Merix Corporation F3Q09 (Qtr End 02/28/09) Earnings Call Transcript

Merix Corporation (MERX)

F3Q09 Earnings Call

April 8, 2009 5:00 pm ET

Executives

Michael Burger – President, Chief Executive Officer

Kelly Lang – Chief Financial Officer

Tom Ingham - Executive President Global Marketing and Sales

Analysts

Joe Wittine – Longbow Research

Matthew Sheerin – Thomas Weisel Partners

Ryan Jones – RBC

[Nick Farwell – The Arbor Group]

[Amitad Passu – UBS]

Presentation

Operator

Welcome to Merix Corporation's third quarter 2009 earnings conference call. Today's call is being recorded. Comments made during the course of this call that states the company's or management's intentions, goals, beliefs, plans, projections, expectations or predictions are forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. Many factors could cause actual results to differ materially from the forward-looking statements including the factors discussed in the press release announcing our results, the company's annual report on Form 10-K for the year ended May 31, 2008 and Form 10-Q for the quarter ended November 29, 2008 that are on file with the SEC and those discussed from time to time in the company's other SEC filings.

I will not turn the call over to Mr. Michael Burger, President and Chief Executive Officer of Merix Corporation.

Michael Burger

Good afternoon everybody. Joining me on the call today are Kelly Lang, our Chief Financial Officer, Tom Ingham, Executive President Global Marketing and Sales and Allan Muhich, Vice President of Finance.

Earlier today we announced results for our third quarter fiscal 2009 and despite a very difficult global economy which we all are talking about, Merix was able to maintain share in key markets, continue to improve upon our operational performance and improve our cash and liquidity position.

Third quarter 2009 revenues was $60.7 million or within the range expected as we began the quarter and represented a decline from approximately 21% from the second quarter of this fiscal year.

Demand continues to be affected by the global recession, particularly in our automotive market segment which was down about 34% from the previous quarter. Also affecting third quarter demand was extended customer shut downs during the Christmas and New Years holidays as well as an extended Chinese New Year of which one week fell within the third quarter. The second week will be included in our fourth quarter.

Although we're disappointed with the overall market conditions, we believe we continue to maintain market share. We also recently benefited from Chinese 3G build out as well as the new U.S. Administration's clean energy initiatives.

This new business was won primarily due to a combination of our reputation as a high quality provider and to our value proposition as we won initial quick turn orders in the United States that eventually transitioned to high volume orders in our lower cost China based factories.

Included in this quarter's results were $20.5 million non cash good will impairment charge associated with our 2005 Asia acquisition and a $1.8 million charge associated with further business restructuring actions we undertook in the third quarter.

Most of this restructuring cost was associated with severance benefits paid on actions that occurred late in the third quarter and I should note that had we taken these actions at the beginning of the quarter, our net loss would have been reduced by approximately $2.5 million.

We anticipate seeing the full benefit of these actions in the fourth quarter.

The restructuring actions have been delivered and we've been mindful of the impact that these changes have had on customers, employees, product quality, factory performance and cash flow. I am very pleased by how our employees have responded to challenges at hand. I am especially pleased by our factory and our customer metrics as they are as good as they've been in recent memory.

Further, a number of our major customers have recently completed standard periodic reviews of our factories and our operational performance scores are excellent.

For a liquidity standpoint, we ended the quarter with $19.1 million cash, a $7.6 million increase from Q2. Further, our borrowings remain relatively unchanged from the second quarter, allowing us to reduce our net debt by $6.6 million in the third quarter.

I'll now pass the call over to Kelly who will comment on our Q3 results. I'll then make a few additional comments and open up the call for questions.

Kelly Lang

Good afternoon everyone. As our press release indicated, third quarter revenues amounted to $60.7 million, down 21% from the second quarter which was due to a combination of extended holiday shut down and the slow down in the global economy. In reviewing the major market segments, we saw declines in all the market segments during the quarter. The greatest decline was experienced in our automotive segment where global sales have been slowed significantly.

We also saw a modest slow down in defense and aerospace due primarily to the holiday shut down and inventory adjustments in the channel. We anticipate that this will reverse itself in the fourth quarter due to normal market conditions as well as the fact that we're seeing further increases in the number of new customers and orders in this key market segment.

