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Executives

Timothy Oliver - Chief Financial Officer and Senior Vice President

Bill Michalek - Director of IR & Corporate Communications

Ahmad Chatila - Chief Executive Officer, President and Director

Analysts

Jeffrey Bencik - Kaufman Bros.

Stephen Chin - UBS Investment Bank

Sanjay Shrestha - Lazard Capital Markets LLC

Vishal Shah - Barclays Capital

Krish Sankar - BofA Merrill Lynch

Paul Clegg - Jefferies & Company, Inc.

Stephen O'Rourke - Deutsche Bank AG

Paul Leming - Soleil Securities Group, Inc.

Satya Kumar - Crédit Suisse AG

Jesse Pichel - Jefferies & Company, Inc.

Christopher Blansett - JP Morgan Chase & Co

John Hardy - Gleacher & Company, Inc.

MEMC Electronic Materials (WFR) Q2 2010 Earnings Call July 29, 2010 5:30 PM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the MEMC Second Quarter Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to host, Director of Corporate Communications for MEMC, Mr. Bill Michalek. Please go ahead, sir.

Bill Michalek

Good afternoon, and thank you for joining MEMC's Second Quarter 2010 Earnings Conference Call. With me today are Ahmad Chatila, President and Chief Executive Officer; Tim Oliver, Chief Financial Officer; and Kurt Burning, Treasurer.

Before we begin, please note that this call will include forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from management's current expectations. These risks are described in the earnings release published today and in our 2009 Form 10-K. As a supplement to this call, we have provided slides on our website to provide more detail regarding the quarter. Please go to the Investors section of memc.com. I will now turn the call over to Ahmad for his opening remarks, and then Tim will review the financial results and outlook.

Ahmad Chatila

Thanks, Bill. Good afternoon, everyone. I would like to start by framing our performance for the second quarter and then offer an assessment of our progress in achieving what we have said we will do. Our headline for the quarter is straightforward. We are pleased to report continued improvement in our operational performance, strategic position and our financial results. We are capitalizing on stronger market demand, reacting to solar supply chain challenges, improving our cost structure and ramping the SunEdison business.

We are simultaneously making prudent investments in our selling capabilities and capacity expansion in technological differentiation and in acquisitions that are all meant to capitalize future period growth. The markets we serve around the world have continued to recover. You are seeing healthy end market demand. The strategic and operational actions we're taking to strengthen our business are taking hold and position us for improved long-term performance. And we've crossed the midpoint of 2010 and look ahead to the second half of the year. I offer this assessment of our progress.

First, in our Semiconductor Materials segment, I've said that I expected the business to improve its performance and profitability quarter by quarter. We said that the second quarter of 2010 would be better than the first. It was. The segment returned to profitability, benefiting from continued volume growth, higher selling prices and improved productivity. It has positive operating income for the first time since Q3 '08 in spite of 20% lower pricing over that period and that is due to market share gains and productivity improvements. The semiconductor material business will provide evidence of further improvement. We need and expect more from this business. The second half of this year is expected to show continued improvement and be better than the second quarter.

Now let's turn to the Solar Materials segment. In this segment, I said we must take actions to de-risk the business, to better control our destiny and to improve our performance. I also said in February’s Capital Markets Day that margin would drive throughout the year. While I'm unable to meet my commitments on improving margins throughout the year due to our lack of control over our own destiny in solar wafer manufacturing and this was exacerbated to the extreme by the German fee and tariff saga, fortunately we have identified this as a risk in 2009 and communicated our intentions to build our advanced wafering plant in Q3 of 2009.

Strategically, the Solar Materials team made significant progress on positioning and de-risking the business that will show some results in Q3. But we'll have significant impact on this business in early 2011. First, construction at our new wafer plant in Kuching, Malaysia, is proceeding as planned. The plant will significantly de-risk our Solar Materials segment by reducing our sole reliance on external vendors. Second, during the second quarter we launched a joint venture in China and continued to form strategic partnerships with certain wafer suppliers to diversify our supply chain and reduce the variability of our future costs. Third, in the second quarter we acquired Solaicx and with it an advanced continuous monocrystalline process and technology. This process provides lower-cost crystal and results in wafers with enhanced electrical performance, allowing cell manufacturers to create higher-efficiency cells with competitive cost. Fourth, we continue to drive productivity in our polysilicon plant in Pasadena, Texas. During the second quarter, the plant produced record high volume, and while we are pleased with this performance, we have a three-year roadmap to drive further cost and productivity improvement at the plant.

Finally, we continue to expand capacity for our high-quality polysilicon and have made significant progress at our Merano, Italy plant. We have produced our first silicon from the expansion, and we will ramp this additional 2,000-ton of annualized capacity over the remainder of the year. This ramp helps to ensure that we have poly to meet our internal needs and that our customers receive products made from some of the best polysilicon available.

Our progress in this bayou is clear. We are de-risking and lowering the cost of our Solar Materials business, while positioning ourselves to provide customers with better products and better services.

Next, to SunEdison. We've said that project completion would be lumpy in the first quarter of this year. We’ve said that we would look into several new financing options to help facilitate future growth. True to our previous comments, the timing of project completion and revenue recognition remains difficult to predict and lumpy. This is due to the long-term nature of project development in different countries and incentive regimes. And while the reported results in the quarters are just a slowdown, the actual level of activity in this business has never been higher. Admittedly, the year is even more back-end loaded than we thought it would be. However, the SunEdison team is poised for a robust second half with 150 megawatts still planned for the year and 111 megawatts currently under construction.

Strategically, during the second quarter, we announced a landmark agreement with First Reserve to allow for the purchase of up to $1.5 billion in SunEdison projects. This is a meaningful development and one that positions us to further grow this business.

