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Electro Scientific Industries, Inc. (NASDAQ:ESIO)

Q4 2014 Earnings Conference Call

May 13, 2014 5:00 PM ET

Executives

Brian Smith – Director-Investor Relations

Edward C. Grady – President and Chief Executive Officer

Paul Oldham – Chief Financial Officer, Vice President-Administration, Corporate Secretary

Analysts

Jim A. Ricchiuti – Needham & Co. LLC

David A. Duley – Steelhead Securities LLC

Tom R. Diffely – D. A. Davidson & Co.

Mark S. Miller – Noble Financial Capital Markets

Jairam Nathan – Sidoti & Co. LLC

Operator

Good day ladies and gentlemen, and welcome to the ESI Fiscal 2014 Fourth Quarter Earnings Conference Call. My name is Britney and I’ll be the operator for today. At this time, all participants are on a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) And as a reminder, this conference is being recorded for replay purposes. And at this time, I would now like to turn the presentation over to your host for today, Brian Smith. Please proceed.

Brian Smith

Thank you, Britney and good afternoon everyone. My name is Brian Smith, Director of Investor Relations for ESI. With me today are Edward C. Grady, our CEO; and Paul Oldham, our Chief Financial Officer. This call will cover our fiscal fourth quarter of 2014 results.

Before we go into the details of the call, I would like to remind you that some of what we say on this call will include forward-looking statements, concerning customer orders, shipments, revenue, gross margins, expenses and earnings. These statements are subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include a number of risks and uncertainties that are discussed in more detail in today’s press release and our filings with the SEC. Actual results may differ materially from these forward-looking statements.

This call also contains time-sensitive information that we believe to be accurate as of today, May 13, 2014 and which could change in the future. This call is the property of ESI.

Now I’d like to turn the call over to Ed.

Edward C. Grady

Thank you, Brian. Good afternoon and welcome to our fourth quarter conference call. I’m sure many of you looked at my career and know that several times in my career; I’ve been asked to face difficult situations with a focus on turning a company around. I’ve done this successfully three times. Unfortunately, while there is a common learning and a common discovery, there is no one common solution, but there is common sense and logic that applies to achieving desired results.

So first, I want to thank our investor base for hanging in there with us over these past many quarters. I want to acknowledge our past failure to execute. So, with that, I’m focused on the present and the future. As I will be completely involved in the day-to-day dynamics of the company, my perceptions and knowledge have grown dramatically.

First, I’m pleased to have this opportunity as part of the ESI management team, to change the direction of the company, to get back on course of profitable growth. I took on this role as Chief Executive knowing there were challenges and I’m prepared for these challenges.

Second, I validated some of my concerns about the direction and strategy of the company and I confirmed that the team at ESI with a strong and capable group of managers, a very talented and clever set of engineering and technical talent and a dedicated well connected global sales team, while our capable operations group and functional organizations that are effective and efficient.

I’m not going to go into detail of the Q4 and FY 2014 results; I’ll leave that to Paul. But I will give you my perspective and shares of actions we’ve taken. First, let’s take a look a Q4 2014. let’s look forward to 2015 and beyond. I want to focus on three metrics: bookings, revenue and cash.

So, first bookings, in Q4, we missed our bookings estimates substantially. We can attribute estimates primarily to one customer where within days of the end of the quarter. We knew our tool hasn’t selected and believe we would get a significant multi-system order. The reality is in the end; the customer took an alternate course and decided to upgrade the installed base, rather than place new system orders.

We were aware that this might produce the system purchases over time and had adjusted our projections, but we did not have the full story. But we do not expect the customer to change. We understand the volatility and the customers demand and we must adjust and become more intimate in their process.

So, we’ve taken action and brought in a new account manager who was deeply familiar with the account and has a track record of the success with the customer. I believe this will make a difference. We’ve taken actions to change our delivery model and sample capability to dramatically increase our speed and effectiveness at addressing opportunities with the customers. This is already opening up new doors for us, and giving us greater insight into new opportunity.

Second, although we anticipate some overcapacity in the flex via drilling market, we underestimated the depth and impact on the OEM supply chain and the effect of more aggressive local competition. Again, we have taken action to deepen our analysis of the supply chain and to aggressively defend our market position, using our balance sheet, defending our intellectual property and introducing new versions of our model 5355 that addresses customer needs, or specific applications in cost of ownership in the flex market.