It is important to note that many of these gains in the military segment were due in part to both Merix's technology and quality reputation and our ongoing strategic focus on this segment. We expect further gains in this segment now that both our North American factories have the key 31032 military certification. These certifications were achieved during the last six months with Forest Grove receiving its certification in late January.

In reviewing recent ITT data North American ITT production revenue, we've now seen 10 sequential months in negative book to bill that implies a demand reduction of somewhere between 30% and 40%. During the same time period, Merix's revenues declined roughly 30% which would indicated that we are in fact holding share.

Merix's consolidated third quarter book to bill was .85. In North America our quarterly book to bill is .91 and Asia was .80. Excluding the holiday periods, our order rates in North America remained relatively flat over the last six to nine months.

Asian demand however has been softer and more difficult to determine giving orders in this region tends to be larger and less frequent than North America. However, recent booking trends show that Asia's demand is bottoming.

Our gross margin declined to 1.4% in the third quarter. North American gross margins were negative 8.3% and were affected mostly due to the lower revenues and lower equalization rate. As Mike mentioned earlier, the timing of the cost reductions came late in the quarter and had minimal affect on third quarter results.

Assuming the actions had occurred at the beginning of the quarter, we estimate North America would have achieved a modestly positive gross margin for the quarter.

Asia's gross margins were down slightly from the second quarter at 10.2% of sales. This region was affected by lower equalization rates and holiday shut down but we were able to mitigate much of the slow down with temporary shut down and employee attrition. Additionally, Asia's margins for third quarter were aided by further improvements in our product quality which has been reducing our warranty costs.

Operating expenses were relatively unchanged from the second fiscal quarter at $9.4 million. However many of you will probably recall that in the second quarter, expenses benefited from the reversal of a couple of accruals including management bonuses. Also affecting this quarter's comparability with a net $300,000 increase of our bad debt accruals to reflect the change in the underlying receivables due to the slowing economy.

Excluding these changes in accruals, the underlying spending level was down by a little over $1 million from Q2 to Q3.

As expected, our capital expenditures continue to decline to $3.3 million which is down from $9.4 million and $5.4 million in the fiscal first and second quarters respectively. This decline was expected given the completion of our HY technology and capacity expansion and the European limitation in fall of 2008.

The investments we've made in our factories over the last couple of years are paying off as the factories and equipment are in excellent shape and we have leading edge technology thus requiring little spending. Q4's capital spending will be roughly $1 million.

The total debt outstanding at the end of the quarter was $78 million which is comprised of $70 million bond due in May 2013 and $8 million under the Bank of America revolver, up $1 million from the second quarter. As Mike mentioned our cash is up to $19.1 million at the end of the quarter. It's the highest level we have seen in the last 15 months.

I'll now turn it back over to Mike to make some closing comments.

Michael Burger

As I mentioned during our last conference call, we find ourselves very frustrated by the economic environment. Our factories and our employees are performing well and our customers continue to value Merix's technology, customer service and quality.

As Kelly mentioned, our booking rates appear to have stabilized in North America. Although more difficult to predict, Asia demands trends seem to have stabilized. In addition to what Merix is experiencing, we also understand that our competitors are reporting similar experiences, thus although difficult to predict with certainly, we anticipate fourth quarter revenues to be relatively flat when compared to third quarter.

In summary, I believe we've made the necessary investments both in North America and Asia to make Merix's value proposition a reality. Further, over the last two quarters, we've made the cost structure changes necessary to reduce our break even point by roughly 15%.

More importantly, these cost reductions did not come at the expense of improvements we've made in our factories. In fact, our operational metrics are better today than ever. Global defects per million are below 500. Yields are consistently above 90%. On time delivery is above 95% and our standard lead times are four weeks.

I believe the combination of strong operational metrics and a significantly reduced cost structure will help us reap the rewards when this market rebounds which we all believe it eventually will.

Thus, Merix's focus will remain on its customers and its commitment to quality, delivery and technology as well as maintaining adequate cash and liquidity to weather the current environment.

As I indicated earlier, I've invited Tom Ingham, our Executive Vice President of Global Sales and Marketing and Allan Munich, Vice President of Finance to answer any questions that you may have, and with that, I'll open up the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Joe Wittine – Longbow Research.

Joe Wittine – Longbow Research

You reported an increase in ASP's during the quarter, I think prices were up 4% sequentially and I'm curious how much of that improvement was mix versus base pricing.

Michael Burger

Almost all of it.