Overall, we are making good progress with SunEdison. All leading indicators are positive in the this business. In April, we said that SunEdison would likely install 150 megawatts of projects in 2010 versus our previous expectation of 100. We will continue to be disciplined in our approach. In the growing solar market, this business provides us with many downstream opportunities that will become increasingly evident as we move forward.

Our SunEdison business has improved. The backlog increased more than our expectations, but we need to continue to scale this business and demonstrate the financial capabilities of this growth engine. That's a brief overview where we stand in each business segment. There is more work to be done, and we are doing it. While I'm not satisfied with our current results, I'm confident that we're making the right decisions, implementing the right processes and hiring the right resources to make us successful. As we look ahead, I’m confident that the second half of this year will provide further evidence of our progress. With that, I turn our CFO, Tim Oliver, for more detailed review. Tim?

Timothy Oliver

Great. Thanks, Ahmad. And thanks, all of you, for joining us this afternoon. My comments today will reference charts that Bill just spoke of, that are provided on the website which both summarize the data provided in the press release and provide additional analysis. Since Kurt has already reviewed the cautionary Safe Harbor language, I'll move right to Slide 3, which is entitled Q2 Results Summary.

Walking down the income statement, revenue in the quarter was $448 million, an increase of 2% sequentially. Higher revenue was due to higher volumes and favorable pricing in our Materials businesses, partially offset by lower direct sales of SunEdison. Year-over-year revenue was up 58% or 48% when you exclude the $31 million benefit of the addition of SunEdison. Wafer volumes in both of our Materials companies were up significantly, while pricing was up in Semi and down nearly 30% in Solar.

Gross profit rate increased 370 basis points sequentially and almost five full points versus last year to 17.2%. We'll discuss the profitability of each reported segment in a couple of slides, but in general, profitability in our Semiconductor Materials business is improving in concert with the volume-driven productivity and improving pricing.

At Solar Materials, favorable pricing and productivity continue to be partially offset by wafer tolling costs at our subcons, and at SunEdison the margin rate was above its typical run rate due to the higher mix of energy revenue.

Continuing down the P&L, the next line is insurance recoveries. The second quarter results include a $12 million benefit related to the recovery of some of the lost profits caused by Hurricane Ike back in 2008. This amount is included in the segment operating income and it’s split between the two segments based on the relative use of poly.

Operating expenses were $86 million, up about 11% sequentially, due largely to the calendarization of the vesting of some past year large equity grants and some expenses related to the Solaicx acquisition. Year-over-year OpEx is up $28 million, driven by the acquisition of SunEdison, the equity vesting I just spoke of, the Solaicx transaction and expenses associated with administering the capacity expansions that we have launched all over the world, particularly in Malaysia and in Italy. All these are partially offset by lower restructuring charges.

Other income and expense flipped to income of $2.8 million from an expense last quarter. This change is attributable to two things: The absence of the very high specific financing costs for SunEdison project in the first quarter and gains in the sale of fixed income investments as we move to shorter duration and higher-rated investments this quarter.

In a more typical quarter, you would expect interest income to only partially offset the lease and interest to cost on the owned solar energy assets resulting then in a net expense. And a fair value of the Suntech’s warrants was adjusted down again by $6.8 million. This non-cash fluctuation in these warrants reduced our reported GAAP EPS this quarter by $0.03 and by $0.05 year-to-date. While we don’t attempt to model the fluctuation in another company's stock pricing in our guidance or planning, the value of these warrants reflected on our books is now very low and the valuation of risk from here is limited.

The tax line shows the tax benefit that is outsized compared to the modest pretax loss. The additional tax benefit resulted from the successful conclusion of a U.S. tax audit for prior periods and reflects the release of an excess reserve held against that audit.

Equity and earnings of JV and minority interest was $1.6 million and represents the distribution of interest of partners in both Semi and SunEdison. You'll remember that the $6.8 million positive number in Q1 resulted from the profits recognized at the closure of the Q-Cells joint venture project. The walk completes at the bottom of the page with EPS of $0.06 a share, including the $0.03 loss I just spoke of that’s attributable to the Suntech warrants.

The next three slides give you an overview of our three reporting segments: Semiconductor Materials, Solar Materials and Solar Energy or SunEdison. Each of these slides provides a rolling five quarter summary of sales and segment margin. The SunEdison Slide, however, only includes data for the post acquisition periods.

So on Slide 4, titled Q2 Results Semiconductor Materials. Like Q1, the Semi business continues to benefit from significantly improved end market demand, from efforts over the last several quarters to regain market position and customer share and from improved prices. Revenue increased more than 70% year-over-year and 14% sequentially, driven in both comparisons by high-single digit price increases and by higher wafer volumes. After several very difficult quarters, Q2 marked the return to profitability for the Semiconductor Materials business.

Higher volume and a better fixed cost absorption that accompanies those volumes, improved pricing and a productivity all contributed to this improvement. The segment also received about $8 million of benefit from the insurance recovery.

Moving to Slide 5, Q2 Results for Solar Materials. Revenue in this segment increased 7% sequentially and 22% versus the prior year. While wafer volume was relatively similar to the first quarter, higher pricing lifted revenue. Year-over-year, significantly higher wafer volumes were only partially offset by nearly 30% decline in market pricing. Segment margin increased sequentially as higher prices allowed us to regain some of the spread we lost to subcontractors in the first quarter. Efforts to diversify our supply base, build flexibility into our supply-demand equation and to form mutually beneficial partnerships all undertaken in Q2 will continue to benefit the margin line as we go forward. This segment also received the remaining $4 million of that hurricane recovery.

In Chart 6 titled Q2 Results for Solar Energy or our SunEdison business, the revenue was down sequentially $31 million as higher energy revenues were more than offset by lower direct project sales. As Ahmad said, because the recognition of project revenue in this business is so dependent on parties and processes outside MEMC or our end customer, because the type of eventual financing affects the GAAP treatment of these projects, we continue to remind you that while our construction and project schedules are reasonably predictable, reported results in this business will be lumpy and will be difficult to forecast for any one 90-day period. The flip in segment margin to a loss of $4 million in the quarter versus a profit of $7 million in Q1 is attributable to the lower revenue. Operationally, SunEdison interconnected another 3.8 megawatts during the quarter, bringing the first half total to 14.7 megawatts. Exiting the quarter, the business had over 111 megawatts in various stages of construction that are expected to be completed during the second half.