Next revenue, our revenue mix is driven by two things; obviously, the bookings in this impacted our expected turns business from both our key customer and in flex. However on the positive side, we did recognize revenue from the first gen 6 glass cutting tool and our business in semiconductor and service were strong. Bottom line, we can only revenue what we book.

Third is cash. In Q4, receivables are up, because of late quarter system shipments driven by product and customer mix changes. while we believe this is not an efficient use of cash, it is timing related and should reverse over time. In addition, we selectively invested in receivables to defend our market from competitive pressures. We believe this tactics is a prudent use of cash and will benefit our business.

Underlying inventory levels are higher than we would like. Looking forward, we are reforming our advanced material purchase policy and process to better match our risk with customer needs and improving our NPI process to better match the timing of service inventory purchases or new product releases.

Last, we spent cash on discretionary unbudgeted items that are now a focus of the team to contain. Paul can provide much more specifics on this topic. So we’ve already taken tactical actions, the result of the past quarter and past years results to affect improvement in bookings, revenue and cash flow. We are in these near-term actions, we have and are putting in place long-term policy, process and structural changes, then we believe we’ll improve predictability of our results.

Let me next address where we’re going. I’ve spent the last several weeks meeting with investors, customers, but mostly with our employees and working with our executive staff, listening to their ideas on how we can tone ESI and we are a sustainable growth company. Laser microfabrication is a large and growing market with lucrative market segments, the specific market dynamics that we are not participating in today.

These segments present opportunities for growth, but we need to make some changes. My initial move has been to change from a centralized command and control environment to an empowered, distributed distribution, decision-making structure with incentives and accountability for results.

Second, I’ve consolidated and restructured the organization around market demand characteristics. we now have four business units, each with a unique set of market dynamics that who share product platform. Each business unit is going back to a clean sheet of paper and developed a business plan that lets that all of the potential applications they can serve, matching their share core competencies with identified market dynamics.

Third, I focus the organization around enabling these business units, supported by centralized functional organizations of sales, operations, central engineering, administration and human resources. Of course, any change of this magnitude and depth is a difficult process, but I’ve been very impressed by the enthusiasm, an open-minded willingness to embrace these changes across the company.

While the company is changing its approach, the market also continues to evolve and we must adapt. The challenges we continue to face as a company include, revenue volatility and uncertainty, customer concentration, low-cost competitors and slow growth markets in parts of our business. We have been in the past enamored by technology and pursued both high market risk and high technology risk for new products, believing the technology could be a sustainable differentiator, as it was in the semiconductor business.

We must acknowledge our failure to commercialize our technologies to a broader range of industries and applications. We must also acknowledge that our new markets, our differentiators are beyond just technology. We must leverage our technology to achieve not just capability, but also cost of ownership’s advantage and speed to solutions.

Additionally, we must be perceived as local by our customers. I believe the first step is to admit we have a problem and we’ve done that. We are aware of these challenges and we plan to tackle them head on. I’ve already taken action to reorganize and restructure the company. I’ve challenged the team, and enabled, and empowered them to think outside the box, to act aggressively and to take – be offensive in the markets and confront competitors.

We’ve established a forum to engage and challenge each other as teams, identify careers for cooperation and organizational improvement, focused on lean operations across the company. We have aggressively brought in new talent in targeted areas and we will continue to do so.

We’ve also developed initial bold action plans to address our challenges. This exercise is not complete, but I’d like to give you a sense of the themes emerging from our discussions around how to grow this company. So first, we need to move away from a unique, customer-driven, opportunistic, and reactionary approach to a market based and applications approach, while maintaining our customer intimacy.

In the future, we will develop, and market systems designed and based on modular platforms leveraging standard parts and subsystems. Our configurable products will appeal to broader markets and take our technologies into multiple industries. We live to serve our customers, but we must increase the marketing contribution to our product development to help us broaden these markets we serve.

Second, we must shift from focusing our efforts on emerging markets and technology high risk applications to existing adjacent ones for both market and technology risks are substantially lower. In the past, we have made large bets on emerging technologies and industry processes, only to discover that the applications did not emerge as we had expected and our market opportunity was smaller than we had hoped.

Existing markets have incumbent competitors, but the market opportunity and customer needs are established, and known, and we have a substantial capability and technology in place to address them today, while we continue to see through our investments in semiconductor and glass microfabrication, we will be actively reallocating resources to pursue this broader set of opportunities.

Third, we must rapidly follow initial technology solutions with redesigned for lower cost in order to address a broader set of micromachining markets. We can successfully apply our IP and technology and to lower cost solutions, which will give us a cost of ownership advantage in some large and established markets that we do not fully participate in today. This would require some investment in channel and localization that, we believe these represent large opportunities for ESI.

