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Electro Scientific Industries, Inc. (NASDAQ:ESIO)

F3Q09 Earnings Call

January 29, 2009 5:00 pm ET

Executives

Brian Smith – Director, Investor Relations

Nick Konidaris – Chief Executive Officer

Paul Oldham – Chief Financial Officer

Analysts

Ben [McFadden]

David [Nurenberg]

Larry Lytton – Second Line Capital Management

Operator

Good day, ladies and gentlemen, and welcome to the ESI fiscal 2009 Q3 earnings release conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Brian Smith, Director of Investor Relations. Please proceed, sir.

Brian Smith

Good afternoon, everyone. My name is Brian Smith, Director of Investor Relation for ESI. With me today are Nick Konidaris, our CEO, and Paul Oldham, our Chief Financial Officer. This conference will cover our fiscal 2009 third quarter results. Before we go into the details of the call, I would like to remind you that some of what we say on this call will include forward-looking statements concerning customer orders, shipments, revenue, gross margins, expenses, and earnings.

These statements are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include a number of risks and uncertainties that are discussed in more detail in today's press release and our filings with the SEC. Actual results may differ materially from those forwardlooking statements. This call also contains timesensitive information that we believe to be accurate as of today, January 29, 2009, and which could change in the future. This call is the property of ESI. Now, I'd like to turn the call over to our CEO, Nick Konidaris.

Nick Konidaris

Thank you, Brian, and good afternoon everyone. Our third quarter was challenging with the global recession weighing heavily on our orders, revenues, and profits. On the bright side, we continued to maintain our strong share position, stayed disciplined in our spending, and managed working capital well. Those actions helped us mitigate the impact of lower revenues and generate almost $9 million of operating cash.

Looking forward, because of the uncertainty of the current economic environment, we continue to take actions to reduce our cost structure and to lower our operating break-even point. At the same time, we're making the critical investments to drive growth in laserbased microengineering when market conditions improve. Although it is difficult to predict the timing, our experience has taught us that when conditions do improve, the turnaround would likely be very sudden and very profitable for ESI. For the third quarter, sales were $26 million and loss per share was $0.21 on a nonGAAP basis. Paul will provide more details on the financials in a moment.

Broadly speaking, the global economic weakness has severely impacted the activity in most of our markets. In addition to the impact of weak memory prices and the financial crisis, consumer demand, the engine of semiconductor growth, has weakened for those products that will help our customers bring to market, including PCs, high definition TVs, smart phones, and MP3 players. The weak consumer product market is further reducing the capacity requirements of our customers, constraining their profitability and their capital spending.

As a result, orders in our semiconductor segment were down, both sequentially and yearoveryear, with virtually no activity from our memory customers. A continuing bright spot is our LED wafer scribing business. In fact, our New Wave Research Division had strong orders and revenues, very near last quarter's record level. In both LED scribing and flat panel repair, new products allowed us to penetrate several new customers this quarter.

In laser singulation, we removed from our backlog the order we had received two quarters ago for our sigma system. We continue to work constructively with our customer to tailor our sigma system to work on a very demanding and cutting edge application. Laser singulation presents a large opportunity in the future. We remain committed to this market and continue to invest to broaden our product offering and strengthen our IT position.

Looking forward, forecasts for memory chip capital spending in 2009 are expected to be half of 2008 levels. Although our expectation is that recovery in capital spending would not occur until late 2009 at the earliest, we see modest potential investment in this calendar year for new technology.

We are well positioned in this market with recently introduced memory repair investments and continue to invest in next generation technology to help our customers make [grade] to 65 nanometer and below nodes. On the other hand, our LED scribing business, while it will be affected by the economic downturn, should remain relatively stable.

Turning to the interconnect and micromachining group, orders were down sequentially. Our flex interconnect business was stable, but demand was slow for our general-purpose micromachining systems. Our key customers for these systems are between projects, but we look forward to seeing good orders again later this year. We believe we continue to gain share and add applications. Looking forward, orders in this segment will continue to be lumpy driven by customer specific applications.

In our passive components group, demand for our electrical and optical test systems hit bottom with no systems booked during the quarter. We did see orders for tooling and other consumables, which should continue through the cycle.