Moving to Slide 7 titled Free Cash Flow Walk. Free cash flow usage was $21 million in the second quarter as cash outflow for capital investments to support future growth outpaced cash inflows. In Q2, we generated $190 million of cash from operating activities versus $110 million use of cash in Q1 and a $16 million generation in the year ago second quarter. The major sources of operating cash improvement in the quarter were improved profitability, a net tax refund and better working capital management.

Moving from there to investing activities, we did invest $95 million in CapEx related to planned growth in our Semiconductor and Solar Materials business units. These investments will expand our semiconductor wafering capability and increase our polysilicon capacity at Merano.

Finally, the last major category when analyzing our cash flow related to the construction of solar energy systems and the eventual proceeds from financing these systems with nonrecourse debt and capital lease obligations. The construction of solar energy systems used $66.8 million in the second quarter. These are projects that the company does not currently plan to sell directly, but rather is to finance through either a sale leaseback or some other form of nonrecourse financing. In this regard, we executed off-takes from financing that generated $33.8 million. The net of these two items in the second quarter was a net cash outflow of $33 million.

Slide 8 transitions to a discussion on our outlook and is called 2010 Guidance. After considering our first half results, it is apparent that we need to amend our outlook. This chart reminds you of our original guidance that we provided back in February, shows where we stand on those metrics at the midpoint of the year and then provide some commentary that aligns our current outlook with that guidance. I'm going to spend a minute on each of these metrics and then give you some second half color by business segment.

On revenue, we now expect to exceed the high-end of our previously guided range of 1.75% to $1.85 billion. Better-than-planned revenue performance at both our Solar Materials and our SunEdison segments should allow us to exceed that range. On EPS, however, it is now apparent that we will not be able to meet our original guided range of $0.70 to $0.80. While the volume upside in the two Solar segments and the aggressive productivity efforts across our company will drive some incremental profitability, it will not be sufficient to offset the impact of the significant margin squeeze in our Solar Materials business. While a whole collection of unanticipated variances in things like taxes, the warrant valuation, insurance recovery and Solaicx’s costs, largely net out for the year and while our operational performance against our original plan has not been flawless, the causality for the EPS shortfall can be almost entirely assigned to the temporal squeeze caused by our reliance on external wafering capacity.

And finally, on free cash flow. While our full-year free cash flow results are heavily dependent on the back-end loaded SunEdison project closures, we still expect full-year free cash flow to be positive. So having said that we don't think providing quarterly guidance is appropriate to our business model, rather than provide you new guided ranges with only five months left in the year, the next three slides try to provide some qualitative help by segment for the second half for those of you who build models.

Slide 9, 2010 Outlook Semiconductor Materials, does just that. The graph on the left-hand side of the page depicts our revenue and profit performance over the last 3.5 years. As you can see, this business bottomed in the first quarter of last year, has been improving steadily ever since. While we are not satisfied with the absolute levels of performance, we are encouraged by the trend and the pace of improvement in this business. Our goal is to extend this pattern through the remainder of the year. For this business, we expect end market demand to remain robust, which should support modest increases in prices in each of the next couple of quarters, particularly in smaller diameters. With production ramping in EPO and continued efficiency gains across our production base, we expect to manufacture and ship record volumes in the second half.

From a profit perspective, further progress on our cost roadmaps, incremental benefit from prior period restructuring efforts and pricing should all help push margins in this segment back closer to the historical averages as we exit the year.

Turning to Slide 10 entitled 2010 Outlook for Solar Materials, here we have a similar look for our Solar Materials business that illustrates the dramatic impact in prior periods of wafer prices and the flow-through into our financial results. After contracting for several quarters in a row, margin rates in this business have stabilized and even increased slightly in the second quarter as we reacted to detrimental price cost dynamic that we experienced in the first quarter.

Looking to the second half, we expect to see sequentially higher volumes in each of the next two quarters, as recent supply and diversification efforts provide additional wafers for us to meet existing customer demand. We also expect prices to increase slightly in the second half over second quarter levels before reverting to the longer-term downward trend toward the end of 2010 or in the beginning of 2011. These two taken together would obviously drive considerably higher second half revenue.

Profitability should be buoyed by two things in the second half. Lower wafer cost due to our productivity and slightly better pricing. And while the impact will not be evident until next year, we will also dedicate significant resources to getting our own wafering capacity up and running as soon as possible.

And finally on Slide 11, the same outlook for SunEdison. SunEdison has accomplished a lot in the first half of the year and as Ahmad touched on some of it. But that was just a warm-up for its plan for a big ramp in the second half of this year. With that 111 megawatts already underway and our plan to interconnect close to 150 megawatts for the full year, SunEdison is poised to deliver much stronger financial performance. Alignment of our procurement processes, of all of our financing efforts with project execution will be the key to our success. So that concludes my prepared remarks. Bob, I suspect that answered a few questions, but I bet there’s a few more so I’ll open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we go to the line of Sanjay Shrestha of Lazard Capital.

Sanjay Shrestha - Lazard Capital Markets LLC

I was hoping to get some more clarity on the SunEdison side of your business. You guys talk about 150-megawatt interconnect and 65% direct sales megawatt under construction of 111 megawatt. Are these projects -- give us a sense of where the financing is and how should we sort of think about the cash flow implications? Some more detail on that. Maybe the overall levels of profit? We’ve been given some pretty attractive...

