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FEI Company (NASDAQ:FEIC)

Q4 2008 Earnings Call

February 5, 2009 5:00 pm ET

Executives

Fletcher Chamberlin - Treasurer and IR Director

Ray Link - EVP and CFO

Don Kania - President and CEO

Analysts

JoAnne Feeney - FTN Equity Capital

Matt Petkun - Davidson & Co.

David Wu - Global Crown Capital

John Harmon - Needham & Co

David Duley - Soleil Securities

Bill Dezellem - Tieton Capital Management

John Roy - Janney Montgomery Scott

Hari Chandra - Deutsche Bank Securities

Brett Hodess - Merrill Lynch

Operator

Welcome to the FEI fourth quarter Earnings Call. (Operator Instructions).

At this time I would like to turn the conference over to Mr. 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, our President and CEO, and Ray Link, our Executive Vice President and CFO.

Before we begin our presentation, we have the regular housekeeping matters to address. This call contains forward-looking statements to the extent that we discuss expectations of our future corporate performance and guidance, customer orders, 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 or other future events or plans. These 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 more detail 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 on the SEC’s website at www.sec.gov or on 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 these 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.

I will now turn the call over to Ray, for the review of the financials and then Don will comment on our markets and the business environment.

Ray Link

Thanks Fletcher. Good afternoon everyone. Welcome to our fourth quarter call. I will go through the financial report and guidance in detail and then turn the call over to Don.

We had a good quarter. Booking, sales and earnings were all above the guidance we gave at the end of the third quarter. Quarterly revenue was the second highest in our history and annual revenue was the highest we have ever reported. Operating income was the highest since the third quarter of 2007 and was 80% above the third quarter, and net income was up 86%.

We generated cash again for the quarter and the year and significantly improved our working capital management. In light of the weakness in the global economy, we are pleased with our results.

Turning now to the details, net bookings for the fourth quarter were $153.8 million compared with the record $175.3 million in the third quarter and with the $156.3 million in last year's fourth quarter. Gross new bookings in the quarter were $181.8 million, making it the second highest total in our history, behind the record setting third quarter.

To get to the net number, gross bookings were reduced by $7.6 million of cancellation from the electronics part of our business and by $20.4 million to revalue the backlog for currency movements. The euro finished at 1.39 compared with 1.46 to the dollar at the end of the third quarter. Even with the revaluation the backlog at the end of the quarter was $330.5 million, which is another record for the company.

Net sales of $151.7 million were up 7% from the third quarter and up 1% from last year's fourth quarter. Research & Industry revenue of $67.3 million was up 41% from the third quarter and was about equal to last year's record fourth quarter. For the year Research & Industry revenue was up 11% from 2007, and made up 40% of the total.

Life Sciences revenue of $18.2 million was down from the third quarter record level, but is up 6% from last year's fourth quarter. As we said before, Life Sciences bookings and revenue will fluctuate from quarter-to-quarter. For the year Life Sciences revenue was $70.8 million, up 36% from 2007 and it grew to 12% of the total.

Electronics revenue was down 8% from the third quarter, down 2% from last year's fourth quarter, and down 23% for all of 2008 compared to 2007. In total, Electronics was 21% of revenue in the current quarter and 25% for the full year, compared with 34% for all of 2007.

Overall, the book-to-bill ratio for the total company was greater than one-to-one for the quarter and the year.

The gross profit margin was 39.5% compared with 40% in the third quarter and 39.7% a year ago. The main difference was due to currency hedging losses, product mix and a small decline in service margins.

Moving down the income statement, the sum of R&D and SG&A expense was $47.6 million, down 3% from Q3. Our normal seasonal increase in operating expenses was offset by the favorable impact of restructuring and the stronger dollar. Amortization of purchased technology was $441,000 in the fourth quarter and we expect that level to continue, barring any future acquisitions.

Restructuring expenses were $820,000, and we expect around $1 million in the first quarter. Operating income was $11.2 million compared to $6.2 million in the third quarter, and $7.5 million in last year's fourth quarter, a good indication of our more effective execution over the past year.

Below the operating income line, total other expense was negative $1 million compared to negative $591,000 in the third quarter. Net interest income was lower due to much lower market rates. With the extreme volatility in foreign exchange rates our currency loss was higher in the quarter. While exchange rate volatility makes forecasting of this line difficult and interest rates remain very low, we currently expect the total other expense line to slow a loss of around $800,000 in the first quarter.

The tax rate was 27.6% for the quarter and 26.2% for the year. We expect the rate to be around 25% in the first quarter. All of this leads to GAAP net income of $7.3 million or $0.20 per share for the fourth quarter, well above our guidance range, when compared to $3.9 million or $0.11 per share in the third quarter.

The fully diluted share count was 37.4 million in the quarter and 40.5 million for the year. We expect the share count will grow only modestly in the next few quarters. This total does not include 3.9 million shares attributable to our 2% and 7.8% convertible notes, because their inclusion will be anti-dilutive at our current income level.

