar year?

Francis J. Kramer

Fiscal year. Every comment I just made heads toward what will happen between Q3 and Q4 of our fiscal year, which is January to June.

Avinash Kant - D.A. Davidson & Company

Okay. Because given the guidance that you have given on the top line for the fiscal year, if I model it, it looks like you don't expect a sequential decline in the June quarter compared to March. Is that --?

Craig A. Creaturo

That is correct, we do. And to Fran's point, we are expecting a little bit of a -- and again, that's also a combination of all the other businesses, again, looking at the non-industrial, the military businesses, as well. But you're interpreting it correctly, that we are expecting that Q4 to be slightly better as far as revenue goes than what we're projecting for Q4.

Avinash Kant - D.A. Davidson & Company

Right. And for that to happen, what percentage of your business is turns, actually?

Craig A. Creaturo

Well, if you look at the overall business again, the one that is the easiest to look at is the Infrared Optics business, and Fran was touching on this a little bit in his comments; that 90 plus percent of what we sell into that marketplace goes into the aftermarket. And with that business being roughly half of our total business, you are right there at 40%, 40 plus percent. The rest of that business, if you add it up, it's probably -- we're roughly about 50-50, if you really look across all of II-IV. Roughly about half ends up going into replacement, half into new systems.

Avinash Kant - D.A. Davidson & Company

Right. So the reason I'm asking is that if you expect some sort of -- even a very minor uptick in June, your bookings have to either stabilize or have to slightly move up in the March quarter. Am I right in assuming that?

Craig A. Creaturo

Yes, and I think also too Avinash, we do have a decent -- even though it has gone down in each of the last two quarters, we do have a pretty good backlog, a decent backlog at $114 million. So we will continue to work our way through that backlog. And we have stayed away from trying to guide to the bookings. And I would tell you definitely in this environment, we wouldn't want to venture into those waters because again, people doing things as far as holding back orders and as Fran mentioned, just being very cautious about placing orders. So we won't be able to guide you any further on the bookings. But either through the combination of bookings that we get or utilizing the backlog we have, that's how we're able to view out toward the guidance that we've given for Q3 and Q4.

Avinash Kant - D.A. Davidson & Company

But in terms of the visibility, it looks like you do have decent visibility on the military side of the business at this point.

Craig A. Creaturo

Yes, I would say each one of our business segments has a military component. And that's leaning heavier right now at all of our sites, whether it's near infrared, our exotic business, or our Marlow Industries business. All three of those have some upside opportunities. And within the infrared optics business, the commercial business, there is a small defense military component, and that has opportunity. So I think that's where we are leaning. Those are the programs that we've been working on or longer-term programs, and they seem to be coming to fruition. So we're rather confident over the next six months of the orders that we've tried to project and analyze and see how they will come through to our sales line -- we're more confident on that side of the business.

Avinash Kant - D.A. Davidson & Company

And in terms of tax rate, what should we be modeling? It seems to be fluctuating quite a bit.

Francis J. Kramer

So I think on this, we've seen in this quarter right around the 25% -- I’m sorry, 28% level. That was off of a -- in the prior -- sorry, 25% this quarter and roughly about 23% for year-to-date if you exclude what we had in the first quarter. We had some about $3.6 million positive impact. When you exclude that out, our overall effective rate 23% is what it is year-to-date. And we think, we'll again, we'll be around that 25% range. Again, the mix of earnings is really what drives the profitability to the extent that it's a little bit more U.S sourced, the rate goes up. To the extent it's a little bit more foreign sourced the rate tends to go down. But right now, the quarter we just completed, right around 25%, and that's probably pretty close to where we will be for the fiscal year.

Avinash Kant - D.A. Davidson & Company

And one final question. Could you talk about the new opportunities that you have been seeking? Where should we expect new opportunities? Is this new projects coming along or totally new businesses that you could go into? Could you highlight that?

Francis J. Kramer

New opportunities, certainly, they are the military. And I highlighted some of that in my talk about VLOC, or Near-Infrared, where the business is shifting down on commercial, but up on military. And a lot of complex optical assemblies or I shouldn't say a lot -- three big running programs that they've now received orders on will produce in the second half of the year.