Timothy Oliver

Sure. As we've discussed in the past, the cash flow implications are relatively similar no matter how we end up financing the projects and while there’s minor changes on how much cash you get on day one, for the most part, you're indifferent as to how we get them financed, so long as we get them financed. Of those 150 megawatts for the full year, we’ve talked a lot about Rovigo at 70 megawatts and while that project, we’re in the process now of getting that project sold. I'm very confident it will happen, both the debt and equity side of that. We have good demand and lots of interest. But I'd say that is because of its size, we hold that one out as a separate project that we're working aggressively and with all the right parties. The remaining megawatts then are more traditional in size to the way we typically have to fund and I think we've identified most all of the funding for those projects, whether they be sale leaseback arrangements, master lease agreements in this country or in Canada or other financing for direct sales in Europe. Most of the rest of the financing is in place. So that will not be the constraint for this year.

Sanjay Shrestha - Lazard Capital Markets LLC

Okay, great. So given the current type wafer capacity, so previously you guys talked about tolling being an impact from a margin standpoint. And until your in-house wafer capacity comes online, how should we think about that? And how much pricing increase given the rise of the wafer prices in the spot market can you implement to some of the existing customers? So is there a profit expansion that could be meaningful enough for the Solar side of the business in the second half?

Timothy Oliver

I think that as we discussed last quarter, first we said we won't let happen to us again what happened in the first quarter. That we will work hard to make sure we have more optionality as we enter the quarter, that we have more optionality both from who we source wafers from, also a better balance in our supply and demand going into the quarter and leave ourselves more flexibility in the pricing end. That being said, it's not so much the absolute level of pricing that we care about or the absolute level of the cost of tolling, but rather the spread between the two. And it's unlikely that in the absence of our own solution, that our margin rates are going to go much above a 20% gross margin until we have that wafering solution. So we are working our way back up from an unsatisfactory margin rate in Q1 to a more respectable margin rate in Q2. We'll continue to work that throughout the year, but the ultimate margin solution for us is our own wafering facility, and we're working aggressively to get that in place.

Operator

The next question comes from Stephen Chin of UBS.

Stephen Chin - UBS Investment Bank

Hi, Ahmad and Tim. I was wondering if you could just share some more details on the JV that you said you signed in China in the second quarter. Maybe share how many megawatts this JV might make for wafers in the second quarter. And how many other solar wafer tolling partners you added. And what your latest thoughts are when this Malaysia solar wafer factory will be up and running. That would be helpful.

Ahmad Chatila

Thanks, Stephen. This is Ahmad. Let me give you some color. So first, we continue to use wafers from our partner that we’re developing the JV with. Albeit at not the level that we would like to get. The JV starting is around 600 megawatts when it’s fully installed. It can ramp up to a much higher number in the long run, of course. We will see probably first revenue from it in Q4, and it will run from there. I don't have on top of my mind exactly when it will be fully utilized. So that's what's going on there. On our internal solution, as I'd always said, we will have some results from it this year, but meaningful financial returns next year. We will start qualifying customers Q4 of this year and ramp in the first and second quarter of next year. And it will also be around 600 megawatts.

Stephen Chin - UBS Investment Bank

We've seen a couple of solar wafer deals signed recently in the industry for multiple years. Is MEMC still interested in looking to sign longer-term solar wafer contracts with customers?

Ahmad Chatila

Thank you, Stephen. The answer is yes. It depends on the supplier. We are working with a few people on that regard. And again, we have to be mindful of the long-range LCOE roadmap. So whatever we sign has to abide by ensuring that we’re successful downstream. So we are open, you'll hear from us a little bit more in the next three to six months. I'm actually, Stephen, very optimistic about the Solar Materials business. I think the worst is behind us. We're still going to have some rocky road for the next few months, but I expect good results Q4 and mainly in Q1 and Q2 of ’11.

Operator

Next we go to the line of Krish Sankar, Bank of America-Merrill Lynch.

Krish Sankar - BofA Merrill Lynch

Number one, either for Ahmad or Tim, 65% of direct sales in SunEdison in the back half. I'm guessing it's heavily skewed because of Rovigo. What would be the percentage of direct sales x Rovigo in the second half?

Timothy Oliver

You're correct. That is what has shifted is from coming into the year, thinking about 40% of our revenue would be direct sale and 60% not. We’re now the other direction. So I would say that in a typical quarter, we'd be 35% to 40% direct sales and the remainder financed either through straight debt or some kind of a sale leaseback option.

Krish Sankar - BofA Merrill Lynch

Got it, got it. And for the Solar and Semi Materials business, you guys said you expect pricing to improve modestly in the second half. Is it fair to assume that's going to meet the low-single digits there?

Ahmad Chatila

Let me think. Yes, I mean the single digit.

Timothy Oliver

Yes, but Solar Materials, I think what I said was we expect pricing to improve in the third quarter and probably in the fourth start to decline a little bit as it declines into 2011. That's our best guess. But second half in totality prices will be higher than the first half because of the lower prices in Q1.

Krish Sankar - BofA Merrill Lynch

Got it, got it. You guys with regards to your solar wafering capacity initially coming up at 600 megawatts, but I believe your long-term plan’s to be 50% in-house, 50% outsourced. So when will you reach that -- when you think you're going to reach that 50% limit in your wafering build out?

Ahmad Chatila

We don't have an exact view because there are a lot of deals back and forth right now. I think that's a good target by end of next year. I mean remember there’s Solaicx as well. So end of next year will be a good target for that. If not, it will be Q1 2012.

Timothy Oliver

To a certain extent, if we fall short, it's because the market is even more robust than we thought, and we’ll have to accelerate some expenditures at the time. If I could just revisit your first question on the mix of direct sales versus the other, I should also say that because the first reserve deal is now in place, that does give us the flexibility to have more direct sales in parts of the world we otherwise might not have as we go forward, so I just didn't want to leave that out.

Operator

And next we go to the line of Stephen O'Rourke, Deutsche Bank.

