Cabot Microelectronics' CEO Discusses F4Q 2013 Results - Earnings Call Transcript

| About: Cabot Microelectronics (CCMP)

Cabot Microelectronics Corporation (NASDAQ:CCMP)

F4Q 2013 (Qtr End 09/30/2013) Earnings Call

October 29, 2013, 10:00 AM ET


Trisha Tuntland - Manger, Investor Relations

William Noglows - Chairman, President and Chief Executive Officer

William Johnson - Executive Vice President and Chief Financial Officer


Avinash Kant - Davidson & Company

Jairam Nathan - Sidoti

Tony Grillo - Needham & Company

Chris Kapsch - Topeka Capital Markets

Jay Harris - Goldsmith Harris


Good day, ladies and gentlemen, and welcome to Cabot Microelectronics' fourth quarter and full fiscal year 2013 earnings conference call, hosted by Trisha Tuntland, Manger, Investor Relations. My name is Bhupendra, I will be your event manager today. (Operator Instructions) And now, I would like to hand the conference over to Trisha. Please go ahead.

Trisha Tuntland

Good morning. With me today are Bill Noglows, Chairman and CEO; and Bill Johnson, Executive Vice President and CFO. This morning, we reported results for our fourth quarter and full fiscal year 2013, which ended September 30.

A copy of our earnings release is available in the Investor Relations section of our website, or by calling our Investor Relations office at 630-499-2600. A webcast of today's conference call and a script of this morning's formal comments will also be available on our website.

Please remember that our discussions today may include forward-looking statements that involve a number of risks, uncertainties and other factors that could cause actual results to differ materially from these forward-looking statements. These risk factors are discussed in our SEC filings, including our report filed on Form 10-K for the fiscal year ended September 30, 2012. We assume no obligation to update any of this forward-looking information.

I will now turn the call over to Bill Noglows.

William Noglows

Thanks, Trisha. Good morning, everyone, and thanks for joining us. This morning we announced strong financial results for our fourth quarter and full fiscal year 2013. During the quarter we achieved record revenue of $116.3 million. Our gross profit margin of 50.9% of revenue and diluted earnings per share of $0.70, an increase of approximately 43% compared to the same quarter last year.

For full fiscal 2013, we reported revenue of $433.1 million, reflecting stronger demand for our products in the second half of the fiscal year, after soft industry demand during the first half. Gross profit margin of 49%, which is the highest annual level since fiscal 2010 and earnings per share of $2.16, approximately 23% higher than last year. Bill Johnson will provide more detail on our financial results later in the call.

Let me start this morning by recapping certain industry trends, which we believe began to impact our CMP consumables business during fiscal 2012, continued through fiscal 2013 and may continue into fiscal 2014.

As the industry continues to consolidate, fewer and larger semiconductor companies are accounting for a greater portion of the capital spending in the industry. We think that more capital spent by fewer companies has resulted in more rational capacity expansion and this has reduced the cyclicality of the industry, when compared to historic trends.

At the same time, the semiconductor industry is now being driven more by consumable products, such as smartphones and tablets versus demand for personal computers and enterprise IT spending. Consumers are now driving industry demand trends and this has introduced more seasonal shifts in demand around the back-to-school and holiday seasons.

Finally, the industries multi-year trend of declining PC demand, being slightly more than offset by greater growth in mobile devices, has resulted in relatively soft overall semiconductor industry growth. The overall effect of all these trends has resulted in a slower growth rate for the semiconductor industry as a whole, which is less cyclical than in the past with greater seasonal swings in demand.

For calendar year 2013, world semiconductor trade statistics estimate semiconductor industry revenue growth at approximately 2% and predicts 5% growth in calendar year 2014. We have seen the impact of these trends on our CMP consumables business, which has generally tracked the overall semiconductor industry growth in the past.

Turning now to company-related matters. During fiscal 2013 we continue to execute our strategies related to technology, customer collaboration and supply chain management. I would like to highlight some of our key accomplishments during the fiscal year.

Let me start by talking about a heightened focus in our company from a technology standpoint. Historically, we have developed new CMP consumables products on a relatively broad basis, in pursuit of fulfilling our mission of being the CMP solutions provider to the overall industry.