Market research indicates that capacity utilization fell during the quarter to under 70%. As a result, we project that expansion in this market will not resume until late in calendar 2009, with the timing of recovery in line with the return to growth of consumer spending in general. On the bright side, we feel very good about our product portfolio and see opportunities to grow share and expand our addressable market using our core capabilities. This should allow us to continue penetrating new customers and return to growth when this market revives.

Turning now to the overall outlook for ESI. Although visibility is very limited, we expect business activity to remain around current levels during the next quarter, as economic uncertainty and cautious capital spending continue to delay investments. In response to this environment, we took actions this week to reduce our head count by 12% and have implemented several temporary measures including executive pay reductions, suspension of the company's 401K match, employee furloughs, and planned shutdowns.

Although difficult, we believe these actions will allow us to largely preserve the strategic investments necessary to position us for growth and profitability when market conditions improve.

Before I turn it over to Paul for the financials, let me give you an update on our proposed merger with Zygo Corporation. On January 14, 2009, ESI received from Zygo a proposal to increase the merger consideration by $4 cost per share and to increase from three to four the number of ESI board seats held by Zygo designees. On January 20, ESI conveyed to Zygo its rejection of the proposal. The Zygo board subsequently notified ESI that it was withdrawing its consideration in favor of the proposed merger.

We are very disappointed with this decision and do not agree with the Zygo board's conclusion. In our view, the strategic rationale for this merger remains in tact, and the structure of the transaction reflects the longterm relative value of the two companies. We're considering our alternatives under the merger agreement, which include terminating the agreement and demanding the breakup fee of $6.6 million as provided in the contract.

We'll keep you informed of our decisions in this matter. Regardless of the outcome, we intend to pursue our growth strategy of expanding to adjacent markets and applications. Now, I will turn the call over to Paul for a detailed discussion of our results for the third quarter.

Paul Oldham

The following information includes results from our third quarter fiscal 2009, which ended December 27, 2008. To improve comparability, we are also providing earnings per share and related income statement results on a nonGAAP basis, excluding the impact of purchase accounting, equity compensation, restructuring expenses, and nonrecurring items.

Orders for new business in the third quarter were $21.2 million, down 37% from the prior quarter. Orders in all three businesses declined sequentially and yearoveryear, affected by the global financial and economic environment. Shipments in Q3 were $26.6 million, down sequentially from $48 million in the prior quarter. Ending backlog was $18 million, down over $10 million from last quarter.

About half of the decline was due to shipments exceeding orders for new business. The other half is due to our decision to remove about $5 million of backlog from our books. Most of this backlog was removed because customers deferred shipment dates, with the exception of the cancellation of the sigma system order that Nick mentioned earlier.

Deferred revenue was up slightly, consistent with historical levels. Revenue for the third quarter was $25.6 million, down 48% from the second quarter. All three businesses showed sequential declines with the semiconductor and passive component businesses heavily affected by the economic environment and the virtual freeze in capital spending in these markets.

Interconnected micromachining was also down sequentially due to slowing activity as well as the shipment of a large order last quarter, which did not repeat. On a GAAP basis, the third quarter net loss was $29.3 million or $1.08 per share. The GAAP net loss included onetime noncash charges of approximately $24 million, including $17.4 million for good will impairment related to the reduction in the company's stock price, $2 million for additional write down in the value of our auction rate securities, and $4.5 million for a valuation allowance against deferred tax assets related to the ARS writedowns.

Excluding the impact of these charges, purchase accounting, equity compensation, and restructuring costs, non-GAAP net loss was $5.8 million or $0.21 per share, down from net income of $1.3 million or $0.05 per diluted share in the prior quarter, but slightly better than the range we preannounced last week.

Gross margin for the third quarter was 29%, including $460,000 in purchase accounting and equity compensation reflected in cost of goods sold. On a nonGAAP basis, margins were 31% down from 43% last quarter on lower revenues. Included in gross margins was approximately $1 million in additional inventory reserves as a result of the deteriorating economic environment and excess service inventory, as customers decommissioned older machines.

Operating expenses of $37.5 million included the $17.4 million good will impairment charge mentioned earlier and roughly $900,000 purchase accounting amortization and equity compensation.

