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Executives

Timothy J. Stultz Ph.D. - President, Chief Executive Officer, Director

James P. Moniz - Chief Financial Officer, Principal Accounting Officer

Analysts

Gary Hsueh - Oppenheimer & Company

Weston Twigg - Pacific Crest

Gus Richard - Piper Jaffray

Bill French - Ravenswood Capital

Edwin Mok - Needham & Company

Presentation

Nanometrics Incorporated (NANO) Q3 2009 Earnings Call October 29, 2009 4:30 PM ET

Operator

Good afternoon and welcome to the Nanometrics third quarter 2009 financial results conference call. Before we get started I would like to call your attention to the following safe harbor statement.

This conference call contains certain forward looking statements within the meanings of federal securities laws. These statements are based on management’s current expectations and involve risks and uncertainties that may cause actual results to differ materially from those described in forward looking statements. Factors that could cause such differences include, but are not limited to, changes in demand for the company’s product, changes in the company's ability to develop new product in a timely manner, the company's ability to manage costs and expenses, changes in business or economic conditions, and the additional risk factors and cautionary statements set forth in the company's Form 10-Q the quarter ending September 26th, 2009, and in the other reports which the company files with the Securities and Exchange Commission and incorporates herein by reference. Leading the call today will be Tim Stultz, President and Chief Executive Officer of Nanometrics. (Operator's Instructions) I will now turn call over to Dr. Tim Stultz. Please proceed.

Timothy J. Stultz

Thank you and good afternoon, everyone. Thank you for joining us for Nanometrics' third quarter 2009 conference call. With me today is Jim Moniz our Chief Financial Officer who will be reviewing our financial results following my prepared remarks.

Today we are pleased to report our return to profitability, with industry leading revenue growth, gross margins, and an improved cash position. In short, we have grown into our business model during the very early stages of the market's recovery.

Financial highlights for the third quarter include a 78-percent increase in revenues quarter-on-quarter and a 12-percent increase year-on-year, a 12.6 percentage point increase in gross margin to 54%, non-GAAP operating income of $4 million, and GAAP profit margin of 6% or $0.08 per share.

During the quarter we also had key strategic product wins at leading logic and memory customers., increased penetration into the growing HB-LED market and expanded acceptance of our Lynx metrology platform.

Early in 2007 we initiated the turnaround of Nanometrics. Since that time we have reported on our primary areas of focus in progress against objectives. The first leg of our turnaround strategy was to restructure our operations to drive efficiency and improve our operational and earnings leverage. The direct outcome derived from those efforts is a stronger business that has grown gross margin through quality and competitive performance improvements, deploys operational expenses efficiently, and consistent with the business opportunity, and has improved cash flow and balance sheet management.

As we have reported, we have steadily improved our gross margins, most notably in service, even as our customers' capital spending budgets and our revenues were shrinking, while at the same time reducing our operating expense by 33%.

Whereas improving our business model practices and operational fundamentals comprise the first leg of our turnaround strategy, just as important were our efforts to strengthen our competitive position without reserved markets and thereby drive market share gains. During the economic and industry downturn we addressed that objective by continuing to invest in R&D and developing and introducing advanced highly differentiated cost effected and extendable product platform for our customers including the Lynx, the Nanogen OCD Suite, and new thin film overlay and integrative metrology product offerings.

These new products are tied directly to our recent key account wins and increased revenues derived from technology purchases. The third leg of our strategy has been to expand our served markets by leveraging our core competencies, our global sales and service channel, and the Lynx metrology platform. These objectives have been advanced through organic development of new products for the solar and high brightness LED markets and acquisitions which added new products to our portfolio to serve the growing solar photovoltaic and wafer scale packaging markets.

Our strategy and business model are baed upon two fundamental believes. First, if we properly and effectively execute against our objectives, to improve our competitiveness and operational efficiency we will be positioned to outperform our sector through market share gains and earnings leverage.

Our second belief is that the semiconductor customers will continue to work on shrinking devices, increasing device density, and increasing process complexity, to meet their technology, performance, and cost requirement.

These trends, in turn, drive the need for more metrology and process control in order to achieve acceptable yields in the face of increasing complexity and tighter process tolerances.