We shift down to Marlow; we have a very good opportunity. I made comments about that. We have been working for a while with a supplier into the auto industry. And that's not necessarily only U.S auto, but the big people who are producing comfort devices for heating and cooling within cars. We've been working with one supplier and we would expect to start production of a device for that market here in the quarter, but it's now shifting out one quarter. So we've worked hard on that and I think it will come.

I know it's into a really depressed auto industry, but people will take on new devices in their new auto designs that they come out with to entice people to buy, and this is where that product is headed. So we feel that's a good thing for us to be on. We will be able to produce that product out of our Vietnam factory.

Avinash Kant - D.A. Davidson & Company

Perfect. Thank you so much.

Francis J. Kramer

The other one, and I would comment -- and I'll be real quick about it. The Infrared Optics business, we do have this capacity to sell zinc selenide and zinc sulfide into military systems and into the Homeland Security Border Patrol. So we've been out of that market. We got back into it about six, eight months ago. Now I think we're starting to get our stride on that where we are making material sales into those areas.

Avinash Kant - D.A. Davidson & Company

Great. Thanks so much, Fran.

Operator

Thank you, our next question comes from the line of Jiwon Lee of Sidoti & Company. Your line is opened.

Jiwon Lee - Sidoti & Company

Several questions, please. First, on the PRM side with reduced pricing and demand in mind, what should be sort of the new revenue expectations on an annual basis? Is it about $14 million to $15 million that you guys expect?

Craig Creaturo

Well, the PRM business last year was, Jiwon, was about $20 million. We've had – the first quarter was stronger than that. The quarter we just completed was roughly around that level. And I think we are expecting overall growth with PRM, notwithstanding the change in the selenium pricing. So, we're anticipating that that business will do a little bit more than the $20 million in revenues that they achieved last year.

Jiwon Lee - Sidoti & Company

Great. And then, if I hear you guys correctly, the 22% fall, the sequential fall in foreign sales, that was more to do with the low power system sale as well as the high power OEM sales; but also you saw a lot worse trends on the aftermarket optics sales as well?

Francis Kramer

Well, let me clarify this aftermarket – I tried to be as clear as I could. One-third of that aftermarket comes direct to us. Two-thirds come through the OEMs who sell to the aftermarket. So we're not able to tell you whether the OEM drop-off is due to assembly line reduction or due to, they're not making the sales into the aftermarket.

I think it's a third feature, they've been working down their inventory. So, the reduction that we had in international sales, multifaceted, for sure a feature of it, and it seemed to hit all parts of the globe equally, is the low power business is off. The aftermarket business for us, direct, is hanging in there very well or reasonably well here in the United States.

And our aftermarket direct component of sales in Japan, Germany, Switzerland, we're not as strong selling direct there. The OEMs control their customers much more strongly in Japan with kind of a loyalty tactic. And the German OEMs and so on also. So, we're not able to tell the aftermarket rate of consumption as well as we can outside of the United States. But my gut feel is that the aftermarket might be a hair less in those areas, a little bit more off, but we do not have that – we don't have as good a visibility.

Jiwon Lee - Sidoti & Company

That's very clear. Thank you. And onto the inventory write-down on the selenium front, which line item do they fall under, Craig?

Craig Creaturo

That is through PRM directly, Jiwon, and that would be part of the – that would be included in the segment earnings for the Military & Materials business.

Jiwon Lee - Sidoti & Company

Okay. And then, is the currency trend that you saw in the December quarter, if that continued, how should we view your sort of a foreign exchange losses going forward?

Craig Creaturo

That's an area that we just have to pay attention to, Jiwon. I think in our comments we – a lot of the losses that we recognized were not really true losses of cash. The only ones we're really on the settlement of are yen forward contracts, where the yen went from about 106 in September down to about 91 in December. And really that was the one that was – that we had some recognized losses.

The other piece is, again, we just had kind of a combination of some pretty significant changes in the current period exchange rates. And again, you had them kind of working the opposite as well in certain ways. You had the yen that was very strong. You had the pound that was very weak against the dollar. We're definitely, at least through the first 21 days here in January, not seeing anywhere near those types of fluctuations, so we don't expect anywhere near the magnitude of foreign currency gains or losses that we experienced in this past quarter. But, it is something that we – it's hard for us to give you a projection or tell you where it's going to be, but at least so far through this beginning part of this fiscal third quarter, we're definitely not seeing anywhere near the fluctuations that drove the big losses that we had in the Q2.