However, in light of slowing industry growth and continued and increasing consolidation of our customer base, we are now focusing our research and developmental activity much more heavily on innovating game-changing technology for leading-edge applications for technology leading customers.

In the recent past we have spent approximately 14% of our revenue on research and development activities. We believe that by focusing on advanced technologies with technology-leading companies, we can drive greater innovation and create more compelling new CMP solutions for our customers that will assure our continued success as technology continues to advance.

The recent growth in revenues from our CMP solutions for polishing aluminum and advanced dielectrics are specific examples of our ability to innovate to meet our customers challenging product performance requirements for leading-edge applications. Additionally, throughout the year we continue to further develop our pad business. This year our first generation D100 and second generation D200 pad products were adopted for a number of applications, including advanced node technologies.

However, we were disappointed that we were not able to grow our pad revenue in fiscal 2013 from the record revenue level of fiscal 2012, due to the slow pace of new business wins, continued competitive pricing pressure as well as customer efficiency gains and their use of our pad technology.

In fiscal 2013, we sold more pads than during the previous fiscal year. However, due to competitive pricing pressure, our revenue did not increase. In addition, as we discussed last quarter, some of our pad customers appear to be extending the life our D100 pads.

While this increased efficiency had an adverse effect on our pad revenue, we believe it build loyalty in these customers and reinforces our value proposition of longer pad life, which can drive further adoption of our technology. We continue to do our pad business as an attractive growth opportunity and look to reestablish revenue growth in fiscal 2014.

From a customer standpoint, we believe the Supplier Excellence Awards we earned during the fiscal year, exemplify our ongoing commitment to collaborating with our customers and consistently delivering innovative high-performing and high-quality products and services.

During the second fiscal quarter, we were honored to have earned Intel's most prestigious award for suppliers, the Supplier Continuous Quality Improvement or SCQI Award and Texas Instrument Supplier Excellence Award. More recently, we were delighted to have received Microchip Technology's Outstanding Supplier Performance Award. These awards recognize our product quality and reliability and our service to our customers. And we are honored to be recognized as an elite supplier within our customers broader supply chains.

Furthermore, our global business teams are focused on a range of formal and informal projects with our customers to address specific business opportunities with them for advanced technologies. Our pipeline of these opportunities remains healthy and we continue to partner with our customers around the world on product evaluations and qualifications.

Finally, from an operation standpoint. We continue to improve our productivity this year, which had a significant positive impact on our strong gross margins performance in fiscal 2013. Our emphasis on and expertise in quality systems and supply chain management has become increasingly critical, as our customers requirements for product quality and consistency continue to increase and product specifications for leading-edge applications continue to tighten.

Continuous improvement and variation reduction in all aspects of our supply chain are the pillars of our global operation strategy. We believe our capabilities in supply chain management and quality systems are unmatched in the CMP industry and represent a competitive advantage for us as technology advances.

In addition, this year we made significant progress in qualifying products from our research, development and manufacturing facility located in South Korea, which we opened in August 2011. As planned, this facility has enhanced our capabilities in the region and has enabled better support for key customers. We were pleased with our ability to ramp this production for this facility in the second half of the year, which contributed to our strong profitability.

Now, let me provide a few comments on our outlook for the overall semiconductor industry for fiscal 2014. Certain industry analysts and some of our strategic customers are forecasting softness in demand in our fiscal year, due to slowing of high-end smartphone growth in favor of higher growth of mid and lower-end smartphones.

Further, PC demand remain sluggish. Industry report suggest that 2013 maybe the bottom of the PC market with a 2014 forecast showing low-single digit growth. If this is true, we would expect to see another fiscal year with softer demand conditions in the first half and stronger demand in the second half, as we saw in fiscal years 2012 and 2013.

To conclude my remarks today based on the sound execution of our long-term strategic initiatives and successful performance in fiscal 2013, we believe we are well-positioned for continued success in 2014. Our ability to provide innovative high-performing and high-quality solutions for leading-edge applications in collaboration with our customers around the world differentiates us from other CMP consumable suppliers.