Our balance sheet remains very strong, a real benefit in the current economic environment. Total cash and investments at the end of the quarter, including restricted cash and long-term investments, was $319.3 million, up $5.3 million from the end of Q3. Operating income cash flow was positive $25.1 million for the quarter and $54.9 million for the full year.

Receivable days outstanding were the lowest in over five years and inventories declined by over 8 million on increased sales and improved the inventory turns.

During the fourth quarter our liquidity position with regard to our auction rate securities improved significantly. In November, we agreed to the settlement that UBS reached with regulators, in which the bank agreed to repurchase all $110.1 million of our auction rate note securities at par on June 30, 2010.

Capital spending in the fourth quarter was $3.5 million compared to depreciation expense of $3.9 million. For the year capital spending was $13.5 million compared with depreciation expense of $16.5 million.

Now let's turn to the details of our guidance. All of our guidance for Q1 assumes an average and quarter end euro rate of $1.35. We expect revenue for Q1 to be in the range of $135 million to $142 million. We expect gross margins to be around 40%. Operating expenses excluding restructuring are expected to remain below $50 million in the first quarter.

GAAP earnings per share for the first quarter, assuming a 25% tax rate, are expected to be in the range of $0.10 to $0.15. Restructuring charges of approximately $1 million are included in the GAAP guidance. Bookings are expected to be above $130 million. Our pipeline of potential business in research and life sciences remains positive. We expect some seasonal falloff in bookings. At the same time, we expect the electronics part of our business to remain weak.

So in summary, we had a good quarter with solid orders and revenue and a significant increase in operating income. Movements in foreign currency exchange rates create the complex picture in our financial statements but fundamentally, the stronger dollar and weaker euro are good for FEI. Even if the top line growth is moderated, our earnings are improved by the strengthening of the US dollar.

With that I will turn the call over to Don.

Don Kania

Thank you, Ray and good afternoon everyone. As Ray said, we had a good quarter despite widespread weakness in the global economy and volatility in foreign currency markets. Gross bookings were the second highest in our history.

The environment remained positive for our research and life sciences businesses and electronics orders declined as we had anticipated. Even with the stronger US dollar, our net bookings in the second half of 2008 were up 13% compared with the first half of the year and annual bookings were up 4% from 2007.

As we look back on 2008, our strategies of technology leadership, increased customer application focus, expanding our global reach and building the management team are paying off. We believe the rating margin improvements and more effective use of working capital compared with a year ago indicate fundamental improvements in FEI's execution with room for further improvement.

We launched our restructuring about nine months ago, including reduction in headcount, pre-positioning the company to be effective in a very difficult macro environment. Also the strategic shift to a lab focus electronic strategy coupled with strategies to expand our other segments has been fundamental to FEI's relative success.

Our results clearly demonstrate FEI is a diversified instrumentation company. The electronics market is a large and important vertical market for us and we will continue to invest in it. At the same time, we plan to develop additional verticals, drive our overall leadership in research and expand our life sciences opportunity.

Turning now to the results of the fourth quarter, research and industry bookings in the fourth quarter were $82.2 million, our highest quarterly total in history, up 21% from the third quarter, and up 30% from last year's fourth quarter. Demand grew globally with over 75% of our research bookings coming from outside the United States with particular strength this quarter from Europe.

The fourth quarter included important orders for leading edge Titan systems that incorporate key component technology improvements while our competitors continue to chase the original Titan. From a longer-term perspective, bookings for research and industry have grown at a compound annual growth rate of over 22% since 2003.

While we expect a seasonal drop off in research bookings in the first quarter, our outlook remains positive with a solid pipeline. Historically, this business has remained fairly stable in recessions.

Life sciences had bookings of $17.3 million, below the record of $25.9 million for the third quarter. As we have said before, booking in this segment will be with uneven from quarter to quarter. Annual bookings for life sciences grew 32% to $81.4 million or 13% of total compared to 10% of the total in 2007. The response to the Titan Krios continues to be positive with multiple bookings in the fourth quarter and the pipeline for the product continues to build globally.

As we expected the fourth quarter net electronics bookings of $22.2 million were down significantly from the unusually high levels in the third quarter. The fourth quarter included $7.6 million of cancellations from Asian semiconductor customers. In one case the customer canceled the order; in another we removed the order from our backlog due to repeated deferrals of delivery.

While the semiconductor capital equipment industry is in a severe downturn, we believe that our bookings driven by technology investment are likely to stay in the $20 million to $30 million range per quarter, with the potential for significant quarter-to-quarter variability. Our strategy of providing leading edge systems, with exceptional cost of ownership in the semiconductor laboratory, positions FEI for technical buys in a difficult environment.

In summary, total bookings were strong in the fourth quarter, capping a very strong second half. We see this as a significant achievement in the current economic climate.

I want to highlight several announcements we made during the past few months that illustrate an expanding strategic direction for FEI. In November, we announced software to improve the speed and accuracy of strained-silicon analysis with our TEMs, improving their utility in the semiconductor market.