Jiwon Lee - Sidoti & Company

Okay, and finally onto the military business, especially the Advance Targeting Pods, and now with the JSF, what's sort of the current expectation of how those programs could ramp up, especially I guess the JSF?

Francis Kramer

Yes, it's quite a long ramp rate on JSF. We are working on maybe the third, receiving the third initial order, shall we say, receiving it, but we're still just wrapping up the shipment of the first order. So we're negotiating on the third, we have the second and it starts to ship in six to 12 months. So there's quite a long lead time between order receipt on JSF initial production or low rate initial production orders, and when the parts start to deliver.

So long ramp, and maybe there's anticipated four or five initial as I call, low rate initial production buys, of which each one gets a little bigger. So, we're just finishing one, headed into two, negotiating on three. So it will take a handful of years to ramp that up, and that's the idea that it's the plane for 2015, 2020 and going out past that. So long, long time to ramp up. A lot of technical features on the plane, which make it the premier plane that all the services are going to be using. So, we got a long front end on it and then we're hoping to have a long-running production of it.

Jiwon Lee - Sidoti & Company

I'm sorry, I forget. For the JSF, the optics that you supply there, how many suppliers are in there, roughly?

Francis Kramer

Well, that's the beauty of this. On those particular products, we're the sole source supplier.

Jiwon Lee - Sidoti & Company

Okay, as well as the ATP, I understand.

Francis Kramer

Correct.

Jiwon Lee - Sidoti & Company

Okay.

Francis Kramer

On the optical pod, the main housing which has to have a lot of optical features, that's what I'm commenting on. There are optics within the chain, the guidance system, the laser range finder, all of that, that are produced by others.

Jiwon Lee - Sidoti & Company

Okay, great. Thank you.

Operator

Thank you. Our next question comes from the line of Scott Blumenthal of Emerald Advisers. Your line is open.

Scott Blumenthal - Emerald Advisers

Good morning, Craig and Fran.

Francis Kramer

Good morning.

Scott Blumenthal - Emerald Advisers

Craig, just a couple of maintenance questions here. You talked about the inventory write-down. Can you talk about the components of the other expense line that was kind of close to $3 million, and you did discuss inventory write-downs, exchange rate losses, severance costs, I'm assuming some of that’s in there?

Craig Creaturo

Yes, Scott, really, of the items you were touching on, really the only one that's included in that other expense line item is the roughly about $2.9 million that we incurred of foreign currency losses. We really met all the other activity that we included in that line – interest income, and we have a small 20%, the equity earnings that we get from our investment in (inaudible) in China. When you net all the other pieces of it out, it pretty much netted to nothing. The only big item that's in there really is the foreign currency losses.

The other items that you mentioned, the selenium write-down, that was part of our operating activity, that impacted the gross margin and all the severance-related activities, we did not – again, because just for simplicity, we kept all those as operating expenses during the quarter. So then really the only thing that's in the other line item is really the net effect of the foreign currency losses.

Scott Blumenthal - Emerald Advisers

Okay. That's really helpful. And keeping on the inventory issue, I noticed a year-over-year, certainly, the inventory levels are up. And I was wondering if you couldn't comment on the actual physical – not the – we are seeing the dollar amount, but the actual physical inventory level, how that stands? And I guess, I would like to know if we can expect the general trend for, since you are taking inventory write-downs, we should start to see a general trend in lower cost of sales coming through since I believe you're FIFO.

Francis Kramer

Okay. So, this is Fran. I will make a couple of leading comments and then Craig can wrap it up on the accounting side of it.

Some of the inventory build is sure strategic. We recorded, the last few quarters, we've been very low in our inventory of zinc selenide and zinc sulfide materials that we have in stock. Now, we've been able to replenish those as our yields have improved and our capacity came online. It's in much better position, so we're more aggressive in the marketplace, a strategic investment to get zinc selenide and zinc sulfide in stock.