Looking ahead, we remain focus on continuing to be a technology enabler and further strengthening our core CMP consumables business, while delivering value to our customers and our shareholders.

And with that, I'll turn the call over to Bill Johnson.

William Johnson

Thanks, Bill. Revenue for our fourth quarter and fiscal 2013 was a record $116.3 million, which reflects continued strengthening in demand that we saw during the third fiscal quarter.

Revenue was up by 5.1% from the same quarter last year and up 5.7% from the prior quarter. Total revenue for the full fiscal year was $433.1 million, which represents 1.3% increase from fiscal 2012. Full year revenue results reflects stronger demand for our products in the second half of the fiscal year after soft industry conditions in the first half and include a $5.9 million adverse impact associated with foreign exchange rate changes.

Drilling down into revenue by business area, tungsten slurries contributed 34.2% of total quarterly revenue with revenue down 2.2% from the same quarter a year ago and up 2.9% sequentially. For the full year, tungsten slurry revenue decreased by 3.6%.

As we've discussed in the past, our tungsten slurry products are used heavily in the production of DRAM chips. And we believe that the decline in demand for PCs with the associated reduction in DRAM demand, accounts for our lower tungsten revenue compared to the same quarter last year and full fiscal 2012.

Dielectric slurries provided 28% of our revenue this quarter with sales up 3% from the same quarter a year ago and up 6.3% sequentially. For the full year, dielectrics slurry revenue increased by 3.2%. Within dielectrics, reverence from our advanced dielectrics slurry business increased by approximately 18% for the full year and represents a record revenue level.

Sales of slurries for polishing metals, other than tungsten including copper, aluminum and barrier represented 18.3% of our total revenue and increased 23.7% from the same quarter last year and were up 5.5%, sequentially. For the full year, our product revenue from slurries for polishing these metals increased by 13.7%, driven by particularly strong growth in our aluminum slurry business, revenue from which more than doubled compared to last year. We achieved record revenue levels for our aluminum slurry products for both the quarter and full fiscal year.

Sales of polishing pads represented 7.5% of our total revenue for the quarter and decreased 11.6% from the record revenue recorded in the same quarter last year and increased 2.7%, sequentially. For the full year, polishing pad revenue was down by 2.2% compared to our record revenue last year.

Data storage products represented 4.2% of our quarterly revenue. This revenue was up 3.1% from the same quarter last year and down 6.5%, sequentially. For the full year, revenue for data storage slurries was essentially even with the prior year.

Finally, revenue from our Engineered Surface Finishes business or ESF generated 7.9% of our total quarterly sales. Our ECF revenue was up 38% from the same quarter last year, up 32.6% sequentially and down 3.5% for the full year. The largest part of our ECF business is QED, and our QED business achieved record revenue for the quarter. Recall that most of our QED business is capital equipment-related, so revenue can fluctuate significantly quarter-to-quarter. I would point out that our QED business enters fiscal 2014 with a very limited equipment order backlog.

Our gross profit was particularly strong this quarter representing 50.9% of revenue compared to 48.6% in the same quarter last year and 49.7% last quarter. Compared to the year ago quarter, gross profit percentage increased primarily due to lower fixed manufacturing costs and benefits associated with a weaker Japanese yen versus the U.S. dollar.

The increase in gross profit percentage versus the previous quarter was primarily due to lower variable manufacturing costs, despite higher costs associated with the transition to a new raw material supply contract with an existing supplier that we discussed last quarter, and higher sales volume, partially offset by higher fixed manufacturing costs.

For the full fiscal year, gross profit represented 49% of revenue, which is above our full year guidance range of 46% to 48% of revenue. Gross profit margin increased from 47.7% of revenue in fiscal 2012, primarily due to the favorable impact of the weaker Japanese yen and lower fixed manufacturing costs. For full fiscal year 2014, we are increasing our full year guidance for gross profit margin to be between 48% and 50% of revenue that is up by a full two percentage points versus our annual guidance for fiscal 2013.

Now, I'll turn to operating expenses, which include research, development and technical, selling and marketing, and general and administrative costs. Operating expenses this quarter of $35.5 million or $2.2 million higher than the same quarter a year go and $3.1 million higher than in the previous quarter.