So fourth, we much better utilize our internal laser capability to create both differentiation and cost advantage in our systems. Our acquired laser businesses posses compelling technology advantages, but we have been too slow in adopting them into our system. Our plan is to accelerate that adoption dramatically.

Fifth, I mentioned that we will develop a more market-based approach to our business, and that might involve bringing in selected competencies and expertise from outside the company in enhancing our distribution channel on variable cost basis. But for the most part, these changes will involve new ideas and approaches and the reallocation of resources rather than starting from scratch are increasing our overall investment.

The technologies in this company are compelling and commercializable. we just need to do a better job applying them and directing them towards larger more established markets. So these five teams are some of the high level thinking as we began to renew and refresh ESI as a company. As our plans are put into action, the key will be execution. I’m excited about the team we have here and about the future of ESI. The changes we’re making are exciting and will take some time to be fully realized. As we continue to put more detail on place, we will share our plans and milestones with you in the coming months.

Now I’ll turn the call over Paul for a detailed discussion of our results for the fourth quarter and guidance for the first quarter of FY 2015.

Paul Oldham

Thank you, Ed and good afternoon everyone. The following information includes results from our fourth quarter and fiscal year 2014, which ended March 29. To improve comparability, we are also providing earnings per share and related income statement results on a non-GAAP basis, excluding the impact of purchase accounting, equity compensation, impairment charges and other items.

Orders for the quarter were $31.7 million, compared to $35.6 million last quarter and $44.1 million a year ago. For the quarter, orders increased modestly in both the semiconductor and the components groups that decreased in interconnected microfabrication. The decrease in IMG was due primarily to a softness in flex via drilling that Ed mentioned earlier.

The fourth quarter is typically a seasonally strong quarter for the flex business, as Korean manufacturers add capacity. So the weakness in the market this year was also the primary factor in the year-over-year decline. Looking forward we expect modest improvement in this market as other OEMs began to place demand on the supply chain.

In addition, microfabrication orders continue to be very soft, as anticipated demand for a large opportunity did not materialize. In fact, the decline in our business as a company over the last few quarters and for the year is largely related to lower orders from this customer, as there have been few new designs and capacity needs have been satisfied through upgrades to the installed base.

Although, nature of this business isn’t something that will change, we believe that future opportunities to continue to abound and we are taking several steps to broaden our exposure to new applications, improve our flexibility and speed, and develop new customers in this segment.

Within the semiconductor group, business levels were up, primarily due to strong activity from our acquired semi-systems business, which saw excellent demand for circuit trend and wafer trend application. ESI acquired this business just over one year ago, and we are very pleased with the integration with the team and with the financial results.

Within the components group orders and revenues were down sequentially as the MLCC market continues in overcapacity, given low overall electronics growth and cannibalization of devices by smartphones. The growth forecast for the overall MLCC market remains very sluggish. The pockets of demand for new capacity will be driven by technology buys, or special application capacitors with new form factors and higher capacitance.

Shipments were $42.3 million, backlog increased, or decreased by $10 million to $27.4 million, largely on shipments of the higher flex orders booked in the third quarter and the shipments of both the gen 4.5 and gen 6 glass systems. Revenue for the quarter was $37.1 million, a decline of 3% from last quarter and down 6% from last year.

Semiconductor group revenues grew sequentially on the strength of wafer and circuit trim business. The other two product group shows sales declines, which more than offset the increase in semi. GAAP gross margin was 10% and included an inventory write-off of about $12.8 million, related to discontinued products and services, as part of our shift in strategy and refocusing our efforts on newer applications.

Cost of sales also included about $450,000 of purchase accounting and $160,000 in equity compensation, bodes well to low, last quarter and last year. On a GAAP – on a non-GAAP basis, gross margin was 46.2%, compared to 44.6% last quarter and up meaningfully from 42.2% last year.

We were pleased to be able to drive gross margins up on lower revenues, margins improved and favorable mix, lower manufacturing expenses, and several favorable items and other cost of sales. Looking forward to next quarter, we expect non-GAAP gross margin to normalize to below 40% range on lower volume, a larger mix of lower margin products and more normalized other cost of sales.