Joe Wittine – Longbow Research

How is the pricing environment right now? How tough is it and what do you expect going forward? Are you seeing abnormal pricing pressures?

Kelly Lang

Actually, I think we're probably all a little bit surprised it hasn't gone to hell in a hand basket. It seems to have, we've moved down obviously on individual pricing, it's not that wholesale like you would expect in this marketplace.

We don't believe that we've lost a lot of business due to price and although we have become a little bit more competitive, we haven't got into a, it hasn't been a fire sale environment at all. That coupled with the fact that what we're seeing coming into our factories particularly in North America, the complexity continues to grow and I think that's what's driving the mix.

Michael Burger

And from timing not to mention Asia with the expansion complete now. The technology that's going into that factory is significantly above what it was just six months ago so that's obviously bearing.

Thomas Ingham

Over the last 18 months we've doubled the weighted average layer count in Asia which is driving ASP's big time in Asia.

Joe Wittine – Longbow Research

With regards to restructuring, the number you gave could have generated an additional $2.5 million during the quarter. It was pretty substantial. Just wondering from a modeling perspective what we should be modeling for operating expenses going forward, kind of what the run rate is down to.

Kelly Lang

I think the run rate we did for the quarter, just kind of looking forward into May; I think you'll see a little further improvement again from the cost actions that happened near the end of the quarter. Something that kind of offsets that is usually near the end of the year, we of course start recording expenses which tend to pick up, so again we will see a modest reduction we believe in the quarter in operating expenses as well even with the seasonal things that affect us. So we should still see a trending down.

The bottom line is I think we're still [inaudible].

Joe Wittine – Longbow Research

Assuming kind of similar revenues from this point like what you're guiding right now, will the restructuring get us above break even on a gross margin assuming another $60 million quarter?

Kelly Lang

We won't get to break even. At the $60 million, we won't be at break even. In fact I think right now and Mike can speak more to this, but our focus today is really, to get to break even, you'd be doing things that would impair our ability to service our customers. And again, as Mike mentioned I think what we're most proud of given what we're going through today, our metrics today at the customer level are extremely good. In fact we're getting great feed back from a number of our customers.

So we're really managing the business from a cash neutral. Certainly we are focused on being profitable long term. I think in previous calls we've talked a little bit about where our break even point is and when we set this company up, before the restructuring Mike has led us through the last couple of years, we were kind of aiming for a $90 million to $95 million kind of break even level.

And of course these markets have not allowed that to occur. We're probably closer to roughly $75 million or maybe $80 million break even level now today. Again without having much of any additional costs added to our cost structure so you kind of have to look at that number probably another $15 million to $20 million north of where we're kind of at today.

Which again, that probably could come in two quarters of reasonably good growth from where we're at today too so we just need to get further firming and we feel pretty good about where we're set today.

Joe Wittine – Longbow Research

With the flat guidance that you're providing, what gives you confidence? I'm assuming you've seen some of the order revisions slow at least. You did note that Asia is still a little bit up in the air I guess. I'm just kind of curious what kind of market environment you're seeing right now.

Michael Burger

Let me take a minute then I'll let Tom respond to this in some individual markets. I think that overall we've been, I think probably everybody in this business has been very focused on order rates and we track it, I'd like to say by the hour, but that's not true. But, it's pretty close.

We track it on a daily basis and we feel that we've been moving sideways in North America now for pretty much a quarter now. Asia as I think we said in our earnings, the problem with Asia is that they're pretty lumpy. They're larger orders and they're not as frequent, and as a result it's really hard to get a trend and depending upon how many data points you want to take.

So we have seen our booking trends begin to flatten out and so we feel like we're moving sideways. You couple that with the anecdotal conversations that we've had with our customer base and I think another interesting and probably positive sign is we don't believe there's a lot of inventory in the EMS channels.

We don't believe there's a lot of EMS in our customer base, and so we're not really worried about the next shoe to drop. What we're worried about obviously is our end customers, the ones that we're engaged in and then their end products. Are they really being consumed in the market place?

But from an inventory perspective it seems to be cleaned up so with the trend line that says that our bookings and our bookings have been relatively consistent plus the inventory situation being relatively healthy, we feel that we're pretty much at the bottom

Thomas Ingham

I agree. I can just also talk a little bit about specifically in Asia on the automotive segment. We are starting to see the channel clear. Obviously there are still a lot of absence of demand just at the consumer level but we think that that is the overall stimulus things going on and just the fact that people are going to start buying some auto's in the second half of the calendar year and the first half of our fiscal year. We think automotive is going to at least begin to rebound. We've certainly hit the bottom there.