The year-over-year increase was primarily due to higher staffing related expenses, including incentive compensation costs related to our strong financial performance, partially offset by lower depreciation expense and clean room materials expense. This sequential increase was primarily due to higher staffing related costs, including incentive compensation costs.

For the full year, total operating expenses decreased 1.4% to $135.6 million, and were within our guidance range for full fiscal year 2013 of $132 million to $136 million. Looking forward, we are lowering our full fiscal year 2014 guidance, our operating expenses to be within the range of $131 million to and $135 million.

Diluted earnings per share were $0.70 this quarter, up from $0.49 in the same quarter last year, and $0.65 reported in the previous quarter. Compared to the same quarter last year, earnings per share increase primarily due to the higher level of sales, higher gross profit margin and lower effective tax rate, partially offset by higher operating expenses. The increase compared to the prior quarter was mainly due to the higher revenue and higher gross profit margin, partially offset by higher operating expenses.

Diluted earnings per share for full fiscal were $2.16, which is up by 23% or $0.41 from that $1.75 we achieved last year, primarily due to a higher gross profit margin, a lower effective tax rate, a favorable impact of the weaker Japanese yen reflected in other income and a higher level of sales. We expect our effective tax rate for full fiscal year 2014 to be roughly equivalent to our full fiscal 2013 rate, which was roughly 31%

Turning now to cash and balance sheet related items. Capital investments for the quarter were $4.4 million, bringing our full year capital spending to $14.6 million, which is below our prior guidance of approximately $18 million for the year. For full fiscal year 2014, we expect capital spending to be approximately $15 million.

Depreciation and amortization expense for the quarter was $4.9 million. In addition, we purchased $10 million of our stock during the quarter. And we ended the quarter with a cash balance of $226 million, which is $24.4 million higher than in the prior quarter and $47.6 million higher than last year. And we have $161.9 million of debt outstanding.

I'll conclude my remarks with a few comments on recent sales and order patterns. Historically, our fourth fiscal quarter is seasonally our strongest quarter of the year. Frequently, followed by some seasonal softening in demand in the first quarter of a new fiscal year and we are seeing that softness now. Examining revenue patterns within the three months of our fourth fiscal quarter, we saw demand for our CMP consumables products in July, increased by about 10% from the average of the three months in our June quarter.

Then revenue decreased sequentially in August and September, because we reserved orders for our CMP consumables products received to date in October, but we expect to ship by the end of the month. We see October results trending approximately 7% lower than what we saw in the month of September and around 10% lower than the average rate over the September quarter.

We think this is consistent with the forecast of certain industry analysts and some of our customers, as we discussed earlier, which called for some softness in demand early in our fiscal year. However, I would caution as I always do, that several weeks of CMP-related orders out of a quarter represent only a limited window on full quarter results.

I'll now turn the call back to the operator as we prepare to take your questions.

Question-and-Answer Session


(Operator Instructions) Our first question is from the line of Avinash Kant from Davidson & Company.

Avinash Kant - Davidson & Company

The first one I had was related to the pads business. And I think in the prepared remarks, Bill, did say that the pad business was kind of a bit soft, but units were higher. Now going into fiscal year '14, what should we expect? Do you think pricing pressure to continue through the next fiscal year? Or you would expect this business to kind of grow based on some of the winds that you may expect going forward?

William Noglows

If I could, let me answer the question, maybe a little more broadly. I think we see three things that have been kind of a barrier to our growth in pads. The first is we underestimated difficulty of the qualification process for pads. It is much more I think severe and intense than I recall for a slurry product and that I think we kind of missed that when we first entered the business. And now we understand it better that it takes a very long time to qualify a new pad and we're seeing some of that.

The secondary is the one we talked about last quarter, where we believe that many of our customers that have been using our D100 pad have been slowly, but surely increasing the life of those pads and running more and more wafers over them. And we began to see that last quarter and we would expect to see that going forward.

We describe that as the impacts to our revenue, but at the same time it validates our value proposition, and that's important for this third point that I'm going to talk about next. And what we're seeing in the pricing environment is many of our customers, they want lower prices, they don't want lower costs. I mean there is a big difference there and that, they asked us for a simply a drop-in technology at lower prices. And we don't do that and we have chosen not to do that and we've chosen not to chase that opportunity, if you will.