GAAP operating expenses were $25.5 million, which included $2.3 million of one-time charges. These charges included $1.1 million of restructuring expenses associated with the closure by basing manufacturing facilities and contractual payments to our outgoing CEO, $1 million of asset write-offs and $200,000 of acquisition and integration costs. GAAP expenses also included $810,000 of equity compensation and $150,000 of purchase accounting.

Non-GAAP operating expenses in Q4 were $22.3 million. The increase from Q3 was due largely to installation costs associated with shipping the glass-cutting systems and the completion in shipment of the technology development tool we won earlier in the year from the leading semiconductor manufacturer.

In addition, we incurred higher legal and IP costs related to a change in catalog, resulting in accelerated filings of several positional patterns. These increases are largely one-time in nature. And as a result, we expect non-GAAP expenses to be down approximately $1 million next quarter. On a GAAP basis, operating loss was $21.8 million, compared to a loss of $4.6 million last quarter. Non-GAAP operating loss was $5.1 million, compared to a loss of $3.5 million in the prior quarter, largely a result of the higher expenses.

Non-operating expense was $6.1 million, the result of an impairment charge against the company’s equity investment in OmniGuide. This charge is a result of our reassessment of this investment, given the current environment in the medical device market, which has impacted recent business results. Income tax benefit on a GAAP basis was $300,000 and a non-GAAP basis $174,000. The benefit was the result of a refund recognized this quarter from a recent IRS audit, which more than offset our foreign tax expense.

For fiscal 2015, we expect to pay roughly $1 million to $1.5 million of cash based on foreign income. As a result, we would expect to recognize tax again – tax expense again, next quarter. On a GAAP basis, fourth quarter net loss was $27.6 million or $0.92 per share, compared to a net loss of $4.6 million or $0.15 per share last quarter. On a non-GAAP basis, net loss was $5 million or $0.16 per share, compared with the loss of $3.1 million or $0.10 per share last quarter.

Turning now to the balance sheet. Cash and investments were $111 million at year-end. We used $15.2 million of operating cash during the quarter, largely related to working capital. For the year, we used $19.1 million, which represents our first year of negative operating cash flow in many years. In addition, during the year, we paid $9.7 million to acquire the semi-systems business and distributed $9.6 million, related to our quarterly dividends of $0.08 per share.

Finally, late in the fourth quarter, we began to exercise our share repurchase program and spend $191,000, repurchase about 20,000 shares. The company continues to have just under $20 million of open share repurchase authorization and expect repurchase shares, opportunistically in the market. For the quarter, inventories increased by $1.4 million before the impairment charge, largely due to lower system shipments, turns were approximately 1.2x. After the impairment, inventory was $68.9 million.

Improving inventory utilization is a key focus for us next year. Accounts receivable increased by $10 million to $37.8 million, largely due to timing of shipments late in the quarter. DSO rose to 93 days. We would expect this situation to moderate somewhat in Q1. Capital expenditures were $2.2 million and depreciation and amortization, excluding purchase accounting was $2 million.

In summary, we delivered good gross margins on lower revenues in our fourth quarter, but we are still below our break-even level. Looking forward, we see many opportunities to grow the business both opportunistically. and more broadly, as we transition our focus to a more market based approach, penetrate adjacent markets, and develop, and implement the other strategies Ed described earlier.

However, the impact of these changes will take several quarters to materialize. in the near-term, we expect business levels to continue in this range. In addition, although the expense structure will remain roughly the same, we are taking several actions to reallocate resources, improve efficiency and reduce discretionary spending, in order to enable the company to make the investments necessary to return the profitable growth.

Given current order and backlog levels, we expect Q1 revenues to be between $30 million and $35 million. Non-GAAP loss per share is expected to be $0.25 to $0.30, largely due to the impact of lower revenues and gross margins and higher tax expense, as I discussed earlier.

Now I will turn the call back to Ed, for a brief summary.

Edward C. Grady

Okay. To summarize, we concluded a different – difficult quarter and we face challenges ahead. But I’m encouraged by customer reaction to the changes we have initiated so far. and I’m excited about the future of the company. We will provide you with more details about our plans to return to growth and profitability as we move forward.

This concludes our prepared remarks. At this time, we will be pleased to take your questions. And Britney, if you can open the line, we would like to have questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And your first question comes from the line of Jim Ricchiuti with Needham & Company. Please proceed.

Jim A. Ricchiuti – Needham & Co. LLC

Hi, good afternoon. Thank you. I wonder if you comment on the microfabrication portion of the business. just given the developments in the fiscal fourth quarter, how would you characterize the window of opportunity, if you will over the next two to three quarters in this portion of the business.