And then we've got a couple of things we mentioned during the call that we've got some visibility into our Q1 on this 3G roll out in China where we're going to have some fairly significant orders. So we think we've certainly bottomed out and we're starting to see some firmness in some of the major markets and some of the longer visibility programs.

Operator

Your next question comes from Matthew Sheerin – Thomas Weisel Partners.

Matthew Sheerin – Thomas Weisel Partners

I missed the commentary on the book to bill overall and by region. Could you give me that again?

Kelly Lang

We were at 25 globally and .91 in North America which I think is a few points above a few data points in our quarter and then Asia was .80, and it's difficult to say, but just talking to other people in the business I think there's no question about that.

Matthew Sheerin – Thomas Weisel Partners

And what's your capacity utilization levels right now in Asia and North America?

Thomas Ingham

I think we're averaging probably between I would argue between 65% and 75%. It's kind of, it changes weekly.

Matthew Sheerin – Thomas Weisel Partners

I think you talked about the overall industry book to bill and your market share and it sound like you're saying that you don't think you lost market share in the last year, is that right?

Michael Burger

I guess there are plenty of rumors in certain parts that are out there that may indicate otherwise, but I think that we look at our customer base and again, we'll be very candid with you, last week we met, I met with a number of customers with Tom and team and I think we're holding up quite well.

We certainly have one large customer in the networking area that we made the decision with them that having as much capacity dedicated to that particular customer where we decided to step down. I would say that's the only one and again, it was one we talked about the last couple of quarters.

Matthew Sheerin – Thomas Weisel Partners

And is that why your communications was down 38% year over year. Is that pretty much, what about your other large networking customer? How are the relations there?

Michael Burger

We're fine. We're fine everywhere else. I don't think we're down anything more than the market with any of them at all and there's no indicators for any reason that that's going to change. In fact, I mentioned the roll out in China by June time frame; we're going to have some significant business with a brand new networking customer.

It's kind of an outlyer like you said when there's closure. We had to make a joint decision to take down some business. But that's the main thing year over year. You hit the nail on the head.

Matthew Sheerin – Thomas Weisel Partners

On the cash from operations, how much did you get from the collection of the Chinese value added tax refund?

Kelly Lang

I'll call it somewhat unusual around the $3 million. Last quarter it was about $3 million. We didn't expect it. It came in during the first couple of weeks so we had $3 million from that and we got kind of a $3 million from production declining so it helped cash flow here in the quarter.

Matthew Sheerin – Thomas Weisel Partners

So if you sort of normalize, without that it was closer to $8 million or something like that, $10 million?

Kelly Lang

Yes.

Matthew Sheerin – Thomas Weisel Partners

How much further do you think you can get in terms of inventory and what would you estimate on cash from ops be this quarter because it looks like you've done most of the heavy lifting or perhaps it gets tougher as you lose money this quarter.

Kelly Lang

I think that we've certainly seen some improvement out of working capital. I mean our DSO's ten days flat in the quarter; t here's probably a couple more days of opportunity in there. I think bottom line is, we did have some things right at the end of the quarter. Accrued comps, we paid so the timing won't be favorable there. So we'll probably from a working capital standpoint, probably between $5 million to $7 million maybe this quarter for working capital net.

That includes actually what we did off the P&L as well, so kind of net cash would be, if everything stayed neutral, probably between $5 million to $7 million consumption.

Matthew Sheerin – Thomas Weisel Partners

On the increase in the doubtful account allowance is that just to be conservative or have you had any specific issues with the receivables or customers?

Michael Burger

No, we haven't had any major ones. We've had probably $50,000 in actual write off the last 90 days. It's really just reflecting just some of the, you look at the automotive base and as you know it's roughly 20% of our business. When you look at some of those, we simply padded the reserve we have for some of those people, but we're not aware of any specific uncollectable issues. It more just recognizing the risk that's in the industry.

Matthew Sheerin – Thomas Weisel Partners

Regarding your commentary that you think that things have stabilized. We've seen other companies across the supply chain say the same thing yet we've seen others say visibility is really too limited, they really can't call the bottom yet. Is there anything that you've seen for instance over the last few weeks, have you see order trends stabilize after getting worse in January or February that gives you any indication or better sentiment that we are in fact at the bottom here.