I think as time goes by and people run out of room on price, they will go back to the cost equation. And we believe that we truly offer our customers lower cost with our pad and value proposition, as well as some of the combination we're seeing now with some of our slurries and our pads.

I think the important message here is that we haven't been willing to compromise our value proposition to win market share. We've held on to our value proposition and not being as willing as many of our competitors have been to reduce price in the face of competitive activity. So I think those three things combined, maybe cause the drag that we saw in 2013 on our pad business, but we remain really optimistic about 2014 both with the D100 and our next generation D200 technologies.

Avinash Kant - Davidson & Company

So if I did the math, the revenues in the quarter came out to be roughly $8.7 million, how much were the pads revenue?

William Johnson

I'm sorry, how much was what?

Avinash Kant - Davidson & Company

What's the pads revenue in the quarter?

William Johnson

You're right, $8.7 million.

Avinash Kant - Davidson & Company

And the next question I had was about the opportunity you're seeing in the aluminum and advanced dielectrics, could you give us some idea in terms of how big it is getting to be at this point and how do you see it growing going forward?

William Noglows

Well, we haven't specifically carved out aluminum, Avinash. We've talked about our metals business, metal tungsten being up 13.7% year-on-year. Aluminum is an application that we're seeing, its being utilized in high-k metal gates. And we think that will extend through to 20-nanometer technology.

I mean at that point, there was some discussion that the aluminum maybe replaced by tungsten, may or may not be replaced, but if it is replaced it will replace by tungsten, which for us it's one of our sweet spots in our business, we are the clear technology leaders in tungsten CMP. So we wee this as a great opportunity and it is stimulating a lot of growth in our metals business than that of tungsten.

Avinash Kant - Davidson & Company

And final one, in terms of the tax rate in the quarter. So the tax rates were lower in the quarter and what was that from and then how should we model it on a quarterly basis going forward?

William Johnson

Through the year we had a number of things that impacted our tax rate. Most recently in the fourth quarter, the tax rate was lower based on earnings in foreign countries where the tax rate is lower than the U.S. tax rate. In particular, we had a benefit in our fourth fiscal quarter of greater profitability in our Korean subsidiary. So we built a new facility and established a new subsidiary in 2010, 2011, it opened in 2011.

We turned profitable in the fourth quarter. And so the pre-tax income from that new subsidiary then enjoyed a tax holiday that we got in Korea, that Korea tax rates are lower than U.S. rates anyway. But that was a significant impact on our fourth fiscal quarter. And so to the extent that that business continues to run, we'd expect some benefit going forward not to extent necessarily that we saw in the fourth quarter, but that's why we've guided on tax rate to about 31% for our fiscal 2014. And if you look historically, that's low. You have to go back to fiscal year 2008 to see a lower tax rate for us.

Avinash Kant - Davidson & Company

Because prior to this you were talking about roughly 34% tax rate, right?

William Johnson

That's right.

Trisha Tuntland

We'll take our next question, please.


It is from the line of Jairam Nathan from Sidoti.

Jairam Nathan - Sidoti

Just wanted to concentrate on gross margins a bit here, can you kind of talk about the different factors that gave you confidence of upping your gross margin guidance for 200 basis points, you talk about lower variable manufacturing costs, so is it better pricing, better cost efficiencies or even currency?

William Noglows

Jairam, I'll take the first part of that question and then Bill will follow me with some more details about the currency effects and some other things we saw. I think a lot of our gross margins strength in this quarter, in this fiscal year, is a result of execution of our strategies. We've talked a lot about innovating new higher value products at the leading-edge and I think we're seeing that.

I mean we have two great examples of our aluminum business that's growing very rapidly and our advanced dielectric business that grew I think almost 20% year-on-year. When we introduced new products, we tend to introduce them at sort of a significant value proposition, which essentially means relatively high gross margins relative to the average for the overall business.