Edward C. Grady

I think Jim, a couple of things that we’re beginning to see change, with the change at one of our very large customers in terms of their executive management and how they’re kind of restructuring, how they look at product releases. We’re beginning to see a bit of a shift in how they look at, when they add capacity and where they add capacity. The concept of repurposing tools that are in their production facility now. so I think in the next couple quarters, we clearly have some visibility on some very interesting projects, but it is not quite the same as the seasonal – seasonal look that we’ve had in the past. Paul, you want to add to that?

Paul Oldham

Yes, I think clearly, one of the drivers is, people adding capacity and capability for 12 product launches. and so we would – there is a window time when we see some programs coming. As we work to implement some of the strategies I had talked about wherever I begin to penetrate other applications with customers. we see opportunities perhaps, to see additional business throughout the year, rather than just in the next couple of quarters.

Edward C. Grady

Right.

Jim A. Ricchiuti – Needham & Co. LLC

Okay. and Ed, if I may, one other question, I wonder if you’re in a position at this point, you share with us. some of the new markets, adjacent markets that you might be – you might be targeting, and I realize it’s early and you may or may not be able to shed anymore light on that strategy?

Edward C. Grady

Yes, it’s a bit difficult right now to talk about them since we’re still validating size of market, the key Jim, is, as we’d look through what are the market opportunities, we want to make sure that we’re going after ones of sufficient size and potential to actually move the needle. I mean chasing after very small markets, even though they’re adjacent, it doesn’t make a lot of sense. So validating what the growth rates and the size of these markets are before we completely move this product set is kind of where we are today. So there’s not a lot that I can give you specific, but certainly in the next several months we’ll be viewing much more specific as the data becomes more clear.

Jim A. Ricchiuti – Needham & Co. LLC

Okay. Thanks a lot.

Operator

And your next question comes from David Duley with Steelhead Securities. Please proceed.

David A. Duley – Steelhead Securities LLC

Yes, thanks for taking my questions. Just a couple – one housekeeping question, did you have any 10% customers for the year and what was the percentage?

Edward C. Grady

We did, we had one 10% customer that will come out in our 10-K. but the last year, our 10% customer was 31%. This year, we expect it to be about 15%.

David A. Duley – Steelhead Securities LLC

Okay. and when you talked about your big micromachining customer, basically I guess upgrading systems and buying new systems, forget whichever customer did – but how does that translate into ESIO, what’s the – what is the cost of a lease system and what roughly is the cost of an upgrade or can you just give us some flavor for how that’s impacted you overall?

Edward C. Grady

Yes, it’s a good question, David. It kind of depends on the nature of the upgrade, and it can vary from something that’s fairly substantial if it’s a laser or a process upgrade, or it can be quite minor in the case of being kind of more handling for a form factor upgrade. And I would say in this case, a lot of it was the latter.

Paul Oldham

I think David, it’s the key for you from perspective is orders of magnitude in terms of revenue.

David A. Duley – Steelhead Securities LLC

Okay. And then I guess, Jim already asked this question, but I know you want to tell us which segments you’re thinking you’re going to go after other adjacent micromachining sectors. but maybe you could just help us understand for those that may not understand, what are like the three biggest sectors out there that use this kind of tools that are potentials for you to attack?

Edward C. Grady

Well, Dave, I think the key and Jim, this is for you as well. The largest growing markets that we serve today are clearly in consumer electronics. those drive the biggest play, it’s a smartphone, it’s tablets and obviously, we participate in other areas. but if you want to talk about where the growth is, it’s in those general OEMs. I think what we call adjacent is within the subsectors of what’s in those smartphones and tablets, what other things can we go, do and add value to within that sector is a key focus area for us. There are other areas that are emerging things, like wearables that are clearly of high interest to us.

some other applications that I think I mentioned, when I was on the road maybe a month or two ago. they’re clearly some interesting opportunities within the automotive sector. So, there are a few places that appeared to be pretty high level of interest. there are couple of their areas of interest and security, but early to give you, which one of those or which ones of the highest probability of success right now. But that give you a flavor for what we’re looking for focused on consumer electronics and other applications. and then broadening that to taking our technology into a few other sectors.

David A. Duley – Steelhead Securities LLC

Okay, that’s very helpful, actually. And then the just couple other questions on the inventory write-down, what exactly – what product lines are you discontinuing from, or maybe take some of the – a bit of a little bit higher levels. I’ve certainly interested in what product lines that you’re discontinuing, but I’m also interested in the new products our company has been talking about over the last year, or so, which ones will continue to be invested again?