Second, as this market turns down, I made the comment that we're now positioned to take advantage of opportunities. If and when OEMs and aftermarket customers need product quickly, that we've been working to be sure we had the inventory of finished optics to the designs that everybody need for their 50,000 lasers positioned around the world. I think we've done a good job, built that pretty well here as we've slowed down our production facility, but as we were slowing, we were looking for what did we need to have and we've done that.

So we feel we are well-positioned. The amount of inventory build that's taken place in a few other areas was maybe strategic, but maybe just the result of not being able to stop things quick enough. So I'm 70%, 80% that the build was strategic. Maybe 20% or so, it was the slow effect in turning the switch off. Now, coming forward in the third and fourth quarter, I think we will have a little inventory build. It's going to be nothing like the magnitude we've been through because of the two reasons I stated. That's over and done with. So I think we'll have a little trick up, but nothing to this magnitude.

Craig Creaturo

And I would just add to that, what Franc said, we have for instance in our PRM business, we have been wanting to increase the supply of the critical raw materials and a lot of the work that we've done on the supply front has started to come to fruition. So, and that's a very positive long-term thing for us that we're gaining some more supply from critical refiners of selenium, using these byproducts from copper miners, zinc miners, et cetera.

And so we're starting to get some of those materials procured where, three, six, 12 months ago, those sources were not available. And I think also too, we do have our EEO business, as Fran mentioned, is growing, and obviously there's a need for inventory there as well. And to Fran's point about that, I don't think the expectation is that we will continue to grow at the rate we have grown even in the just completed quarter, even in the fiscal year-to-date. In Q3 and Q4, I think it will be very slight as Fran quoted. I think he is right on, I think it will be just some slight inventory builds in selected areas.

The only area that, for instance, in Infrared Optics, we're starting up our new sales and marketing entity in Italy, so we will be carrying a little bit more inventory than has historically been carried by a distributor. Again, that comes back to the whole strategic nature of why we're able to carry that amount of inventory and be there for the OEMs or for the aftermarket customers.

Scott Blumenthal - Emerald Advisers

Okay, Craig, and Fran, that's very helpful. And my last question deals with the volume and magnitude of what you think you are going to see in the zinc selenide and zinc sulfide materials business. Maybe you could give me an idea of what you expect that business to be like this year, next year, and kind of ultimately where you think that can grow to?

Francis Kramer

That's maybe more depth into our business than what I would care to go into, but we have two different businesses, using and producing zinc selenide and zinc sulfide and consuming in the optics we manufacture and sell.

Scott Blumenthal - Emerald Advisers

Sure.

Francis Kramer

That's certainly important. And the other side of it of selling materials as merchant suppliers to other optics houses who are making such products, that's the area that we were out of. We've been back toward it now in the last six months and expect more of it in the next few months. I really don't have a quantification of that. We don't break out the numbers to that level of detail. And I think we've gone further today in breaking out bits of our business segment data than ever before. And I'm not comfortable going any further, but I can tell you it is an important business for us and we think we can grow it.

Scott Blumenthal - Emerald Advisers

Okay, Fran. Fair enough. Thank you for your time.

Francis Kramer

You’re welcome.

Operator

Thank you. Our next question comes from the line of Chris McDonald of Kennedy Capital. Your line is open.

Chris McDonald - Kennedy Capital

Hi, good morning. Things for taking my call. Just a couple of quick questions. One on selenium. If I understand you right, Craig, you mentioned you think PRM can actually be up year-over-year from a revenue standpoint. So given the decline in selenium, the thought process is that unit volume is up pretty meaningfully through that operation. Is that correct?

Craig Creaturo

I would say, Chris, you are right on as far as directionally where we think PRM will be. I think the other piece is – and Fran touched on it on his comments is that the tellurium market, especially the piece going to photovoltaics, is steady to slightly up. And the pricing of that, half of the business, if you look at it as two halves, half of it being tellurium production, half of it being selenium production, the tellurium production and the demand there is still remaining very strong.

And again, there is a very – currently there's very drastic price difference if you would per pound, if you were looking at tellurium being seven, eight, nine times the price per pound of selenium. So, the volumes have kind of been there and stay and the price has been more steady. So I think overall that's one of the reasons we are still expecting even despite the slight decrease in tellurium. As Fran mentioned, the volumes there are helping to offset the larger decrease in the price of selenium that we are experiencing.