So we've been executing on the topline and along the way our team on the operation side continues to find ways to improve productivity, reduce variation and drive out cost. So we've been talking a lot about execution of these strategies. I think we're seeing it in the numbers and we've seen steady progress year-in, year-out on the cost side and we're beginning to see significant inroads on the revenue side and the ability to bring value to our customers.

So I gave you the high level, and so I'll let Bill fill in with more of the details.

William Johnson

For the quarter specifically, last call quarter we talked about anticipation of a headwind on the order of a 150 basis points related to higher cost associated with a new raw material supply contract with an existing supplier that we expected to be around on a transitional basis.

And we did see that. We saw about a 180 basis points headwind, but then we had lower variable cost in a number of other areas. Another raw material, we saw some significant savings. And we had a high record revenue in our QED business, which is high margin business. We saw increasing margins in pads. So a number of other things more than offset that adverse headwind associated with that new supply contract.

Jairam Nathan - Sidoti

And on the OpEx, again, you're kind of guiding down for 2014. Is that mostly coming from SG&A or you think you will take out something from R&D as well?

William Johnson

The downward guidance on operating expense is really pretty modest, right. It's just really down by about $1 million on either end of the range. That's really in light of some of the trends that Bill talked about, a slower and semiconductor industry growth or seasonality. In that environment, we're just going to be more attentive to operating expense. So I don't think there is any particular number or particular area where we'd focus more that really just kind of trying to hold operating expenses level.


And it's from the line of Tony Grillo from Needham & Company.

Tony Grillo - Needham & Company

So just a couple of questions for you, you may have somewhat gotten into them a little bit already. But we're seeing a lot of, obviously softness going into Q4 in semi, and you guys appear to be doing somewhat well relatively. And I was wondering, if you guys can maybe talk about some upside here just for kind of going forward into the first half of '14 after this quarter?

William Noglows

Well, Tony, we're looking at what everybody else is looking at. I mean TSMC is talking about down 10% in the fourth calendar quarter. Most of our customers are reporting a down quarter for the December quarter, as are the analysts that follow the industry. I think those prepared comments this morning and what we're seeing in the current month of October, indicates that we're tracking with the industry.

We had a pretty good fourth quarter. We're up both year-on-year and sequentially, which we're happy about. But we're watching and what we've seen over, this will be the third year of this new seasonal trend that we think is here to stay and it's just the way the business is going to be. I think for Cabot Micro, we'll start the year probably with relatively soft first two quarters and then come back strong in our third and fourth quarter.

Tony Grillo - Needham & Company

And then kind of looking at margins, you guys obviously gave the guidance for the next year. Would you kind of see a ceiling on margins, if you look in the next three to four years kind of in that time horizon?

William Noglows

Again, I think we're pleased with where we are. We're able to increase our guidance for the coming year. A lot depends on the future success of some of the new products that we're currently working on with our customers and the continued success of our operations group and their ability to find opportunities to reduce cost and increase productivity.

We've been pretty successful over the years and I'd anticipate continued success. I think at this point, all we're going to say or willing to say is that we're happy to be able to increase the guidance that we offered for the full our year from 46% to 48% to the new 48% to 50%. I mean that's a significant increase I think if you look at it. And then I think it expresses our confidence and our ability to do those two things and it's continue to innovate and continue to find ways to increase productivity.

Tony Grillo - Needham & Company

And I guess, kind of my question is if you were to look a couple of years down the line, and sitting in that 50% range, the company would be very happy with that.

William Johnson

There are number of headwinds even as we tried to take advantage of the factors that Bill just talks about, at the same time customers always want lower costs and the easiest thing is lower price. And we don't lead with that, but there is always a lot of pressure around that. And so just as we have opportunities for further productivity improvement and things like that, richer products mix, things like that, there are headwinds and so the guidance is for the next fiscal year and we'll have some new guidance for you next year at this time.


It's from the line of Chris Kapsch from Topeka Capital Markets.

Chris Kapsch - Topeka Capital Markets

I had sort of a follow-up on the gross margin look going forward, but more specifically in fiscal '14. I appreciate the up guidance, and the mid-point of that guidance would be the sort of replicating the full year 2013. So I'm wondering, what sort of things could happen that with result in the margin coming at the high-end of that range?