Paul Oldham

Yes. I’d say Jim, for the – the most parties are still largely legacy type products in semi, a little bit in LED and a few of the other older areas. We continue to sell on some of these products from time-to-time. I think as we’ve tried to refocus our efforts, we’re trying to bring those products to an end-of-life, and really concentrate our efforts on the newer areas.

I will say, as Ed mentioned earlier, we will certainly be carrying through our investments in the semi conductor market around 3D packaging, and we will be assessing how the glass, microfabrication market evolves and develops. and then certainly, from a new product area, there are many applications in consumer electronics, and adjacent areas in some of the other markets that we addressed.

David A. Duley – Steelhead Securities LLC

Well, I guess the LED stuff to kind of comment on the table?

Paul Oldham

Yes.

David A. Duley – Steelhead Securities LLC

Okay. Thank you.

Paul Oldham

There still may be an application here and there that takes advantage of our cutting capability in different types of material. But that the LED is not focused for to the company.

Operator

Thanks. And your next question comes from the line of Tom Diffely with D. A. Davidson. Please proceed.

Tom R. Diffely – D. A. Davidson & Co.

I guess first of all, a question on the cost side. I guess initially, do you have expectations for some more restructuring cost in the June quarter or more write-downs?

Paul Oldham

We don’t have any expectations for that at this time.

Tom R. Diffely – D. A. Davidson & Co.

Okay. when you look at the OpEx, being down $1 million or so, it looks like it’s still ahead of where it was a couple quarters ago, and so I assume that the initial investment for some of these new programs. But I’m curious, is there an increase in the COGS side of the business as well, or any of the gross margin line?

Paul Oldham

Well, you’re right. There is a little bit of investment as we look at some of these new programs, but again, lower than we saw in the fourth quarter. On the COGS side, we have a number of programs to improve our gross margins, everything from looking at material costs being more efficient in manufacturing, improving quality to reduce warranty, lower scrap and we’ve seen benefit from a lot of those this year in fact, our gross margins in the mid-40s at these revenue levels is really I think probably is good at performance for the company at this – at these revenue levels as I’ve seen. And that’s due in part to two of those efforts.

So those efforts will continue on, we will continue to look for ways to lower manufacturing costs and drive improvements. We do see as we look into our next quarter that we’ll see some impact of mix and lower volume and we’re not going to account on all of the savings we’ve seen here. But certainly, we’ll continue to try to drive those as we go forward.

Tom R. Diffely – D. A. Davidson & Co.

Okay. Is there any way to quantify what your break-even was what it is today, obviously, it’s mix dependent, but on a general basis?

Paul Oldham

Yes, it’s mix dependent. We’ve always talked about it kind of being between $45 million and $50 million, and kind of towards the lower end of that, I think we’re probably towards the middle of that $45 million to $50 million, or maybe a little bit higher that depending on the mix. If we keep the mix, we had recently, then I would say, it’s well into that $45 million range or maybe even a little lower. I think given our broader anticipated mix of between $45 million to $50 million is the right way to think about it.

Tom R. Diffely – D. A. Davidson & Co.

Okay. And then when you look at your large customer and the upgrades versus the new tools. Based on the programs that you’re working on with them, does it look like, they will be able to upgrade for future programs as well or at some point do you need new tools?

Paul Oldham

the specific upgrade was an existing installed base that was doing a particular application. So the answer I guess Tom, is what we’re seeing today are some substantially new applications that are quite interesting to us, it’s back to the same question is, will these things that we are working on from a development perspective actually materialize into products, that gets released the manufacturing. And what we’re doing now with our new account managers is really getting into a deep dive to understand better.

If these will get adopted, and where they’re going to get adopted, not so on. I think the answer is there are some cases where you can repurpose tools, and they’ve done that. And in the case of most of what we’re seeing now as new applications, it’s new technology.

Tom R. Diffely – D. A. Davidson & Co.

Okay, okay. And then how would you expect a rollout, if there is going to be one in the glass cutting tools to work. Is it they have a couple of tools in their hands right now; it takes a few quarters to evaluate them. and then potentially volume orders later in the year, or how do you look at that?