Stephen O'Rourke - Deutsche Bank AG

I know you don't want to quantify what the new EPS guidance is, which is below the previously guided range, but how should we think about this? Is there a modifier that maybe you could provide whether it be modestly below or meaningfully? And second question, Ahmad, last call you talked about potential double ordering? I think in Solar materials, what's your view on this now?

Timothy Oliver

Do you want me to take the first one, and then you take the second one. Right, the first one, here’s how I think about it. We did an acquisition, Solaicx, that's going to cost us some EPS this year. Let’s say it's a nickel. We've got currency working against us in some of the SunEdison projects that hurts. We've lost a nickel on these warrants that we can’t control and so that all walks us down a bit. In the absence of that, we still looked at our guidance and said can we scramble back and make the number for the year? And 90 days ago when we talked to you, we thought we might be able to, if we could improve margins rapidly enough in the Solar Materials business and if the SunEdison business could have a really remarkable second half. I think where we sit today is we're going to put an awful lot of pressure on the centers and businesses as it is to have a great second half. Whether or not we should be putting more pressure on them to have a remarkable second half and whether they were capable of even doing it, we're not certain. Were there more time left in the year and were quarterly guidance appropriate to our business model, were we able to predict things in 90-day periods and if we could be very certain as to how the financial close on SunEdison projects will play out, I think we could be more specific. But with all those uncertainties I just described, we thought it's better to be a little bit more vague and plan for a robust third and fourth quarter and be able to talk to you in the fourth quarter about 2011 more specifically.

Ahmad Chatila

It's a long I can tell you, but the reality is we can't. Our business is a little bit lumpy. We're confident that the performance is going to improve, as I said. All metrics are in the right direction. It’s just a little bit lumpy, more than we wanted. And since we don't control the wafering capacity, we're uncomfortable in telling you exactly where it's going to be. But the main impact at the end is the wafering capacity. When it's all said and done, we entered the year which actually takes me in a good segue to your question, I mean we entered the year thinking that the market is six gigawatts. That's our view. Other people's view were seven to eight, knowing that last year was 5.5 and lo and behold, Q2 was at 3.7 gigawatts. So it's a 14.8 gigawatt market. And that's where we misjudged our situation. If we knew in December that the world’s going to be 15 gigawatt, and let me tell you that no one told us that, no one said it’s going to be, we didn’t think, of course, that it would be, we would have made different strategic decision. We would have been maybe more transactional about our wafering capacity. So it didn't happen. From now, double ordering, the one that I was worried about, Steve, is Germany. I was worried that people are just over-ordering, trying to catch the higher tariff rates before it declines. But so far, a lot of my customers who sell modules are telling me that they continue to get strong demand from Germany. So that's one. I also know, because we’re in downstream operation around the world outside of Germany and Czech Republic, that the demand will increase. So then the big question becomes, Steve, in any commodities it’s the demand-supply equation. It’s really nothing to do with the demand is there or people are double ordering or not, will the supply meet demand or will it be higher or lower? And that's how we have to think about the business from a pricing perspective. But the volume, I assure you, it is high and it will continue to be high. The big question is going to be the margin. And it's going to be dependent on the price. So that's how much we're grappling with at this moment. I don't know if I answered your question, but that's our view.

Operator

And next we go to the line of John Hardy, Gleacher & Company.

John Hardy - Gleacher & Company, Inc.

I know it wasn't a huge increase in terms of days, but I was hoping that you could detail some of the components in the increase in inventories and maybe give a little bit of color, Ahmad, on what you think of the Semi inventory situation as we head into the second half.

Ahmad Chatila

Well, first of all, from a semi inventory situation, it is lower for us from beginning versus the end of the quarter and in total square inches. We have a plan to reduce it further. The demand is very strong. Working in Semi for 12 years before I joined MEMC and selling commodities from memories to founded wafers, I’m kind of always anxious about cycle management. But I tell you, so far the demand is very strong until Q4. I don't have a view on Q1 so I'm not worried about the inventories in that regard. Not ours at least. From a customer perspective, I see special strength in automotive, John, and I see a lot of strength in power electronics and there's a lot of tightness in capacity because a lot of those products going into epi wafers and there's not enough epi wafers. In other markets I don't have a view how it's going to emerge in the long run, but again to repeat, to reiterate, Q3 and Q4 look pretty good for the Semi business.

Timothy Oliver

And if you're speaking about our inventories, in fact, as Ahmad said, inventory in Semi went done in the quarter. The two other units increased inventory slightly. I'd say that the Solar Materials it had to do with timing. That inventory is now gone. And in SunEdison, it would be preparation. I spoke of the 111 megawatts under construction. Many of those projects fall into WIP. So you'd see that there.

John Hardy - Gleacher & Company, Inc.

Right, great. Obviously, the working capital situation is pretty dynamic with all the building going on in the second half. So with that in mind, is there any update on sort of how you're thinking about poly capacity in 2011 by year end?

Ahmad Chatila

Yes. So far, we have not announced our 2011 plans, but I assure you it's going to increase. So we're very excited about the progress that the Solar Materials division has made in Merano. They got first silica now. We're going to get to our 12,500 number that we told you about for the last two years. So 2011 is going to be up. [Indiscernible 1:16:13] we’ve been measured, we're trying to fight a war and trying to get the top spot, although we have the money to do it. So we're going to be measured, but will be up, and the demand is up on our wafering, both in Semi and Solar so we have to satisfy at least most of it in sight.

Operator

And next, we go to the line of Vishal Shah, Barclays Capital.

Vishal Shah - Barclays Capital

I apologize, I missed part of the call. So I wanted to ask you about your Solar margins. I know that wafering is tight, but are you able to pass off the rising tolling costs all to your customers? And can you maintain margins above a certain threshold level there? And secondly, I know you're not giving guidance, but consensus for third quarter is at $0.23. I'm assuming you're seeing flattish margins for Solar and SunEdison so are you going to be able to hit that target? Are you talking about $0.10 to $0.15 now? Or can you give us some sense of what Q3 should be?