So that's why we definitely have revised those forecasts as we have gone through the year and pulled it down, but it definitely shows that PRM will grow here in FY '09.

Chris McDonald - Kennedy Capital

Okay, and then thinking about the selenium price decline on the Infrared Optics business, when would -- that's more of a positive impact in fiscal '10 versus fiscal '09? Is that --?

Craig Creaturo

Yes, I would say that's correct, Chris. I think we continue to procure material, and again, we put that into crystal growth processes. And by the time we end up selling into a manufactured part, that takes several months to go through that whole crystal growth process, qualification and making it into a part, et cetera. So, we will -- as we have been procuring material and have a supplier of selenium on hand, that is adequate for our business, we will continue to utilize that and we will start to see some further benefit from that, specifically more so in FY '10 than we would have seen here in FY '09.

Chris McDonald - Kennedy Capital

Okay. And lastly, from the margin performance, certainly it looks like the yield continues to improve in Infrared Optics. I'm just wondering what inning of the ball game we're in on that being back to normal or back to what you would deem acceptable levels from a yield standpoint there at the Saxonburg facility?

Craig Creaturo

I think the zinc selenide, zinc sulfide yield is back. We are now producing at the yield and the rates that we felt we had done two years ago at our best. So we are back to our best performance there. We do carry quite a bit of inventory. These processes, when they go bad, you better have an insurance policy. So we have a considerable inventory.

So the time that that new higher-yielding product flows through our inventory out into our work in-process, finished goods and shipped, it's quite a lead-time. So although we are back on the yield side, the lower cost of that flowing through along with lower cost selenium, I am thinking it's six, eight months out, and maybe it's more. It just depends how low the consumption goes. We have a normal usage rate of zinc selenide that now is off, just this turndown reduces the amount that we are taking out of our inventory.

So our months on hand will be a little longer than what we target. But we always target to have good insurance. And that's part of the business and be able to do this with these volatile yields, others do not have that type of a buffer and haven't been able to compete. So we're pretty happy we have it, but it does create the problem that the costs do not come down as quickly when yields improve and prices like selenium falls.

Chris McDonald - Kennedy Capital

Great. Thanks for walking through that. I appreciate it.

Operator

You have one final follow-up question from Avinash Kant of D.A. Davidson & Company. Your line is open.

Avinash Kant - D.A. Davidson & Company

Yes, just wanted to have a quick conversation about the margins. Given that business in the non-military side has been declining, have you seen any margin or a pricing pressure there?

Francis Kramer

Well, pricing pressure is huge right now. Everybody is going to try to improve their margin based upon their supplier. So, saying that the commercial accounts were not asking for price reductions and really working hard to get their costs down would be not correct. We've got a lot of requests, and certainly it's one you take a case at a time. Really we want to hold our price and – but we also need to keep our business and our market share in a few select places, I think we will drop our prices to get market share from other suppliers, so – or else, other competitors. A lot of pressure out there, Avinash, and we are doing I think reasonably well, not reducing prices. But here and there, we will.

Avinash Kant - D.A. Davidson & Company

Any particular competitor who is dropping it significantly in the market or --?

Francis Kramer

No there's not because there is a counter to where we know we are not getting 100%. Maybe we've been 70, 80%, and there are a couple. We're saying hey, here's your -- if you want a little price off for 100% of the business, you can have it. And maybe there are a couple accounts like that, but they're not the big guys but they are in there. So we're trying to work that because we really think in this downturn there's a chance to pick up some share. We can do it on price.

Avinash Kant - D.A. Davidson & Company

Okay, perfect. Thanks.

Operator

Thank you. And we have no further questions.

Craig Creaturo

If there no more questions, then I would like to thank everyone for participating today. Our next earnings release for the quarter ending March 31, 2009 is tentatively scheduled for before the market opens on Tuesday, April 21, 2009, with a conference call to follow that same day at 9 a.m. Eastern time. Thank you for participating in today's conference call.

Operator

Thank you, and this concludes today's conference call. You may now disconnect.

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