Paul Oldham

Yes. Tom, the adoption of this notebook touch glass at the higher CT has certainly been slower than we are the glass manufacturer as anticipated. and at this point, the way we’re thinking about it is that we’ve got a couple of tools that are now installed app touch kind of manufacturers. And that will give us a chance to kind of assess what will be adoption or what will be the adoption rate. Until you get these tools on someone’s factory floor, it’s hard sometimes to anticipate in these emerging areas how quick, we let the adoption will be. so at this point, I’d say, we’re excluding in a little of bit wait-and-see mode, but we would expect if there is a pickup, that will be one or two at a time, and kind of go from there.

Tom R. Diffely – D. A. Davidson & Co.

Okay. And then finally, this is what on my chamber literally on the sapphire usage in the industry. Maybe, just tells where you are as far as cutting sapphire and if you have products or programs in that area?

Paul Oldham

Yes, actually it’s an interesting great – that’s a great question. Because we – through the LED application, we had some very significant investments in sapphire cutting, as part of the LED program. and we are putting a significant amount of effort into understanding what the implications are of applying sapphire to multiple applications in consumer products, whether that’s variables, or smartphones, or whatever.

We actually – similar to what GT has said, they see great opportunities. so we’re taking that as a key to make sure we have all the technology and tools in place to meet the needs of both cutting, marking, scribing, whatever needs to be done for those applications. so we actually feel quite good about being positioned in both the strength in glass, as well as the sapphire markets.

Tom R. Diffely – D. A. Davidson & Co.

Okay. And those are tools that you have on hand today that doesn’t need to be developed?

Edward C. Grady

Now, we actually have the capability today.

Tom R. Diffely – D. A. Davidson & Co.

Great, okay. Thank you.

Edward C. Grady

Any other questions?

Operator

And your next question comes from the line of Mark Miller with Noble Financial Capital Markets. Please proceed.

Mark S. Miller – Noble Financial Capital Markets

You mentioned you were seeing more aggressive competition, was that in the flex via drilling area?

Edward C. Grady

Yes, yes.

Mark S. Miller – Noble Financial Capital Markets

Have you lost any legacy accounts there, or in other areas?

Edward C. Grady

We haven’t lost any legacy accounts, we probably have lost an order in the past, not in Q4. but I think we may have lost an order in Q3. but basically, we’ve recognized where the short fall is, and I think what’s interesting is that the 5335 comes to market and we start demonstrating the cost of ownership of that tool versus our competition, it’s actually being very well received, so – and we have great plans on how to take that forward. So, yes, we had an issue in Q3, we’ve addressed it in Q4 and we’re ready to fly in it as we go forward.

Mark S. Miller – Noble Financial Capital Markets

Okay. You took a hit for the shipment of this developmental system and the first DiamondBlaze. I assume that there will be future DiamondBlaze systems. Is this a one-time hit or we’re just going to – that we’re going to see other costs due to shipment of other DiamondBlaze tools?

Paul Oldham

Yes. I think for the most part here, Mark, these are the first shipment of these tools, they’re both very substantial tools, the DiamondBlaze was the gen 6, it’s our first tool of that size that we’ve deployed for the field. The technology development tool for semiconductor is a very sophisticated, very high accuracy tool.

And I think given an unique requirements of each of those and coming together sort of both last quarter, that drove a lot of the extra expenses to kind of get over the top to get tools installed and running and accepted at the customer site. So I think that we’ve learned a lot from that, we were kind of over the hump on the learning curve and we won’t see in that nature of expense return.

Mark S. Miller – Noble Financial Capital Markets

Just finally, you mentioned last quarter that the rollout of, or the acceptance of adjacent rural glass was somewhat slower that had had an impact. Has there been any improvement or speedup of that process?

Paul Oldham

Well, like we said, there has been some customer announcements about adopting this glass, but it’s been relatively slow and it’s generally been for thicker glass, rather than the thinner glass, if this tool is really developed for. and so at this point, we’ve been able to get the tools into touch panel manufacturers, that gives them the capability wherein their factory, they can be developing and manufacturing this glass, and we’ll see if that that enables to be kind of thing that starts to facilitate a quicker adoption of the glass by the OEMs. So at this point like I said, we’re happy to have the tools installed and will be assessing the market as it goes forward.

Edward C. Grady

And mark, just a quick addition to Paul’s comment, I think we said this in the past that we see the adoption of this on kind of the lower end smaller, I’ll call it PC type applications and some of the lower end tablets. so I think what really is the leading indicator of the demand for this product is going to be is, how the PC market behaves and how the Tablet market adopts this. so I think the key thing to remember is, if you watch those sectors, I think you’ll see what might happen.