Michael Burger

Again, we're cautiously optimistic. I think one of the things we track in our business is just activity levels in terms of quoting and then our closure rates against those and we're seeing quote activity pick up pretty significantly through this quarter which implies a lot of new development stuff, but also it's not just new development it's full lead time on old orders.

So we're bidding on a lot more business than we have from the previous quarters for example. And our closure rates, the percent of business that we're closing has remained relatively high. In fact, it's fluctuated between 35% and 40%. When it gets to 50% I think it's too high. So we've been I think relatively aggressive and we've seen the activity pick up coupled with the fact that we're seeing consignment pools kind of increase as a rate.

And we've also seen as we've talked about earlier in our commentary the actual booking levels be relatively stable and moving sideways versus continuing down.

Operator

Your next question comes from Ryan Jones – RBC.

Ryan Jones – RBC

I was wondering about the sale of the Hong Kong facility and whether or not there's any update on that?

Michael Burger

No update today. We're still actively marketing it. We've had a couple of interesting parties but nothing to announce at this time.

Ryan Jones – RBC

We could still expect $10 million to $15 million you think for that facility?

Michael Burger

That's correct.

Ryan Jones – RBC

Any update on getting Asia caught up on a reporting basis?

Michael Burger

Our plan is that our first fiscal quarter, meaning our quarter that starts in June of this year, so that's two months away will be real time reporting. We're actually capable of it today, but we're just trying to make sure the other comparables because of the break in period etc. So it should be up and rolling here in the first quarter.

Ryan Jones – RBC

Could you talk about at this point what your willingness would be for different strategic alternatives? I know this question has come up before but I'm just curious with the stock price at these levels maybe what you would consider in terms of potentially a deal with one of your competitors or one of your peers.

Michael Burger

Honestly we don't really talk about that. We appreciate the question, but it's just our policy to talk about stuff like that Ryan.

Operator

Your next question comes from Joe Wittine – Longbow Research.

Joe Wittine – Longbow Research

Just a follow up on the balance sheet. Other assets were liquidated by about $8 million sequentially. Just curious if that was part of the impairment or if that was something else.

Michael Burger

That has to do with the BAT accruals or the [inaudible] on the import and then the Chinese government refunded. It was perfect timing with respect to that, so this quarter we actually had a nice payment of about $3 million, which was extraordinary. We would have anticipated frankly last quarter because our cash velocity was down a little bit.

So normally given the demand environment, we'd probably see a $3 million net refund in the quarter we were in versus what we got. I think looking at Q4, we'll probably see about $1 million consumption just because the demand in production is actually higher this quarter given our outlook for revenue etc.

Joe Wittine – Longbow Research

I'm curious if you're seeing capacity coming out of the market at this point particularly in North America, weak players closing their doors or acquisition activity. We heard about the major announcement from PTMI closing its facility up in the northwest. I'm just kind of curious what you're seeing from your perspective.

Michael Burger

You guys have probably got the same data that we've gotten as it relates to the big guys, you know the public companies. We, anecdotally we continue to hear of smaller shops closing their doors and liquidating, auctions available, that type of stuff, but they're mom and pop. So from our perspective, the major capacity is what you and I have read about. But anecdotally, there seems to be a lot of guys, a lot of smaller shops that are just not able to keep it up.

Operator

Your next question comes from [Nick Farwell – The Arbor Group].

[Nick Farwell – The Arbor Group]

I apologize if I was a little confused on the cash flow. Could you review the third quarter? The operation cash flow as $7.6 million as I recall. Then you had $3.3 million in CapEx and you increased debt by $1 million. And then I missed the incremental comments about the Chinese tax rebate.

Kelly Lang

The cash from Ops actually I think is roughly $10 million. We consumed, again these are round numbers, $3 million in CapEx, most of it just finishing the payments on the HY build out. And then the other is a net $1 million. What we did there was we kind of reviewed this on a prior call but our V&X instead of being two it is one facility and we moved the borrowing base to either side, but basically there's an $8 million supplement on the Asia assets where we essentially maxed that out and we have the ability of that business generating cash flow, we can get it out of China without holding tax.

So we took the advantage of the opportunity to max that out if you will that we could get it out once cash starts flowing out of there.