Economic realities and incentives, however, currently force our customers to address these challenges largely through the retooling of existing facilities versus building new plants or increasing wafer sizes.

In our opinion, this environment favors equipment supplies who offer products that meet current technology requirements while at the same time offering extendibility and upgrade paths through several technology nodes, thereby improving our customers' profitability through lower cost of ownership and greater returns for their capital expenditures.

In summary, supported by an improvement in the capital equipment market and business environment, as well as execution against our stated objectives, we are experiencing a sharp increase in demand for our leading edge thin film OCD and overlay products. Our Nanogen OCD software suite and upgrades to our large installed base.

With further improvement in the semiconductor industry, as predicted, we expect our technology driven product placements to position us to benefit from production ramps and capacity expansions as they occur. Longer term we expect to have incremental contributions to our business from our recent entry into wafer scale packaging metrology resulting from a recent acquisition of a Unifire interferometry product line. From growth of the high brightness LED market driven by increased use of solid state lighting for large format televisions, smart phones, computers, and industrial lighting, and from the overall growth in the solar photovoltaic market.

From where we sit today we see continuing improvements in the business environment including the trend of more metrology and process control and further acceptance of our differentiated products. We have enjoyed significant quarter-on-quarter revenue growth over the last couple of quarters and expect revenue growth to continue, albeit at a slower rate as absolute revenues increased.

I will now turn the call over to Jim Moniz.

James P. Moniz

Thank you, Tim, and good afternoon, everyone. Nanometrics press release containing third quarter fiscal 2009 results was sent out by business wire today, October 29th, around 1:00 pm Pacific Daylight Time. The press release may also be found on our website at nanometrics.com. Also on our website are reconciliations to non-GAAP figures referred to in our prepared remarks such as non-GAAP operating income.

Third quarter revenues of $25.8 million were up 78% from the previous quarter and were up 12% from the third quarter of fiscal year 2008. Revenue by geographic region is based upon the ship to or first in use destination and during the quarter the breakdown was Korea at 54%, US at 25%, and rest of world at 21%. Revenue by product type was stand-alone and integrated metrology at 57%, service and upgrades at 37%, and materials characterization at 6%.

Gross margin in the third quarter was 54% compared to 41.4% in the previous quarter and 44.1% in the third quarter of fiscal year 2008. All segments of our business contributed to the improvement in gross margin including the higher level of overall revenues, increased upgrade revenues, and improved factory absorption.

Total operating expenses in the third quarter came in at $12.4 million. In comparison to prior period and excluding asset impairment and restructuring charges, we saw a 23% increase in operating expenses compared to $10.1 million in the second quarter of 2009 and a 13% decrease compared to $14.2 million in the year ago period. The sequential increase in operating expenses was primarily driven by increased payroll expenses in response to the sharp revenue ramp and added expenses associated with the unifier business acquired in June. Even with these increases, our cash operating expense grew at one-fourth the rate of revenue growth.

Interest and other expense in the quarter was flat and included $0.5 million of interest expense offset by $0.5 million associated with gains on foreign currency. The net profit for the third quarter was $1.6 million or $0.08 per diluted share on a diluted share count of 19.4 million shares.

Earnings per share included approximately $0.04 of stock-based compensation expense and benefited from approximately $0.03 of unrealized gains on foreign currency exchange rates.

Now turning to the balance sheet, cash came in at $17.2 million, an increase of $2.7 million above the previous quarter. Our borrowings against our line of credit remained flat at $3.5 million compared to the end of Q2 and we have since repaid this amount in full. We generated $2.8 million in cash from operations in the third quarter and we have available to us the full amount of our $15 million credit line on which we are all well within all our covenants. All in all we feel good about our cash and cash flow management.

Accounts receivable came in at $21 million, which was higher than the previous quarter by $6.1 million driven by the increase in revenues. DSO was at 73 days which is down from last quarter's DSO of 92 days. Inventory came in at $32.4 million, which is a reduction of almost $2 million from the previous quarter. We ended the September quarter with a headcount of 399 employees, nominally flat from the previous quarter.