I know you mentioned continued focus on operational excellence and driving productivity in the manufacturing supply chain, but in terms of product mix, is there things that could happen as the course of fiscal '14 ensues that would drive towards the higher end of that range. For example, like tungsten demand recovering or the continued growth in some of these more innovative leading-edge applications, that's sort of thing?

William Noglows

It's a great question, Chris. I think on the positive side, if we continue to see growth in some of these new applications, for instance aluminum and advanced dielectric and some of the materials that we're currently working with customers on that are, what I would describe as sort of in development or early stage development, those always help our gross margin., the introduction of those new products.

We've had a bit of mix swing in the last couple of quarters, as a result of the weakness in the DRAM market and the PC market. Our tungsten business has been a little sluggish. We would expect that that business to comeback with the return of growth in PCs and the utilization of DRAM technology. So I'm trying to discuss upsides here.

And the other upside is I expect and I know my colleagues expect to find opportunities to reduce costs again next year through the productivity we work and the work we do and the variation reduction work we do. It's more of a continuation of the same. Bill talked about some headwinds and I think when we give gross margin guidance for next year, we tend to be conservative. And I think for good reason, there is some unknowns come at us during the year that we need to manage and address when they come.

I think we feel really good. Our yields are running really high right now, and as a result, there is some of our activity on the upside. And our R&D team is pretty excited and motivated about some of the projects we're working on with some of our leading-edge customers. So I think our guidance is where we think it will be. If that changes for the year, of course, we'll tell people, but we're feeling pretty comfortable with being right up there, close to 50% gross margins, which we think it's a pretty powerful number in the supply side for the semiconductor industry.

Chris Kapsch - Topeka Capital Markets

And then just following-up on that, I mean if you look even more granularly on the sequential basis, there's impressive gross margin in the fiscal fourth quarter and in spite of that I think you said a 180 basis point headwind from the raw materials supply contract and higher fixed manufacturing cost. When you talked about the headwind from the raw material, it sounded though that you would hope to offset that overtime, not with other sort of margin enhancements, but really through possibly looking at selective price increases I thought.

So I'm wondering is that something that you feel is not necessary given the margin performance in the quarter, in spite of that headwind and given that soft end-market backdrop, particularly looking near-term. And then can you just talk to more specifically what was the higher fixed cost manufacturing related to?

William Johnson

Last quarter, we talked about higher cost related to this new raw material supply contract for the existing supplier that we expected to be on it in kind of a transitional basis, because we think we have the number of means to mitigate that higher cost. So we saw the higher costs this quarter. We'll see some of it next quarter. Overtime, we think that we can mitigate it over the next couple of quarters or so. And that's a number of different things, approaches that we can take to achieve that, so we'll manage that we think.

The other thing specific with the fourth quarter, we did see high level of sales, high level of productions or capacity utilization was pretty strong and that was another benefit that I didn't mentioned. But we expect to manage the transitional effects of that new supply contract and managed that over the next several quarters.

Chris Kapsch - Topeka Capital Markets

The high sales and high production rate so to speak, to I think lower sort of variable manufacturing cost, but you did also mentioned in the press release, high fixed manufacturing costs. So I'm wondering, was there incremental capacity added recently that I'm missing?

William Johnson

I didn't address that part of your question. The higher fixed manufacturing costs were really mostly related to higher compensation expense around incentive compensation. We have an annual bonus plan and given the strong performance for the year and the fourth quarter. The same thing that drove higher operating expense sequentially and also had an impact on the cog side.

Chris Kapsch - Topeka Capital Markets

And so the other question is that looking at the OpEx guidance and sort of a follow-up to another question. But you came in at the high-end of this past year's range. You're bringing the range in a little bit. If you were at the midpoint, I would suggest lower overall op expenses for the full year. I'm assuming that there is annual merit raises and and so forth.

You're looking at that OpEx expense and figuring that R&D is a big component of it, and if you against the backdrop of your comments about collaborating with the bigger leading-edge customers and trying to develop innovated solutions with them, just wondering like what you're doing with your R&D dollars to continue to pursue your strategic objectives and collaborating with those customers? Are you able to increase the R&D dollars even though overall OpEx is going to be lower or are you just concentrating the programs more on the bigger customers?