Around the same time, we also added software automation to our 3D tomography applications for Life Sciences, improving our ability to model molecules and other biological structures. Then, near the end of the year, we took an important step in the emerging industrial part of our business with the purchase of the assets of Intellection, an Australian automated mineralogy company. This purchase will compliment our existing mining application that uses software supplied by our partner, JKTech.

These are examples of how FEI is moving to provide solutions in each of our markets. We have leading measurement technology; we have building solutions that increase the value FEI delivers to our customers.

In early January we announced an outsourcing agreement with Ultra Clean Technologies, a public NASDAQ company, under which they have taken over the management of our Oregon factory, and will manufacture products for us as well as others, thereby lowering the overhead costs for US built products. In addition, over time we expect to benefit from UCT's sourcing and manufacturing engineering expertise to further lower our cost. This is one step in the restructuring program that we announced last year with more to come in 2009.

Turning to the outlook, the first half outlook for Research and Life Sciences segment of our business, which together made up 65% of our bookings in the fourth quarter, is reasonably robust. Our pipeline for new business is solid. These businesses, which are dominated by government and institutions around the globe, tend to be cash-based and have long buying cycles.

For example the European Union and the Indian governments have reaffirmed their nanotechnology initiatives, and the French, German and Dutch governments have allocated increased spending as part of their stimulus programs. In the US, endowments, philanthropy and state budgets will all contribute less to institutional coffers and that could restrain spending, but the Federal government appears to be poised to increase spending by about $6 billion on basic research through the NSF, DOE, NIH and other agencies.

In addition, we believe our new products and technology leadership can expand FEI's share in a large life sciences equipment market.

Along with many others, we expect a weak semiconductor capital spending in the first half of the year. Again, we believe our lab focus strategy gives us an advantage over a more capacity driven equipment companies. For the service part of our business we are also expecting some slowing in the historical steady rate of growth, as some equipment comes off line and more customers opt for time and material service rather than signing annual contracts in this market.

With respect to the competitive environment, the Japanese yen had maintained its appreciation against the euro and the dollar. This substantially improves FEI's cost position relative to our Japanese competitors, both inside and outside Japan, and we intend to claim that advantage.

Looking at our pipeline and our strong competitive position, we remain optimistic about the first half prospects for Research and Life Sciences. At the same time we are keeping a tight limit on our expenses and have planning scenarios that we can act upon if necessary as the year develops.

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 majority of major orders around the globe. We will add value with our solutions focus, including more efficient sample and data management, and therefore give us an opportunity for better gross margins.

The diversity of our markets and global customer base provide us with the range of opportunities in a difficult environment. Our Research & Industry and Life Sciences businesses remain strong. While volatile exchange rate creates challenges for our team, the strong dollar and yen are positive for FEI.

The operating supply chain, manufacturing improvements for our restructuring program will lower our costs and create a more natural currency hedge. We have a strong balance sheet with more cash than debt and we will continue to generate positive cash flow. We are proud of our performance and 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 now ready for questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions).

Our first question is from the line of Satya Kumar with Credit Suisse. Please go ahead.

Unidentified Analyst

This is (inaudible) for Satya. Thank you for taking my question. Your orders are over $150 million for two quarters in a row, but your revenue guidance is $135 million to $142 million, are you being conservative on your revenue guidance given current conditions?

Don Kania

I would make two comments about that. I think number one, you are correct, we think in this environment it is prudent to be conservative, but also, as we look at the order book in Q4, it contained a large number of orders whose deliveries are scheduled for later in the year and so I think the conspiracy of those two spirits had us come town on the revenue range that we guided to.

Unidentified Analyst

Okay. And secondly, your service orders are strong in the fourth quarter, as compared to typically down in the fourth quarter. So is that because of the service orders that you had got from cost or is there any of the factor that's happening in service this time?

Don Kania

I think, if I remember correctly, we were down slightly in the third quarter, and if you look at the average for the past three quarters, we are comfortable with that rate. Typically Q1 is the strongest order for service orders and that's usually annual renewals coming through and so we expect that to happen in the quarter. Ray is looking at some numbers.

Ray Link

Yeah. They were only up a little bit over Q3. Q3 is actually our lowest quarter for service. We have a good portion of our service businesses in Europe. That's generally a slow quarter overall for that. But if you look back, historically, Q1 is generally our best quarter for service as a lot of people re-up their annual bookings. So, I wouldn't really draw much into the relatively small increase over Q3.

Unidentified Analyst

Okay. Okay. Thank you very much.

Operator

Thank you. Our next question is from the line of JoAnne Feeney with FTN Equity Capital. Please go ahead.

JoAnne Feeney - FTN Equity Capital

Thanks. Nice quarter, guys. A couple of questions about the higher than expected revenue number last quarter. Does that reflect some forms of shipments from the first quarter? Is that part of the reason why your first quarter guidance is lower than your order run rate would suggest?

Don Kania

I would say that with respect to the revenue in the fourth quarter, the team just did a great job. (inaudible) work is one way to look at it. At the end of year make the numbers, get a bigger bonus and that played through I think for us. I think we will stand by our comments about first quarter revenue. I think we've got an order book that had some generally a little bit more later deliveries and a lot of good size orders.