Timothy Oliver

So let me take those in order. Let me go back to your presumptions for third quarter. I think we just said on the call that we do expect margins to expand sequentially in both the Materials companies for the remainder of the year. So you should continue to see margins expand and, in fact, if you pull the graphics from our charts, we talked about the trends in each of those charts and said we expect to extend those trends through the remainder of the year. So in the Solar Materials business, there’s really only three ways for us to do that to expand margin. And this is margin rate by the way. We can get prices up or we can get cost down, and there's two buckets of costs for us. There’s our own productivity on the poly side. And then there’s our wafering cost. Two of those to a certain extent, we can drive harder than others, but we think we have managed this spread between pricing and solar wafering, external wafering, very, very well in Q2, and we think we can continue to do that in Q3 and Q4. We also, under our own control, expect to drive considerable productivity on the poly side. You put all those together and that should enable margin expansion in each of the next two quarters for the Solar Materials business. As far as external expectations or consensus numbers for the third quarter, I'd do myself a disservice in trying to predict the third quarter, but I would say is you can build a model around margin expansion in our two materials companies and a robust second half for SunEdison and come to your own EPS conclusion. EPS quarter-by-quarter will be very dependent upon in what quarter we close, reach financial close for SunEdison’s projects, and that's hard to predict.

Vishal Shah - Barclays Capital

Are you able to get financing for the 70-megawatt project? What's the status of that?

Timothy Oliver

Yes, we answered that one just a little bit earlier, but the answer that we gave was yes. It's not complete. I don't want to mislead you. It's not done, but it's well underway with a lot of participants and a great deal of interest.

Operator

Then next, we go to the line of Jeff Bencik, Kaufman Bros.

Jeffrey Bencik - Kaufman Bros.

Can you talk about the Semi outlook in terms of pricing going forward in Q3 and Q4?

Ahmad Chatila

Yes, Jeff. This is Ahmad. Pricing will be higher in Q3 and Q4. Again, each quarter in the single digits.

Jeffrey Bencik - Kaufman Bros.

Okay. And then just what are your options on the Solar wafering in terms of the tolling costs? How did those costs change Q1 versus Q2? And is there really anything material you can do Q3, Q4 before the new plant comes on line?

Ahmad Chatila

Yes, well, so first, the costs went up Q1 to Q2 and they're going up again in Q3 in some cases. So overall, the average is going up, but our pricing’s going up as well. And as we described earlier, we have a JV launched. Hopefully, we'll see the first results out of it in Q4. We also have introduced new partners that will see some results in Q3, but the main impact is in early 2011. And so far so good on our internal plans. We're going to qualify people in Q4 and ramp in 2011.

Jeffrey Bencik - Kaufman Bros.

Okay. And just Semi’s for a time frame. I know you said it starts out at 600-megawatts, but that's probably not what you're going to produce in Q4. So any timeline on the ramp on that?

Timothy Oliver

We’ve said we’ll exit the year at a 600-megawatt run rate for 2011. So we'll be just qualifying and testing as we exit this year.

Jeffrey Bencik - Kaufman Bros.

Okay. So that won’t be for that full quarter, that’ll just be at the year end you’ll exit at that run rate?

Ahmad Chatila

We’ll have 600 megawatts potentially by Q2 of ’11. We have not announced any plans to expand beyond that. We will do so as the market progresses.

Operator

And next, we'll go to the line of Christopher Blansett of JP Morgan.

Christopher Blansett - JP Morgan Chase & Co

I have a couple of questions. One is it sounds like you have a lot of kind of one-time charges in the second quarter. I wasn't sure if you can give us any incremental guidance for OpEx in the second quarter or in the third quarter. Sounds like it's going to come down again.

Timothy Oliver

Yes, that's a fair point. I think OpEx is about overstated by $4 million or $5 million this quarter relative to where we think it would be next.

Christopher Blansett - JP Morgan Chase & Co

And then on seasonality for the Semi side, we're still kind of in the rebound of demand here following pretty weak demand last year. I guess when you think about the revised guidance for this year, does that take into account what you might consider normal seasonality or better-than-seasonal effects in the second half for the Semi wafers?

Ahmad Chatila

Well, I don't know if I'm going to be able to answer your question, but let me give you my perspective. 2/3 of our growth is market share gains and 1/3 is rebound. So we are confident about Q3 and Q4 at this moment in time in Semi.

Christopher Blansett - JP Morgan Chase & Co

Lastly on taxes and the like, how should we look at tax guidance for the rest of the year? What would your taxation have been without the one-time benefit, NOLs going forward? How are we looking at those now with the improved margin profiles for both Solar and Semi going forward?

Timothy Oliver

It's going to be hard from a tax strategy to do better than a negative tax rate. But you should think about this business having a tax rate over time dependent upon what region we generate our profit in, therefore, which business generates most of the profit in the, say, between 15% and 20%.

Operator

And next, we go to the line of Jesse Pichel of Jefferies.

Jesse Pichel - Jefferies & Company, Inc.

Tim, can you quantify your current view of the Phase II restructuring cost savings in Semiconductors? And how much of that is going to drop to the bottom line in Q3 and Q4?

Timothy Oliver

I think about a third -- we originally talked about a $55 million annual benefit. With the half of the year left, I'd say we get 1/3 -- of the $55 million, only half a year left, I think we’re at a third of the run rate we would be at in totality. That project has lagged a little bit because of the demand picking up as much as it did. We've been pretty orderly in moving one machine at a time, but I’d say we’re at what a third of the total run rate will be at when we're all done.

Jesse Pichel - Jefferies & Company, Inc.