[Nick Farwell – The Arbor Group]

So the $10 million from operations, add $1 million from debt, you're at $11 million roughly, take out the $3 million for CapEx, you're at $8 million. $3 million of that came from the Chinese tax recapture?

Kelly Lang

It was actually $6 million. $3 million was, I'll just try to explain it. It was an extraordinary amount that we got from the Chinese recapture. The total was roughly $6 million. That was included in the cash from ops.

[Nick Farwell – The Arbor Group]

I was just trying to balance out that last $8 million. You're saying $6 million comes from the tax recapture?

Kelly Lang

Yes.

[Nick Farwell – The Arbor Group]

And the incremental $2 million is basically from production.

Kelly Lang

Or other changes in working capital both consumption with cash through like AP or generation of cash.

[Nick Farwell – The Arbor Group]

When you look at fourth quarter, you made some comments about fourth quarter cash expectations and you said something about a $5 million to $10 million cash burn?

Kelly Lang

Again, it's just timing. In Q1, I think if everything stayed equal, we'd probably see that number be a positive but a couple of things working against us in our fourth quarter is we've got an interest payment on our bonds which we'll pay that. We've got against the timing of our compensation that we pay semi monthly. This last quarter we, it was like a full two weeks of accruals if you will in the second month were actually payment through to the end of the quarter so it really has more to do with the timing of fluctuations within the balance sheet itself.

I wouldn't say we're actually consuming cash at long term. It's more temporary swings if you will in accounting.

[Nick Farwell – The Arbor Group]

I'm a little confused by the comment that fourth quarter may be flat, yet you're going up against a seasonally presumably, or in the past has been, a seasonably, notwithstanding the economic environment I understand, but typically a seasonally better quarter combined with the comments you made about "RP activity". And you're offsetting a Chinese New Year when you were shut down.

Kelly Lang

As we said, Chinese New Year we actually did get one week of Chinese New Year in Q4.

[Nick Farwell – The Arbor Group]

So I would think you would be guiding to an up as opposed to a flat quarter sequentially.

Michael Burger

We're scared.

[Nick Farwell – The Arbor Group]

There's not something I'm missing.

Michael Burger

No, we're scared. That's it. We're just being cautious. We're honestly, I think all of us are a little bit shell shocked. I'd say all of us, certainly everybody in this room and I think we are optimistic about the activity that we're seeing. We're very excited about specific customers and customer action.

We're a little bit nervous about some of the underlying stuff like automotive. We read the same stuff you do and it's a big chunk of our business. We hope that we've hit the bottom but we're not really sure, so honestly we're just I think probably hyper conservative based on history.

Kelly Lang

With Asia having a one month reporting lag, we're essentially in their final month of the quarter, so we've got, not that we're certain on what the book is going to be there, but the lead time is shorter and visibility is pretty good on that side. North America I think is going to be more the risk if you will because we're already a month into the quarter there.

[Nick Farwell – The Arbor Group]

I guess that's why I thought you had increased visibility and it appeared the front end signs are encouraging, if that's the right expression.

Michael Burger

It is encouraging but I wouldn't, we're not in a situation where we want to over commit at all. Really, we are not seeing any seasonality in this economy right now. There's just too many other factors that are in there to really see. I don't think there's any underlying consumer demand really pushing seasonality right now.

[Nick Farwell – The Arbor Group]

But typically you get over burns in inventories and then sort of corporate world depending upon their own usage, tends to slowly recover. In past cycles that's the way it's been and I presume what you're saying, what I hear is you're beginning to see people reorder, not because end use demand is exploding but they're burning their inventories beyond what's reasonable.

Michael Burger

What's interesting you know typically because there's not a lot of inventory in the channel, it's kind of like hurry up and wait. We get some demand and then all of a sudden we've got to hurry because they basically have blown it and then it's kind of, I think we're all kind of muddling through exactly what this cycle is, and no one is taking any risks on inventory right now.

[Nick Farwell – The Arbor Group]

So typically, that's every cycle. This may be even greater depending upon one's perspective. That's happened the last five cycles I've been involved in and typically when things start to improve, if they gain momentum, they reverse process of the scramble back to normalized inventories.

Michael Burger

We'd like to think so but I think it's early for us to call that we're recovering.

[Nick Farwell – The Arbor Group]

The one month stub that you have for the China operation, how are you going to P&L that? Are you just going to put in into your equity account at year end or what happens to it?