So, it's a good thing for us overall obviously. And then number two is in this environment, we are taking a relatively conservative approach to forecasting our revenues, all aspects of our business because it's what you don't know that will kill you.

Ray Link

I would just like to elaborate on that. We really had very good execution throughout the team whether it was in manufacturing, in service. Generally, we have a large portion of our revenue in the third month of the quarter. That was true in December, but we effectively got everything out well before Christmas. So, we just had really good execution. We track a number of deals and ones that had some probability of not completing in time did complete in time. So, I would credit more to execution than any real pull in. I don't think we really saw any of that.

JoAnne Feeney - FTN Equity Capital

Okay. And then if you could perhaps help us out a little more on the semiconductor side with some details perhaps. Can you elaborate on where the orders that you are getting are coming from? Are these coming from the ODMs, or are they coming from foundries, logic or memory? Is this a minimal level of orders in your opinion at this point, are customers switching to lower cost systems or are they just not showing up at all?

Don Kania

I think the way to view the semiconductor is one by way of reminder, the number, the 22. whatever it was is net of the cancellations.

JoAnne Feeney - FTN Equity Capital

Right. So, it's 30.

Don Kania

Yeah. So the arrival of new orders was up on that. I think generally what we saw is tech buys, leading edge sort of next generation -- moving down the shrink curves in terms of acquisitions from the customer base. The leading edge names did some investing in the quarter. It's probably best way to look at it. There was a bit of data storage but it's a relatively small component throughout the quarter.

I think the thesis seems to be holding from our perspective. We got companies are continuing to invest in technology. We are seeing that investment and the variability from quarter-to-quarter will be dependent on who's buying in which quarters overall. But we think the range that we guided to, we said $20 million to $30 million per quarter is kind of the numbers we are looking at as the base level for technology purchases.

JoAnne Feeney - FTN Equity Capital

So, it sounds like then -- is that $20 million to $30 million in anticipation of there might be more cancellations or do you see, you know, sort of new orders possibly sinking as low as $20 million?

Don Kania

I think our view is you should look at the middle of that range as the number we are going to run at. This last quarter was 22 net of those cancellations, the flow was a little higher. So, do we expect more cancellations? I think the answer is no, and a relatively small part of our backlog has in fact rolled up in this segment right now, and we scrubbed it pretty hard this quarter, that's why we voluntarily canceled the one order.

We decided that that was not going to happen and so our perspective is we think we probably knock everything out we need to knock out of the backlog and we will continue down that road, we'll see fluctuations and orders. I know it's a relatively broad band but we will see the orders flow in that kind of range.

JoAnne Feeney - FTN Equity Capital

And do you see this perhaps as an opportunity for share gains or are your competitors sort of taking advantage of the downturn to steal some business by pricing lower? Has there been any interest in Magellan to-date.

Don Kania

I think the interest in Magellan has increased and we are trying to position ourselves as favorably as possible during the slow period to make sure that Magellan, when spending increases again, wins the business. So becoming the tool of record in a variety of places.

And we remain confident in our ability to maintain that position overall. So, I think we are doing the right things there and when you look at our other offerings, particularly, in the TEM area where we are showing superior cost of ownership and leadership technology together, we feel like we have the winning combination there. So this is a time for share again for FEI.

JoAnne Feeney - FTN Equity Capital

And on the pricing pressure, are you seeing more of that now?

Don Kania

In semi?

JoAnne Feeney - FTN Equity Capital

Yeah.

Don Kania

I would say no more than usual. I think, there's always pressure and there's always competition and they're always held against us in the court of law but generally I would say it is not unusual, unusually large than it was say six months ago. I think it is the same level.

JoAnne Feeney - FTN Equity Capital

Okay. That's all from me. Thanks.

Don Kania

Thank you, Joann.

Operator

Thank you. Our next question is from the line of David Wu with Global Crown Capital. Please go ahead.

David Wu - Global Crown Capital

Question really is on the restructuring, when would these restructuring expenses, basically be completed? Seems to me every quarter there is million or so of restructuring. And I also have a follow-up, which is, are we talking about outsourcing to Asia, of your Czech factory of the low end, I guess SEM equipment, approximately when do you think that we can anticipate such things happening?

Ray Link

Let me address the restructuring first. Unfortunately, the accounting rules, the old rule is that you can take a restructuring charge and expense it when you announce it. Now you pretty much announce the restructuring plan and the expenses are pretty much on a pay as you go basis. We do expect restructuring to trickle on for several more quarters pretty much at the levels we were in Q4 and projecting in Q1. It shouldn't be too significant, but it will be a few more quarters of restructuring.

David Wu - Global Crown Capital

How about the outsourcing part.

Don Kania

As you heard us talk about we completed the efforts here with the Hillsboro factory. We believe that the low end SEM activity is targeted for the latter part of this year.

David Wu - Global Crown Capital

When would do you think we will see it in the gross margins?