I'll now expand a bit on the revenue growth outlook provided by Tim. Our Q3 2009 revenues represent double-digit growth from the third quarter of 2008 and a 78% growth over the prior quarter. This came on the heels of a 44% quarter on quarter growth rate in the second quarter. Clearly that rate of sequential quarterly growth is unsustainable. We are, however, seeing the order pipeline building for a more modes uptick in revenues for the fourth quarter, which will continue our quarter-on-quarter revenue growth trajectory.

This quarter we had record upgrade revenues. We expect revenue from upgrades to return to a more nominal level in the coming quarter with the mix of revenue shifting more towards product sales. With the improvements we have made to our cost structure and operational efficiencies, continued revenue growth should have a positive impact on our product gross margins. Core service margins have also improved through improvements in quality and efficiency. The reduction in upgrade business, however, will have an offsetting effect on total gross margins, resulting in a more normalized, yet still strong, total gross margin.

That concludes our prepared remarks and now I would like to open up the call for your questions.

Question-and-Answer Session

Operator

(Operator's Instructions) Our first question comes from the line of Gary Hsueh with Oppenheimer & Company.

Gary Hsueh - Oppenheimer & Company

Great. Thank you for taking my question. I'm not going to complain about great numbers, but had a question just about sustainability of gross margin. You guys are clearly performing above and beyond, I think, what your stated financial model was earlier this year and so I'm just wondering — you talked about sustainability of revenue growth on a sequential basis, I'm just wondering, could we expect gross margin to still exceed the 40%-50% range at this current level in Q4 or is there enough of a falloff, as you said, on the upgrade business, where we get back kind of that financial target model? I am just trying to figure out how much gross margins should actually come in, in the December quarter.

Timothy J. Stultz

Hi, Gary. This is Tim. Thanks for calling in and thanks for not complaining about the numbers. With response to your gross margin question, we did have record upgrade revenues, which contributed nicely to our service gross margins. And we expect the upgrade revenues to come down to more of a normal quarterly level. With that there is an offset to total gross margin, but our product gross margins are still pretty robust and our service margins have continued to improve. So with regard to the model you are referring to, I feel very comfortable hitting that model and being at or above t, but I don't expect to sustain this level of margin if the upgrade revenues drop.

Gary Hsueh - Oppenheimer & Company

Okay. Just a follow up question here about product revenues then. A lot of semi cap equipment peers of yours are running into supply constraints or bottlenecks in terms of outsourced manufacturing of their tools to meet customers shipment or delivery dates. Are you experiencing any bottlenecks or supply constraints in turning around tools in manufacturing?

Timothy J. Stultz

So far we haven't and we used two outsourced manufacturing suppliers, one is quite large, and they have a lot of capacity so that backed up by our manufacturing capacity has resulted in us not having an problems meeting our delivery commitments.

Gary Hsueh - Oppenheimer & Company

Okay, great. And just a longer term question with the interferometer business and the future revenue stream coming from Intel, I'm just wondering as you start to layer in some of this business, if this business — and I think the fear is that typically the Intel business does layer on at significantly lower gross margins, is that business big enough at lower gross margin enough to kind of disrupt this target financial model that we're looking at in '09 when we look out to 2010?

Timothy J. Stultz

Yeah. Well, without speaking specifically to any given customer, the long-term purchase agreements and the products and the sale prices will continue to support our margin model.

Gary Hsueh - Oppenheimer & Company

Okay. And just last question about taxes, what should we be modeling in terms of a placeholder for tax rate in 2010 at this point?

James P. Moniz

I think at this point in time we're not forecasting really a significant tax rate. We do have over $30 million in NOLs and most of that will be used to shelter whatever US income we get and that we would forecast in 2010. We may see some slight provision for international profitability that's generated, but at this point in time I don’t know that I would forecast really a significant tax rate or any tax rate as we go into 2010 — maybe a few points, but not much more than that.

Gary Hsueh - Oppenheimer & Company

Okay, great. One final kind of background question: any 10% customers in Q3?

James P. Moniz

Yes. There was Samsung and Intel.

Gary Hsueh - Oppenheimer & Company

Perfect, thank you.

Operator

Your next question is from the line of Weston Twigg with Pacific Crest.