The second question I have is whether you can quantify for us the cost savings of moving from a tolling vendor to internal. Because if we look next year at, even say, 25% margins for your tolling vendors, when you're only talking about $0.05, $0.06 of pie there that you could actually save by moving that in-house, that is if your costs are in line with the world's best in China. So could you just talk about that a little bit?

Ahmad Chatila

Hi Jesse. This is Ahmad. Let me try to explain it for you. So asides from margin, second which you mentioned, we have a lot of innovation that gets our costs to be lower than the best-known methods. I think Ken mentioned that in the February Capital Market Day and when he was asked how much of that he said more than double digit and cents. Fair watts at tolling. And we're confident about that. And the third thing, when you send your poly to a subcon, they don't give you enough wafers per kilogram. So we will save further amount by getting more wafers per kilogram. And the fourth thing is we have some innovation on improving the efficiency for wafers. So there’s like a win-win win-win win solution for us. So the cost will be significantly lower and the reason why, you might ask, like, okay, so why don’t you do everything inside? The reality is we don't have enough money in our view to build all the [indiscernible 1:25:54] we want on poly and wafering and Semi and continue the momentum across the board. So that's where we are.

Jesse Pichel - Jefferies & Company, Inc.

And if I could just follow up with a third. That’s great. Thanks for that clarity. Are you having any issues securing modules to fulfill the pretty big SunEdison pipeline you have or does that contract you announced with JA Solar fulfill it?

Ahmad Chatila

The answer is it has not been easy. I mean just the same way that our customers are yelling and screaming for not getting enough solar wafers, I mean we are in the same mode on modules. The good news it's only on the 50-megawatt so we actually have helped them a lot from the wafering business to get some of our cell providers, which is the bottleneck. It’s the wafer and the sellers has been the bottleneck to support our needs. So we’re getting what we want, not in the same fashion that we estimated in the beginning of the year. So there is tightness in the market.

Operator

And next, we go to the line of Satya Kumar with Crédit Suisse.

Satya Kumar - Crédit Suisse AG

Just wanted to drill down a little bit into Semis. You mentioned pricing could be up both in Q3 and Q4. I was wondering if you could say if it's low-single digits or high-single digits?

Timothy Oliver

I’d put it this way. We got high-single digit price increases in the first half of the year in totality. Taken together, the next two quarters would get us to mid- to high-single digits. So we’d be low-single digits in each of the two quarters so the price increase in the second half will be very similar to that in the first half and we expect it to occur over two quarters rather than just one.

Satya Kumar - Crédit Suisse AG

Okay. And then how about volumes. How much were volumes up in Q2? And how much do you expect volumes will be up or down in Q3 and Q4 for Semis?

Timothy Oliver

You're talking sequentially?

Satya Kumar - Crédit Suisse AG

Quarter-on-quarter, yes.

Timothy Oliver

Well, if we were up 14% in revenue and mix was relatively benign, and we said we had high-single digit price increases, the rest would be volume.

Paul Clegg - Jefferies & Company, Inc.

Okay. How about Q3 and Q4?

Timothy Oliver

We have capacity coming online in Q3 and particularly in Q4. So we will get similar lift from our share gains and market demand, and then add on top of that some incremental benefit from having more capacity come online.

Satya Kumar - Crédit Suisse AG

I guess like the main thing, you're not really giving clear EPS guidance for the second half. I can understand it's very lumpy because of SunEdison. I was wondering if you could help us a little bit in thinking about the trajectory, right. I mean the rate of profitability improvement that you saw in Q2 in Semis, it looks like the rate of profitability increase is going to decelerate in the second half because the cost savings are getting pushed out and the price increase are moderate. But I was wondering if you can talk about what swings it around. Like if you close the financing on Rovigo, or if you don't close it, how to think about the sensitivities. Because it seems like it's fairly important and people will be focused on that.

Timothy Oliver

Okay, so let me talk about gross margin by business despite the fact we've moved to segment operating margin but when they're bouncing off of -- it's a little bit more illustrative at this point. The gross margin expansion in the Semi business in Q2 was high. We expect nearly that much of improvement in each of the next two quarters. So I am not worried about margin expansion in the Semi business in the latter half of the year. They’ll get lift from volume and they'll continue to get productivity gains. So while it might not be quite as dramatic as Q2, they will get very significant margin expansion in each of the next two quarters. And in fact, we've been consistent in saying that were we to talk about gross margin, this business would have gross margin at the end of the year, they’d get very close to their historic average of 30%. So from where we are, that's a big increase.

Ahmad Chatila

Either way, you need to look at the SunEdison business exactly what Tim told you. The gross margin is going to improve throughout the year. We're going to get close to our historical average by end of the year. If not, in Q1. And then come 2011, we will unload our U.S. plants, two of them. And that would help us in a significant way. At that time, we have fully utilized our Malaysian plant for 200 millimeter. And also from a capacity perspective, we're building a Korean [indiscernible 1:30:33] plant that is going to be operational in Q4 of this year. So the Semi business looks like a good business. And even if the cycle goes the other way, let's say sometime 2011, we still have bullets in our pocket on the shutting down of two U.S. plants. We're very satisfied with it. It’s not exactly where we want it to be. And there’s still a lot of issues here and there, but God, I just want to tell you, in Q1 '09, we had significant negative gross margin in the business. And then again in Q2 and Q3, then it's positive in Q4, more positive in Q1, now higher double-digiting in Q2 and it's going to go up and to the right the next two quarters as we know. So the business is really humming. Market share gains, customer awards, better quality, better delivery, better product portfolio, better costs, better pricing management. Actually, if you look at the chart that Tim showed you, you'll see that the pricing started declining from Q4 '07, actually structurally that industry has been in decline and actually one surprising data that now you guys can see which our pricing mimics that market pricing a little bit, is we could not give up on pricing in 2009 as much as people think. A lot of those pricing were annual and six months’ kind of contract. We're done in Q4 '08 and earlier, some of them in Q1 '09. But after that, we've been on an upward trajectory. People appreciate us. They have close to doubled our share from Q1 '09 so that business, I'm very, very optimist about. Not exactly where I want it to be, but very good story.