Don Kania

The restructuring benefits?

David Wu - Global Crown Capital

No, the outsourcing from SEM.

Don Kania

What we have described overall is as we get into the latter half of this year, predominantly the fourth quarter really you will start to see within the gross margins the effects of restructuring, and that is a whole variety of activities, we are not splitting out any individual activity, but in aggregate those benefits as we burn through inventory, as we garner the benefits of the outsourcing activities, those will flow through the P&L. So meaningful in the fourth quarter.

David Wu - Global Crown Capital

I was wondering, last question is on the coverage. Obviously, there are different times for deliveries on your backlog. How well covered does the second half look at this early point?

Ray Link

Clearly the bulk of our backlog covers the first six months, but we do have backlog flipping out even as late as Q1 of next year and approximately about 10% of the backlog goes out into Q1 of 2010.

David Wu - Global Crown Capital

I guess the majority, 60% or 70% will be in the first half.

Ray Link

We generally don't break that out but you can assume it is heavily weighted in the first half of the year.

David Wu - Global Crown Capital

Okay. Thanks.

Operator

Thank you. Our next question is from the line of Matt Petkun with Davidson & Co. Please go ahead.

Matt Petkun - Davidson & Co.

Hi. Good afternoon. Don could you be any more specific about maybe gross margin targets. For Q1 you are looking for 40% gross margin, if we were to assume similar mix and similar euro, by that time Ultra Clean will be in place and you should have higher margin products within the mix. I am just wondering what you hope to target in terms of a gross margin exiting the year if we are at similar levels, similar mix?

Don Kania

We are trying to be very careful right now in this environment about not talking about the second half of the year. So, Matt, what I am going to comment is twofold on this. One is we expect improvements and we targeted and articulated improvements in the past. I think a big part of any margin estimation has do with total revenue within the period. The biggest mover of margin is revenues. And so we are not going to at this point give that level of details of guidance on the second half other than just say that we will see the benefits of restructuring at that point, but you have to stay tuned as we develop our view of the second half and then we will talk more specifically about specifics of improvements in that part of the year.

Matt Petkun - Davidson & Co.

Okay. Fair enough. The other question is more of a housekeeping question, but just on the revaluation of the backlog, in your press release in early January, you said that you would be taking figures of 5% to 8% revaluation relative to gross bookings in Q1, but it was more like an 11% revaluation. I am just trying to understand why it was so much deeper than we had modeled.

Ray Link

Well, the gross bookings were greater than we said they were going to be, so the net should be about the same. First of all, we said 170, the gross is 181 but the difference primarily had to do with where we decided that one of our orders in backlog which kept getting pushed out and rescheduled was ultimately going be a cancellation, so we dropped that amount from our backlog, and that was the biggest single difference from it down 5% to 8% to the actual down of 11%.

Matt Petkun - Davidson & Co.

But the revaluation was the 20 million, and then you had 7.6 in the cancellations.

Ray Link

When we gave the guidance which I believe was on January 5th or thereabouts, at that point in time, we had not decided on the status of what should be dropped out of backlog from a cancellation.

Matt Petkun - Davidson & Co.

Okay. Fair enough. I guess I am just confused because the euro itself was down roughly 5% quarter-over-quarter, and it looks like you took a 5% hit to total backlog which at the end of the quarter which would imply that all of your orders were in euros.

Ray Link

A good chunk of the orders are in euros. We're not denying that, but it's the ending rate at the end of Q3 versus the ending rate at Q4.

Matt Petkun - Davidson & Co.

Okay. I think that's all from me. Thanks a lot.

Operator

Thank you. Our next question is from the line of John Harmon with Needham & Co. please go ahead.

John Harmon - Needham & Co

Hi, good afternoon.

Don Kania

Hey, John.

John Harmon - Needham & Co

Since your press release said that the transition to Ultra Clean would happen in the first quarter, sorry if you've addressed this, but should we see any impact to margins in the second quarter?

Don Kania

We won't start to see the effect of our restructuring activities until a little bit in 3 and a lot in 4. That's the Q3, Q4.

John Harmon - Needham & Co

The same kind of thing. Thank you.

Don Kania

Yeah. It's all in the same pattern. We try to keep it all together and keep it simple for you guys.

John Harmon - Needham & Co

The fourth calendar quarter ought to be the seasonally strongest quarter for life science instrumentation. Did you see cancellations there? Anything unusual happened for you?

Don Kania

Life sciences, no; nothing unusual, strong Krios order flows we described. We had an exceptional Q3 so the latter half of the year was quite strong for us in the segment. So, we feel pretty good about it. There was probably some euro adjustment on that too. I don't know that number off the top of my head. Big backlog reval, but I think the business remained strong and robust.

And the way I would think about the business right now if you want to take a bigger perspective is particularly with the Krios is we're at the phase now where we're getting the early adopters buying. We've seen good adoption in the US, Europe, and China and the pipeline remains amongst that group strong.