Weston Twigg - Pacific Crest

Thank you for taking my question. One question is following up on the comment on 10% customers would you expect those same customers to be 10% next quarter? And specifically I'm just kind of wondering about this sort of a recent, on the memory side, the recent win last quarter? You had Q3 and Q4 shipments from — I'm wondering if those would be stronger shipments relative to Q3 in Q4?

Timothy J. Stultz

Thanks for calling in, Wes. With regard to the two 10% customers we see continued good business with them, but we also see some other customers increasing their spending rates which can start to shift the mix in terms of what constitutes 10% total. So I would expect that there’s a possibility of adding one or more customers to that 10% list

Weston Twigg - Pacific Crest

Okay. And then just regarding the large memory order that you announced earlier last quarter with Q3 and Q4 shipments dates, are the Q4 shipment levels larger than the Q3 shipment levels for that customer?

Timothy J. Stultz

The order we announced was spread over a couple of quarters and it's kind of evenly spread right now in terms of the total shipments.

Weston Twigg - Pacific Crest

Okay. And then I just also wanted to dig into the materials characterization business. I'm not sure if I calculated this right, but at 6% of sales I only get $1.5 million, and that's fairly low. I know it's a lumpy business, but I'm just wondering if you expect that to be rebound in a significant way given the exposure to HB-LED and solar.

James P. Moniz

So I think there's two elements that we've talked to previously. The first one is one of the key products that gets rolled into the materials characterization is the FTIR which is used for bare silicone defect analysis, and that business all but disappeared during this downturn and those are higher end tools. And so we are starting to see some activity there and I expect to see contributions to the materials characterization revenues from that product line, the FTIR.

We also are seeing some nice traction in HB-LED and I expect that to pick up, as well as solar, with probably more than dozen engagements. We have over 30 HB-LED customers now and approximately 40% of those are ones that are new to us within the last two quarters. So we're at the early stages of those and that those are lower ASP products, but we're starting to see volume opportunities and I think that you're going to see some nice improvements in materials characterization as a result.

Weston Twigg - Pacific Crest

Okay. Thank you.

Operator

Your next question comes from the line of Gus Richard with Piper Jaffray.

Gus Richard - Piper Jaffray

Yes, thanks for taking my question. Could you break down your revenues by end market, DRAM, foundry, et cetera?

Timothy J. Stultz

Sure. Hi, Guys. Thanks for calling in. So our total memory was about 70%, 69% of the sales were in memory and it was about 58% on the DRAM and around 12% on flash. Around 21% foundry logic another IDM, and on the balance with the compound LED solar and substrate.

Gus Richard - Piper Jaffray

Okay. And then on the Unifire product and actually the upgrades, can you give us just an idea of where those revenues came in for the quarter as well?

Timothy J. Stultz

So with regard to the Unifire product there have been shipments, but as a result of the acquisition and the revenue recognition rules, we have not recognized ourselves, any revenue from Unifire so the products are going out and they are nice and we have got some happy customers, but as we go into Q1 we'll actually start to have some revenue recognition opportunities. It just has to do with the accounting of an acquisition. With regard to the upgrades we don't break that out from service, but if you look at our service numbers in this quarter and compare them to service runs in the previous quarters, you could say that there's been a pretty substantial uptake in upgrades and I would expect that to drop probably 20 or 30% or so.

Gus Richard - Piper Jaffray

Okay. And so more to a normalized service margin, and I guess the question there is what is the normalized service margin? Is it in the mid 40s?

Timothy J. Stultz

No. So — well, the core service margins, which I believe you know, came up from a low of -27%, are running into the low 30% range so it is like 33% in the quarter. And then the contribution to that from upgrades will bring that up and higher. So I would say we are somewhere like 35%-40% total in that range on the service side. But service upgrades also will represent a smaller total percentage of the revenues and so the product margins will actually carry us as we go forward.

Gus Richard - Piper Jaffray

Got it. So just to sum that up, the service and upgrade line gross margin should be in the 40s somewhere, just given the upgrades aren't going to go to zero.

Timothy J. Stultz

Yeah. Well, the upgrades won't go to zero.

Gus Richard - Piper Jaffray

Okay. I understand, okay.

Timothy J. Stultz

We just had a very strong upgrade quarter.

Gus Richard - Piper Jaffray

Right, got it. Okay, thanks so much.