Excluding the impact of these items, nonGAAP operating expenses were $19.1 million, nearly $2 million below the prior quarter, reflecting lower labor costs and discretionary spending. As a direct result of our cost reduction actions, our nonGAAP operating expenses in Q3 were almost $7 million lower than the same quarter last year.

As Nick mentioned, we are taking several actions to further reduce our cost structure, including a 12% reduction in head count and several temporary measures. We expect these actions to result in additional reduction in operating expenses on a nonGAAP basis of roughly $2 million in the fourth quarter.

Third quarter interest and other income was approximately $1 million, roughly consistent with last quarter. Both quarters benefited from a foreign exchange gain that we do not expect to repeat going forward. Although we expect cash levels to be roughly flat, we also expect yields on our cash to be lower next quarter as interest rates have dropped significantly over the last two months. In addition, during this quarter, we recognized a further impairment of our auction rate securities of $2 million driven by the continued deterioration in the financial and credit markets.

This reduces the carrying value of these securities to approximately $7 million. During the quarter, two of these securities converted to preferred stock under the terms of the instrument and will now pay a dividend instead of interest. We continue to receive interest on the balance of these securities and continue to have the ability to hold them for an indefinite amount of time.

Income tax for the quarter was a benefit of only $1.8 million, largely due to the $4.5 million impairment of deferred tax assets mentioned earlier and the nondeductibility of the good will impairment charge. On a nonGAAP basis, the tax benefit was $4.5 million or 44% reflecting the reenactment of the R&D tax credit and consistent with our expectations.

Turning now to the balance sheet. Cash and investments were $166 million, up $4.5 million from the prior quarter. This balance includes $159 million in cash and liquid investments and the net $7 million in auction rate securities. Operating cash flow totaled $8.9 million for the third quarter, as losses from operations were more than offset by improvements in working capital.

Inventories were down by about $2 million in the quarter, as ongoing reduction efforts were partially offset by lower demand. We continue to manage inventories closely and expect our inventory balance to continue to decline over the next few quarters. Inventory turns were 0.8 times on lower revenues.

Accounts receivable decreased by $25 million and days sales outstanding decreased by 6 days to 85 days, reflecting strong collections and disciplined accounts receivable management. Capital expenditures were $.5 million, down significantly from prior quarters. During the quarter, we did not repurchase any stock.

Looking forward, visibility continues to be very limited, making it difficult to provide reliable guidance. However, given the economic environment and cautious capital spending, we expect business to continue around current levels. We are targeting shipments in revenue in the fourth quarter of approximately $20 million to $25 million and a nonGAAP loss excluding stock compensation, purchase accounting, restructuring, and other nonrecurring items of between $0.20 and $0.30 per share.

In addition, we expect to recognize restructuring costs of approximately $2.5 million related to our cost actions and transaction costs of approximately $2 million related to the Zygo merger. Now I will turn the call back to Nick for a brief summary.

Nick Konidaris

To summarize, we are in the midst of an extraordinarily difficult market and economic environment. However, I believe that so far ESI has weathered this economic crisis well. We have a strong market position, have significantly reduced our cost structure, and have increased our cash balance. Looking forward, we will work to increase efficiencies, manage our cost structure, and focus on investments for new technologies and applications to expand our addressable markets.

We believe we have the financial strength to endure this cycle and make critical investments necessary for growth when market conditions improve. In our experience, this improvement can come rapidly and result in significant leverage in our business. This concludes our prepared remarks. We are ready for your questions.

QuestionandAnswer Session

Operator

(Operator Instructions) Our first questions comes from Ben [McFadden], please proceed.

Ben [McFadden]

Quick question. In your disclosures, you talk regarding the Zygo transaction, considering your options in terminating and going after the break fee. I was also wondering what your thoughts are on just letting this go to a vote. The way things are trading, it’s still a fairly sizable discount for Zygo shares from the merger consideration. I was wondering what your thoughts were on pursuing that route versus trying to terminate it pre-vote.

Nick Konidaris

It is one of the alternatives that we have in mind. We are considering that, along with the other alternatives we mentioned.