What we hope to see here in the near future now is the science start to flow more substantively and some of the first papers are starting to flow out. One was recently reported in Australia.

This will start to represent we believe, then, the tipping point for the next generation of buys to happen which could be significant, more significant than the early adopters and so that's something we are watching very carefully right now, we're in that interim stage. But please with the results to-date.

John Harmon - Needham & Co

Okay. Thank you. And finally, if I compare your Q1 guidance to what you reported in Q1 a year ago, low revenues or earnings per share, on the margin, is there anything different? I mean clearly semiconductor equipment has deteriorated. Is there anything really different on the margin front or any…

Don Kania

I think that you hit the nail and then the big nail there is that I would guess in that quarter, if I remember, right. It was 30 some percent of semi.

Ray Link

Yeah. We had $56 million in revenue in electronics in Q1 '07 which will be substantially higher than what we have in Q1 of -- excuse me -- Q1 of '08. I am sorry. $46 million in Q1 '08 in electronics and that's still substantially higher we're going to have this quarter.

John Harmon - Needham & Co

Okay. Thank you very much.

Don Kania

Thanks.

Operator

Thank you. Our next question is from the line of David Duley with [Soleil Securities]. Please go ahead.

David Duley

Good afternoon.

Don Kania

Hey, David. I love the name.

David Duley

Thank you. I got a couple of just kind of housecleaning questions and all because that's some kind of 30,000-foot question. First of all, have you booked any Titan Krios for revenue yet?

Don Kania

The answer is yes.

David Duley

Okay. And I guess my impression would be that's a fairly new product, a lot of these ones that you have put out in the field, is it fair to assume a lot of the revenue from those units is still to come or did you get them accepted really quickly?

Don Kania

David, our policy is that when we ship a product, it's revenue ready.

David Duley

Okay. What are the two most important variables? I have asked this question before, to gross margins going forward? And as a follow on to that have you ever improved gross margins as a percentage when revenue has gone down?

Don Kania

Well, the most - revenue is Rob obviously the biggest driver of gross margin. That's the easiest way to move the needle. And then I would say that the number two there, becoming less important is electronics mix was down and certainly the mix of products. So, I would say today it's probably the mix of new versus old products what dominates us more than mix of electronics versus non-electronics. The newer products having higher margin than our older products. So those are the two things to watch.

Ray Link

We did improve gross margin from 38.1% to 40%, Q3 versus Q2 of '08 and revenue dropped from Q2 to Q3 by $13 million. That was really driven by pretty good performance in our Service business and a pretty good overall mix of products and we also had some benefits from currency. It is really, as Don said, revenue is a huge driver obviously, especially as we have incrementally more revenue in products than service which has higher margins. Mix, the more high end products whether it is Titans or our wafer DualBeams or DualBeam products that help us and currency.

David Duley

Okay. The 30,000 foot macro question is, if you listen to a lot of your brethren in the semiconductor equipment industry they're all on their second or third restructuring programs. You mentioned how you start at it. Restructuring program nine months ago, you start the CDM pack about new, well the lambs of the world are into the second or third, because their business has gone down so much. I am just wondering what makes you think that semi business isn't going to leg down from this $20 million or $25 million level of revenue that it is at now? I guess that would be the key question.

Don Kania

I think there are really two sides to that. Number one is, we have looked at the world and they will fluctuate quarter to quarter, so any one quarter may be off that number, but if you look at the average and what people have told us they need to spend and we look at our view of what they need to spend, the numbers hold together.

The other side of the coin is, FEI as a whole now is much more resilient, because I think the tremendous opportunity we have in Life Sciences, the continued growth of Research gives us an opportunity to offset that anyways. In fact, if you look at '08 by way of example, it is precisely what happened during the year, our electronics business eroded during the year as the marketplace eroded, yet Research and Life Sciences made up the gap and thus orders grew on the year, revenues grew year-on-year. So that formula is a positive one for us and it works.

David Duley

If we do see the semi business take another leg down like I guess other people in this industry are certainly forecasting that for their businesses I mean, do you have restructuring plans in place to address that outcome, because I seem to remember that even though it is a small percentage of revenue it is still the highest margin product and moves the needle around a lot.

Don Kania

I think in the last quarter this set the stage here. The Electronics portion of our business was 20%. So, we can focus on this area, but I think that the story of FEI is elsewhere. And what we have done to internally address the issue of more difficult business environment of Electronics is we have rotated resources to those areas where the opportunities are much more robust, to Life Sciences and to our Research areas. So we have consciously done that. It is not obvious to you on the outside, because the R&D line looks the same and marketing looks the same, but what in fact has happened is we have shifted those resources out, though we still continue to invest in this area, not in the same proportion that we have in the past.

David Duley

I think something should be noted here is, congratulations on a good margin number with your semi business probably and its lowest levels in a long time.

Don Kania

Well thank you, I appreciate that. Lowest it has been, at least the memory that we have around this table.

David Duley

Nice quarter and look forward to talking to you soon.

Don Kania

Thank you, Dave.