But this is not an application, that’s going to smartphones, or to some of the higher end tablets. so I think that’s rather than us, I mean we’re going to certainly learn and we’re going to improve the tool, and we’re going to help our customers, be able to get samples, so that we can help them show the advantage of this. but again, at the end of the day, it’s going really be reliant on what the end users; the OEMs do with their products to take it to market.

Mark S. Miller – Noble Financial Capital Markets

If I could just go back to that first question about the aggressive competition, is this primarily through pricing or technology? How is it being aggressive, is it more pricing, I assume?

Edward C. Grady

I think it’s – it initially was a bit of a technology challenge. they came out with a new product that had some interesting cost of ownership advantages, and we were able to counter that with 5335, but most aggressively, I guess it’s been pricing terms, the normal kind of things that people do to try to buy into a market.

Mark S. Miller – Noble Financial Capital Markets

Thank you.

Operator

And your next question comes from the line of Jairam Nathan with Sidoti. Please proceed.

Jairam Nathan – Sidoti & Co. LLC

Hi, thanks for taking my question. Just kind of sticking to that competition and margin topic, as you expand into newer markets, some of which might not be as sticking over to the final solutions and stuff, do you see any pushback, as far as pricing goes for these tools, and how do you expect to counter that?

Edward C. Grady

So I think a couple of things. First, is the applications we’re going after are clearly things that that we see an advantage and what we can do the smaller hole drilling, the better cutting more precise cutting, there is a less damage to ceramic surfaces. all of those things that we can do very well, we think those are advantages, and in fact we’ll differentiate us from our – at our customers.

But at the same time, to answer the second part of your question, we have to figure out how to take our technology that we put in to these more advanced solutions, and almost immediately look at how do we redesign for lower costs. And then as to the bottom line simply is, rather than just rely on technology, we have to rely on our technology to drive the capability, but also to drive cost of ownership, because at the end, if you can’t get the cost of ownership right, the technology and the capability won’t be adopted. So does that help – help you understand where we’re going?

Jairam Nathan – Sidoti & Co. LLC

Yes. Yes, sure. And just I want to follow up; you talked about in-sourcing of lasers. how soon do you think that’s possible and what kind of – can you give us some idea of what kind of savings that could be achieved?

Paul Oldham

What’s interesting to me is that we have had a very, very strong pole internally, since I started working with the team here. And at least, two of the platforms that we have on the horizon have adopted our internal lasers, and we have more on the way of actually retrofitting back into existing systems that we’ll be using that are installed and our existing products that we can replace the merchant laser with a better performing laser from our internal operation.

Jairam Nathan – Sidoti & Co. LLC

Okay. and then any idea of how much – what kind of the savings that could be expected from that move?

Paul Oldham

Well, you will start off relatively small first, because we haven’t had large penetration of this. but I think over time, this could generate 100 to 200 basis points of margin improvement for us over the course of the few years.

Jairam Nathan – Sidoti & Co. LLC

Okay good, that’s good. And my last question and if I ask you to look at your portfolio of businesses there, what’s your thoughts on the whole component segment and the MLCC as you talked about it being, it could potentially to be a sluggish growth segment. What are your thoughts as far as weakening that business?

Paul Oldham

Yes, I think on sort of our traditional businesses for example, in MLCC. that business has been very slow growing, and largely in over capacity for the last couple of years. In fact, the only business we’ve seen there on a system business has been more for technology buys for smaller chips, this metric 0402 chip. And I think as products adopt those smaller chips, we’ll continue to see technology buys from time-to-time there.

We’re also seeing interest in other types of capacitors that would also require slightly different formats, which would then require new to our buys as well. But in general, this is going to be a slow growth market. we have a solid sort of tooling, and kind of supplies business in this area. But from the system perspective, I think we would characterize it as low growth with technology buys and some of these new chips or smaller chips are adopted into devices.

Jairam Nathan – Sidoti & Co. LLC

Okay, thank you. that’s all I have.

Operator

(Operator Instructions) And at this time, there are no further questions. I’ll turn the call over to Ed Grady for closing remarks. Please proceed, sir.

Edward C. Grady

Okay, thank you all for attending our call. We’re pleased that you were able to get some questions out and you’re welcome to call Paul, Brian or me, if you any further questions. Thanks for attending the call today.

Operator

Ladies and gentlemen, that concludes the presentation for today’s conference. You may now all disconnect, and have a wonderful day.

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Source: Electro Scientific Industries' (ESIO) CEO Edward Grady on Q4 2014 Results - Earnings Call Transcript
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