Kelly Lang

It will be a retained earnings adjustment that will be effective in our first quarter of next year.

[Nick Farwell – The Arbor Group]

Will you identify that in the first quarter?

Kelly Lang

We'll identify that and give you a bit of clarity of what that number is. It will help you with your modeling to get a better sense of what's happening.

[Nick Farwell – The Arbor Group]

So it will actually appear in the first quarter as four months from China and you'll isolate that one extra month and say really we're going to put it in retained earnings.

Kelly Lang

It won't be in the P&L. It will be in retained earnings. Now we may do it on a non-GAAP basis to help you guys understand it and kind of what happened in that month, but from a 10-Q you won't see much of that. When we get onto the call, you'll get some clarity on what that is.

[Nick Farwell – The Arbor Group]

But the first quarter will be clean apples to apples year to year. There won't be any stump period, just the residual gain or loss from that month will go into retained earnings.

Kelly Lang

Exactly.

Operator

Your next question comes from [Amitad Passu – UBS]

[Amitad Passu – UBS]

I was hoping your could repeat the commentary on the aerospace and defense segment and if you could share what your expectations as you look at the June quarter particularly in respect to aerospace and defense. Do you think that segment could improve sequentially and any other thought around trends that you see in that segment?

Michael Burger

Thanks for the question. We just actually had several customers in defense and aerospace that were off a little bit and kind of had an aggregate number that added up that we were actually down in the segment and a lot of it was actually timing in December and January, just kind of around the holiday period.

But to the second part of your question, we are actually seeing it as a segment that's going to grow. It's without a doubt our most active segment in North America in terms of new customer acquisition right now and we are getting a tremendous amount of surveys and qualifications going on in that segment. So we're extremely bullish on defense and aerospace for the next several quarters.

Thomas Ingham

The interesting thing about aerospace and defense, although there's a lot of rumors about defense spending etc., we're relatively under penetrated in that market segment so our play is all around market share and we think we're well positioned for that. So even if spending or for example spending budgets continue to be cut, I still think there's huge opportunity for Merix.

[Amitad Passu – UBS]

Can you give a sense of how your business is split between commercial, aerospace and defense?

Thomas Ingham

The commercial aerospace side is very, very small. It's well less than 10%. It's almost all on the military defense aerospace side.

Operator

Your next question comes from Ryan Jones – RBC.

Ryan Jones – RBC

I was wondering about the linearity of automotive sales over the quarter.

Michael Burger

As I said, it's pretty chunky because they're relatively large orders but we're moving pretty much sideways today on a month to month basis.

Kelly Lang

Essentially we started to see some automotive weakness from the quarter not from a revenue standpoint. We started seeing some of that in our second quarter. We definitely saw a more rapid decline in the early months of the quarter and I'd say it's a more steady flattening as the quarter ended.

A couple of things happened in our segment. I think it's pretty typical of most that feed that automotive business is that most of it is on undermanaged inventory. So they're essentially pulling more than they were necessarily ordering. We're kind of seeing that inventory in the channel getting pretty thin right now so we would think the order rate would start stepping up before too long.

Ryan Jones – RBC

Do you have good visibility into demand trends by region and could you comment on any disparities between Asia and North America and Europe.

Michael Burger

We have relatively good visibility into it. Again, you kind of have to look through our customers not only where they're regionally based but who they're participating with. So we don't have an exact number but two of our three largest, we have three large automotive customers, two are European based customers, therefore they have a higher concentration of European and Japanese auto manufacturers than they do the U.S.

But then we have a U.S. based manufacturer that also has a relatively high percentage of Japanese players. So what we see is actually Europe is right now the healthiest market of the three then followed by Japan and third, North America.

Ryan Jones – RBC

Do you think that might be driven by recent regulations in Europe?

Michael Burger

No, not yet. I know what you're talking about. The reason with the stuff in Germany with the stimulus, we're not seeing that yet although we do anticipate that we will see some of that because like I say, we do a lot. If you look through the chain with Volkswagen, with BMW, Mercedes and we think that that will help those suppliers quite a bit.

But actually in the meantime, I think it has just been because our customers are more highly concentrated in Europe that we're seeing that their business is holding up a little bit better.

Thomas Ingham

We haven't been hit as bad as some of our contemporaries.

Operator

WE have no further questions. Do you have any closing remarks?

Michael Burger

We appreciate your interest and your time today. We'll talk to you next quarter.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!