Ben [McFadden]

Also, financially, what are the implications under the agreement of pursuing those two different routes?

Nick Konidaris

If we pursue the termination of the agreement, we're going to demand the breakup fee. If we pursue the going to a vote by the investors, it's something, by the way, that we would support if there would be a cooperative effort on both parts to go to a vote because we would not be interested for a hostile takeover. The financial implication would be that if the shareholders of Zygo were to turn down the proposed merger, then the breakup fee in that case I think would be $2 million plus expenses, and that is [inaudible].

If of course, they were to approve, there would be no financial implication. In that case, as we stated, we believe that merger makes sense. The relative valuation between the two companies continues, in our opinion, to be the case in the long term. I think we're going to be as a result of this potential merger, would have a stronger company with bigger scale, bigger size, more cash, and tremendous opportunity in terms of synergies in the top line and bottom line to grow and benefit the shareholders of the combined company.

Operator

Our next questions comes from the line of David [Nurenberg] please proceed.

David [Nurenberg]

First, I just wanted to express our agreement with you and the board not paying an additional $4 a share for another company that is probably going through the same kind of nuclear winter that we are. That just doesn't seem to make sense. As you know, we are supportive for the strategic logic of the combination and wish you the best of luck if you can succeed in putting it back together without being held up for more money.

Nick Konidaris

That's our strategy.

David [Nurenberg]

Second, just wanted to commend you and Paul and all of your colleagues at the company as you labor through this incredibly challenging time for all that you have been doing to preserve the financial and organizational strength of the company. You have managed, I think, to do an excellent job of cutting your costs and generating cash. Frankly, I am positively surprised that the operating losses are as modest as you have been able to work them down to be and that you were able to generate nearly $9 million of operating cash flow. I am very pleased with how you are holding things together during this hard time.

Operator

Our next question comes from the line of Larry Lytton with Second Line Capital Management. Please proceed.

Larry Lytton – Second Line Capital Management

I had a comment, then a question. First of all, I want to underscore my own view with respect to the prior comment. I think the strategic rationale of the Zygo merger was clear and remains clear, but, if anything, I think the terms that were previously offered were more than fair. I think Zygo’s response is borderline absurd. I would emphasize that I don't think there's any reason to pay them any more than what was offered.

My question is do the terms of the agreement actually, or the fact the agreement is still open, preclude the company from repurchasing shares in the market and, if not, given we’re trading around cash value, what's the current feeling about share buybacks?

Nick Konidaris

The safe harbor regulations from SEC really don't make it practically feasible to do share buybacks while you are looking to really increase the count of shares at the same time. So, as a result of that, we did not have any share buyback last quarter.

Larry Lytton – Second Line Capital Management

In terms of what you said in your comment, are you saying that in spite of the fact that the Zygo board is no longer recommending the merger, it's conceivable that they'd be willing to let it go to a shareholder vote, even without their recommendation and that's a possible course?

Nick Konidaris

I am not speaking for the Zygo board. If there was a way to go to a vote, because the agreement obligates us to go to a vote, if there's a way to go to a vote that is a cooperative way, and emphasize this. We would be supportive of going to a vote because of all the rationales remain in tact and the benefits to both companies by combining forces. If we cannot find a way to go for a vote on cooperative way, then that's a different reality than the one that would compel us to go to a vote.

Operator

We have no further questions in queue. You may proceed, sir.

Nick Konidaris

To reiterate, the economic downturn has dampened capital spending in our markets. Despite the market challenges, we’re executing on our strategy to expand into new markets and applications which should enable the company to emerge from this period positioned for growth.

With respect to the Zygo merger, we are working to decide on the best course of action for our company and our shareholders. In the near term, our focus on creating a lean operating model would allow us to maximize returns at this historically low revenue level and allow faster earnings growth as market conditions improve.

Thank you very much for joining us. You are welcome to call Paul, Brian, or me if you have further questions. This concludes our call. Thanks for your interest in ESI.

Operator

Thank you for your participation in today's conference. This concludes the presentation, you may now disconnect. Have a good day.

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Source: Electro Scientific Industries, Inc. F3Q09 (Quarter End 12/27/08) Earnings Call Transcript

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