Timothy Oliver

So I think to Ahmad’s point, where we're giving guidance for a single business, we could give guidance for that business. I think the other two businesses are much more difficult to predict in this environment. We do expect the Solar Materials margins to expand and we do expect them to expand in each of the next two quarters. But admittedly, we don't control all of the variables in that supply chain and we're cautious there.

Ahmad Chatila

I want to say also another thing just so that you guys can model better. We'll try to coach on better modeling. I still see a lot of modeling errors, gross modeling errors. We can’t share with you everything, but I'll try to with time the next six months is share with you more and more and be a lot more transparent. On the SunE business, you should check other companies that report their data, especially divisions within larger companies. They’re bigger competitors than us and our EBITDA’s better than them. So you can now get a view of how good Semi is for us. So if they're at zero EBITDA, we’re either high-single digit or double digit higher EBITDA than they are. So now you can get a view on how we’re operating the business.

Timothy Oliver

Did that help at all?

Satya Kumar - Crédit Suisse AG

Yes, I think that's pretty good on Semi and I understand the Solar is sort of going flattish.

Timothy Oliver

No, not flattish. I want to make clear. We do expect it to get better. It was awful in Q1 and we've done a tremendous amount of work between then and now, and I think we saw some of the gains from that work in Q2. It’ll get better in Q3 and Q4.

Satya Kumar - Crédit Suisse AG

Yes, I guess SunEdison is the big swing factor it appears in the second half because you're doing all these direct connect projects and you've only done very little of them in the first half. So could you maybe think about giving guidance without SunEdison? How much it might look like? That is the big swing factor and...

Ahmad Chatila

Let me give you a perspective. So I gave you a full perspective on Semi. Now you know our story. So let me give you a full perspective on Solar Materials. So Solar Materials, we had significant profits in the past. Allocation, super high-priced poly, we sold a lot on the spot, we wake up early 2009, the demand is not there and we have only one or two customers and we’re under pressure. And then throughout 2009, the team decided that look we need to control our destiny in wafering, and we launched it. And we launched a wafering plant with advanced technology. We didn't want to do a Me–Too plant because we knew that by 2011 it will be irrelevant. We didn't want to buy another company. We could have because they have all the equipment like 270-kilogram machines and 450-kilogram machines. We felt this is the wrong thing to do. But lo and behold, the market went from six gigawatts or 5.5 to now a run rate of 14.8. So we got caught flat-footed. But that business will also improve quarter on quarter on quarter. It won't be exactly where we want it to be. It will improve and in 2011, we will have a very good year. Why is that? Because our internal plant will have lower costs than other people. We have Solaicx which is kind of the high end and we have a JV in China. So that diversifies the risk. And we're going to find two or three deals on the side that would allow us to expand the volume tremendously year on year. So I'm actually very excited about that business. Last thing is at SunEdison, all the leading indicators are great. We are in a lumpy situation because the business is young. As we have a lot more megawatts being installed and projects being done then the lumpiness will smooth out. And when the financing is a lot more broader than what it is today, also, the lumpiness will smooth out. But I assure you that the backlog and pipeline, how we measure things, is increasing at a very good rate. We are very satisfied with the business.

Satya Kumar - Crédit Suisse AG

What is the direct connect backlog that you expect for 2011 for SunEdison?

Ahmad Chatila

I'm not going to tell you today, but it's going to be much higher than 2010. Not backlog, but the amount of installations. Look, we did not acquire SunEdison because of the backlog they had because it’s really worth nothing. It’s like 600 megawatts. Who cares? We bought SunEdison because it's a great platform, and they're adding backlog on a weekly basis, and we monitor it. It’s a fantastic business. So it's going to be much higher than 2010, but unfortunately right now, we're still new in the business and the accounting/financing/construction’s a little bit lumpy. In 2011, it will be a lot smoother. And it’ll also be bigger. And it's a big growth division. It’s going to be one of the major divisions in the company.

Timothy Oliver

Bob, we have time for one more question.

Operator

And that comes from the line of Paul Leming of Soleil Securities.

Paul Leming - Soleil Securities Group, Inc.

On the Semiconductor business, first, I just want to confirm I heard you say in your remarks that the shipment level, the unit shipment levels in the second half of the year will be all-time historical records for MEMC. Did I understand that correctly?

Timothy Oliver

I think I said production, but they would both be true.

Paul Leming - Soleil Securities Group, Inc.

Fair enough. And then the second question, did I just hear Ahmad say you're bringing on a new 300-millimeter wafer fab in Korea in the fourth quarter? And if I did get that right, can you flesh out at all kind of the rough size of where will that start on a monthly wafer production basis? What's the capability? Is that plant in anyway owned by your traditional Korean partner?

Ahmad Chatila

First of all, the plant is under the JV that we have with our partner there where we own 80%, they own 20%. That plant will start qualification of product in Q4. Actually, it's a Lotus plant because we already put some equipment there and did some of the process for the last 12 months so that's one of the first decisions I made is to again regain share in Korea where we have gone from a 40% market share in 2003 to 4%. And the main decline was because we didn't invest in 300-millimeter. So it was a no-brainer. We will start qualifying in Q4. It will be around 50,000 wafers or a little bit more, maybe 75,000, by 2011. It will take our capacity in the 500,000 to 550,000 range per month. That's how we're looking at it. If we're successful there, which I think we will, we'll expand it further.

Bill Michalek

Paul, thank you, and thanks to everyone who called in. We'll talk to you all soon.

Operator

That does conclude our conference for today. Thank you for your participation and for using AT&T Executive teleconference service. You may now disconnect.

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Source: MEMC Electronic Materials Q2 2010 Earnings Call Transcript
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