Operator

Thank you. Our next question is from the line of Bill Dezellem with Tieton Capital Management. Please go ahead.

Bill Dezellem - Tieton Capital Management

Thank you. A group of questions and lets start with Europe, if we could please. I don't think on the call anywhere you have really addressed what caused the strength in your results in the European continent. Would you please discuss that first of all?

Don Kania

Sure. Europe particularly in this period is investing in core TEM technology. So we saw robust results from let's just call it old Europe in terms of investment into that area. So some of the strength we saw in the Research bookings was due to investments in Europe.

I think the other piece we just need to highlight is in terms of our reporting, that much of the independent channel as we describe it flows through Europe as well. So, some upticks in places like India and other areas would flow through that line as well. But primarily it was investment in cutting edge TEM technology in old Europe that drove the growth. Also in Life Sciences there was some strength there as well.

Bill Dezellem - Tieton Capital Management

And would you view that investment in the TEM arena as something that will be recurring going forward or has the demand really been satisfied, I will call it the higher level of demand when we move back to a more typical European run rate?

Don Kania

I think regionally, if you look at the prospects for the six-month period that we like to talk about, I think it remains robust. As we highlighted in the talk, several countries are using their stimulus to invest in areas that we overlap with significantly. Europe has been a traditional user of our technology, sees it as central, Germany is a great example, sees it as central to economic strength. And so, I don't think we are done. I don't think we've saturated the marketplace. In fact, in some areas, I think we're still a little bit early. So, we feel good about Europe.

Bill Dezellem - Tieton Capital Management

And then there's been a fair amount of discussion about the restructuring on the call. One thing that has not come up is I believe you had originally been sharing with investors that you are looking for up to $10 million of restructuring charges in the second half of 2008. The actual number I think was somewhere closer to a couple of million. Would you please highlight what created that difference in your original thinking versus the actual outcome?

Ray Link

Part of it has to do with less severance; it's one of the bigger drivers in that.

Bill Dezellem - Tieton Capital Management

And so you're looking at, call it $6 million to $8 million less of severance than originally planned?

Ray Link

We have planned and did a few things differently and we opted not to. And there are some, when we have planned we thought there were some fairly significant severance costs had we done some things in Europe that we did not do.

Bill Dezellem - Tieton Capital Management

So, and those decisions have been made to not to do those. It's not a delayed factor. It's just simply because of the currency started to work a little bit more in your favor?

Ray Link

What we said earlier on the call was we expect the restructuring line item to be somewhere around the million dollars for a few more quarters.

Bill Dezellem - Tieton Capital Management

Right, thank you. Let's shift, if we can please, then into Ultra Tech. Are you expecting to see an increase in gross margin, all other things being equal as a result of Ultra Tech coming partnering with you or are there different benefits that you're expecting?

Don Kania

What we don't want to do is split out activities. I think we should see the Ultra Clean move as a positive move in FEI moving forward to reduce its cost structure, have more variable footprint, and garner savings.

We are not going to go through the details of what the benefit of each of the steps that we have taken, that we haven't talked a lot in detail. But we want to give all of you the message that we are making progress down this road and this is obviously one very visible activity that we are working with. So, we are going to go back to it.

In aggregate, you will start to see some benefit in the third quarter; the majority of the restructuring benefits show up in the fourth quarter of this year.

Bill Dezellem - Tieton Capital Management

Thank you. And then maybe a little easier question to dial into. I think that Don in your opening remarks, you made reference to the fact that you're planning on developing additional verticals. Would you please provide additional perspective around that thought, please?

Don Kania

Yeah. Well, the easiest one right now that we are building upon is our, let's call mining and minerals are with intellection acquisition. Those of you remember the story, we primarily focused on precious metals mining in the initial foray with JK Tech.

What intellection brings is base metals as well as oil and gas opportunities and so it expands that base significantly, and so over time we think the combination allows us a big footprint in a very, very important marketplace. That's one that I would say I hate to call it mature but our thought processes are maturing. We have an understanding of the markets. We have hired people from the industry; we got a good feeling of where we need to go and what we need to do.

I think behind that we have several, one of which is would be fiber and fiber measurements. More and more in the area of whether it is making filters or making materials that are fiber bases, the understanding the nano level structure of those fibers in a process control manner is critical to success and so we are starting to see opportunities there as well.

So, those are some examples of industrial opportunities where you have process control, return on investment that mimic the electronics business but not in scale at this time.

Bill Dezellem - Tieton Capital Management

And are you feeling like these additional verticals that at this point you are still, the thought process is still immature but are you thinking there is a large number of these with big opportunity or do you feel as though the opportunities are reasonably limited as you point out mining being one of them?

Don Kania

I think there a meaningful number of them where we can grow substantial business around over time.

Bill Dezellem - Tieton Capital Management

Great. Thank you again.

Operator

Thank you. Our next question is from the line of John Roy with Janney Montgomery Scott. Please go ahead.

John Roy - Janney Montgomery Scott

Thanks. Actually, my question has been answered. I was curious about some color on the life sciences business. Thanks much, guys.