William Noglows

Chris, again, the great question. I think the way you finished that question is right on it. We are concentrating and focusing our activity on what we described as the leading-edge technology development customers. And we've categorized our customer base and you can guess who those are.

I think the other thing is, and then sort of stepping up a bit, in this environment of slowing industry growth in consolidation, we just feel like being responsible about it, we think we need to kind of try or best to keep our OpEx as flat as possible. And I think that's what we're trying to indicate in our guidance. Now we will do our best to keep our OpEx flat and get the leverage off, any growth we get on the revenue line.

Our intent is to not scale back our R&D activities. Our intent is to focus our R&D activities on those opportunities where we think we can bring the most value and the best solution to our customers. So I think you hit it right on your question. It's a question of focus, it's not a question of shrinking the overall program. It's putting our best scientists on the best opportunities to create value for our customers and ultimately create value for us and our shareholders.


Our next question is from the line of Jay Harris from Goldsmith Harris.

Jay Harris - Goldsmith Harris

Given the fact that revenues are growing at roughly, let's say, at single-digit rate. What was there about your operating expense increase that was strategically important and really operating expenses relative to the revenues, will that ratio come down during the next fiscal year?

William Johnson

If you look at through the year, Q1, Q2, Q3 we ran operating expense around the $32 million to $33 million per quarter. It's really in the fourth quarter where we saw that increase up to $35.5 million. And as I mentioned that increase was largely incentive comp around the strong financial results. So to the extent now, we set guidance of $131 million to $135 million, so the midpoint about $133 million. And that implies the similar kind of run rate that we saw in the first three quarters of the year, like $33 million or so and change.

So no change in strategy in the fourth quarter, like Bill talked, about we'll try to manage those operating expense going forward. In the past, we've talked about trying to set a goal of operating expense of 30% of revenue or less. And there have been a couple of years or I think we achieved that a few quarters, but that's the goal. I mean it's a simple goal, roll operating expense slower than revenue, but we're trying to keep it or get it below 30% of revenue.

Jay Harris - Goldsmith Harris

And if we could go over to the pad business for a moment, kind of the longer life that your customers are experiencing with your pads, when do you think, you'll start to get the benefit of that in terms of topline growth?

William Noglows

Well, Jay, I hesitate even try to answer that question. I think we continue to believe that the pad opportunity is probably the single largest incremental growth opportunity in front of us today. We have a lot of confidence in our technology. We have a lot of confidence on our value proposition. What I said in my comments earlier is that we're disappointed in that pace and rate at which we've been able to penetrate some of our customers, and their reluctance to change the pad because of their qualification process. As well as this industry, like I said earlier, many of our customers they just want a lower price. They're not interested in doing the work to get a lower cost.

At some point, we believe that will come to ahead and they're going to have to go ahead for the costs, because I think many other customers that we sell to today are enjoining the cost benefit that we provide with our longer pad life. And at some point there will be competitive pressure in the channel and we think people will turn to us for our pad. But I can't predict when that's going to happen, Jay. I think it would be a mess for me to even try. But we're working very hard at it. Our field teams are out there everyday with the customers. They have pads on tools. They're doing the work that we need to do to quality our pads.

Jay Harris - Goldsmith Harris

Well, I'll presume that when a pad gets qualified in one of the fab that a customer owns, you still have to go to the other fabs and they independently do their own qualification. And on that assumption, how many fabs have qualified your pads at this point? And how many are in the qualification process?

William Noglows

Well, let me address your first question, first. The assumption that it we have to re-qualify it, every fab is very customer dependant. Some of our customers run a central purchasing technology approval process where once they accept to technology, they very quickly implement it across all their fabs. Other customs have, what I would describe, as just kind of a intramural approach, where you've got some pads factory-by-factory.

Today we have some 30 customers that are buying our pad, which we think is significant and we had continue to have trials and qualifications and discussions with, I think there is another 30 or 40 something like that, so the activity is still robust and I think rich. It's just taking a long time, Jay. So that's the answer.

Trisha Tuntland

That is all the questions that we have this morning. Thank you for your time and your interest in Cabot Microelectronics.

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