Operator

Your next question is from the line of Bill French with Ravenswood Capital.

Bill French - Ravenswood Capital

Congratulations, Tim, and to your whole team. Very good quarter. My question has to do with the other long-term liabilities line which last quarter jumped from about 800,000 to 2.5 million and it's continued to increase. Could you explain that lien to us, please?

James P. Moniz

Hi, Bill. This is Jim. That other long-term liabilities change is exclusively based on the Unifire purchase that we made late in the June quarter. And that purchase essentially had to be split between what we thought we would have to pay long term and short term so that increase of about $2 million was what was determined, payments that would have to be due after a 12 month period of time.

Bill French - Ravenswood Capital

Okay. And that runs off as you pay them?

James P. Moniz

That will run off as we pay them, yeah. That is correct.

Bill French - Ravenswood Capital

Okay. And is the easy kind of true op — in other words is there some circumstances in which it might not be owed or it is —

James P. Moniz

No, not really. It is just the timing differences. When we recorded the sale we recorded some intangible assets associated with that and then obviously some inventory and some fixed assets and this was just the liability side of it. Some of it went into the short term and the balance went into this long-term you were looking at.

Bill French - Ravenswood Capital

Okay, that makes sense. And forgive me, I had to jump on late so if this has been addressed, but the disposition of the Korean real estate asset?

James P. Moniz

That is still in the process. As you remember from last quarter we had written that down to what we thought would be a market value and we said it may take us a number of quarters the economic real estate market worldwide and especially in Korea. So we are still actively marketing that, but it would be premature for me to say anything, but we have not sold that yet, but we believe we would do that hopefully in the next quarter or two.

Bill French - Ravenswood Capital

Okay, very good. Thank you. Good quarter.

Operator

Your next question is from the line of Edwin Mok with Needham & Company.

Edwin Mok - Needham & Company

Hi, thanks for taking my question. Can you help me out a little bit with the advanced (inaudible) strategy markets with the (inaudible) and how you guys are proceeding and how do you look at the market going forward?

Timothy J. Stultz

Thank for calling in, Edwin. We're pretty excited about wafer scale packaging. It's really more of a back end of the front end rather than a true back end market and it's two particular areas that I think are exciting. One is the micro bumps and the other one are through silicon. And the Unifire product has been accepted for applications in the bump art of the packaging and we are doing some development and have some engagements to apply it (inaudible). I think both of those are going to be nice growth markets going forward.

Edwin Mok - Needham & Company

Do you see that, as you mentioned as part of the (inaudible), do you see that strategy working with a company like (inaudible), or do you see actually a sun room solution taking off by integrating that into your Lynx platform? Which way do you see is more opportunistic and will have better growth as you go into 2010?

Timothy J. Stultz

I'm sorry, I wasn’t sure, was that about the Unifire?

Edwin Mok - Needham & Company

Yes, about the Unifire, sorry.

Timothy J. Stultz

Yeah. So as the Unifire stands, when we acquired the product line it was a stand-alone product, but our strategy at the outset was to integrate it into the Lynx metrology platform. It just gives your customers a lot more extendibility, it gives them a low cost of ownership and a lot more flexibility, and it gives them the chance to put a bump tool next to an OCD tool or a (inaudible). It was the same robotic handler and data acquisition and sharing.

So everything we're doing is really to extend the utility and acceptance of the Lynx metrology platform.

Edwin Mok - Needham & Company

I see, great. That’s all I have, thank you.

Timothy J. Stultz

Okay. Thank you for calling.

Operator

At this time there are no other questions in the queue and I'd like to turn the call back over to Dr. Tim Stultz for closing remarks.

Timothy J. Stultz

Thank you. In closing, it is not beneficial to examine the exploratory work, innovation, dedication, and sacrifices of our employees, who through a very challenging time have remained stedfast in their commitment to build a better Nanometrics and clearly without whom none of our achievements would have been possible.

I also want to thank our-long term shareholders for their continued belief and support of the company and reaffirm our commitment to continuous improvement toward operational excellent and improvement business performance. Thank you again for calling in. We look forward to updating you on our fourth quarter results conference call.

Operator

And ladies and gentlemen, thank you all for your participation in today’s' conference call. This concludes the presentation and you may now disconnect.

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