Don Kania

Sure.

Ray Link

Thank you.

Operator

Thank you. Our next question is from the line of Hari Chandra with Deutsche Bank. Please go ahead.

Hari Chandra - Deutsche Bank Securities

Thank you. Are you contemplating any share repurchases?

Ray Link

Not at this point in time. I think there's better use of the capital.

Hari Chandra - Deutsche Bank Securities

And on the operating expenses, is $50 million run rate good for '09 in terms on a quarterly basis or how low can it trend down?

Don Kania

Well, we're only giving guidance one quarter out. So what we gave was under $50 million excluding the restructuring.

Hari Chandra - Deutsche Bank Securities

And not to beat the dead horse here on the gross margin, but is there a way for you to quantify the gross margin benefit that you can capture from restructuring and outsourcing at the current quarterly run rate?

Don Kania

We are not going to go into that detail here.

Hari Chandra - Deutsche Bank Securities

All right. Thank you.

Operator

Thank you. Our next question is from the line of Brett Hodess with Merrill Lynch. Please go ahead.

Brett Hodess - Merrill Lynch

I know you guys don't want to give too much color on margins, but I'm just wondering as you enter new verticals like, mining, life science, and fiber or what not, do you expect when you initially entered that, you have a lower margin because you are developing applications or you are customizing equipment for it, and then over time the margin rises in it as you sell more volume of it? Or is it more of a case when you move into those new verticals that because you are doing something so specialized you get a better margin to start? Can you talk about that a little bit at least?

Don Kania

Sure. We can talk about that. I think it has been a learning experience for us. So, I don't think we got the full margin benefit of our early forays into mining, because we were too timid with respect to pricing based on return on investment. So we are learning that model. But ultimately, what we are seeing is the ability to offer significant software content along with hardware, affords one the possibility to have very nice margins in selling into these industrial verticals.

So, the microscopes that we are selling and microscopes we build for a long time with minor modifications, it is really the software around that which as you know can be extremely high margin, highly differentiates you and the marketplace, one, and two allows you to garner greater profits from the business.

Brett Hodess - Merrill Lynch

Okay. Thank you.

Operator

Thank you. Our next question is a follow up from the line of JoAnne Feeney with FTN Equity Capital. Please go ahead.

JoAnne Feeney - FTN Equity Capital

Hi. Thanks. More on the gross margin. I notice that in your guidance you're obviously guiding for a down quarter in revenues, but you are guiding slightly up in gross margin and you are using the same exchange rate in your guidance as you did for the fourth quarter. So could you help us understand why you have confidence that you can maintain that gross margin quarter to quarter, even in the face of declining revenues.

Don Kania

I will let Ray add as we go along. A couple of things. One is the mix of new products is robust in the first quarter, certain deals that were favorably closed and if you remember and if you go back historically we have seen challenges in earlier quarters because of deals that were closed at higher dollar to euro rates, eroded over time as they sat in backlog and now we are seeing the opposite effect, as well as just better pricing. So that's one aspect that we have certainly identified within the quarter. I will turn it over to Ray for the other aspects.

Ray Link

Basically, when we look at what we are shipping, we are shipping a better mix of higher end TEMs. We obviously had a very good quarter in Q4, but we had a large number of more mid-range products that were shipped during the quarter.

Just to comment on the guidance, we said it would be around 40%. I don't know if I would read that as being regarding margins up. It could be 0.5% in movement that can take place on one deal or a few penny movements in the euro.

JoAnne Feeney - FTN Equity Capital

That's helpful. And should we then infer that the gross margins within your Research & Industry group are fundamentally moving up?

Ray Link

I would categorize it as Research & Industry and Life Sciences - all of those are moving up.

JoAnne Feeney - FTN Equity Capital

And you mentioned this new TEM that you are seeing some traction with or an improvement over the old. Does that also bring on higher margins?

Ray Link

That's really what I was referring to. We're shipping more Titan Krios versus mid range products.

Don Kania

I think you are referring to the, we've talked a little bit about upgrades of the Titan itself.

JoAnne Feeney - FTN Equity Capital

Yes, that was a comment I was picking up.

Don Kania

That answer is that is true, that's a higher margin improved version of Titan. Just like to keep our competitors on their toes, keep moving the target for them.

JoAnne Feeney - FTN Equity Capital

Great. That's helpful. Thank you.

Operator

Thank you. (Operator Instructions). And gentlemen, we have no further questions at this time. I will turn it back to you for any closing remark.

Don Kania

We would like to certainly thank everyone who dialed in. We appreciate it very, very much and also it is a pleasure to thank all of our employees for doing a great job in the fourth quarter and we look forward to a prosperous 2009 in a difficult environment. So, thank you all very, very much.

Operator

Thank you, sir. Ladies and gentlemen, if you would like to listen to a replay of today's conference, please dial 1-800-405-2236 or 303-590-3000. You can do so by using the access code of 11125543 followed by the pound key. That does conclude the FEI fourth quarter earnings conference call. Thank you very much for your participation. You may now disconnect.

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