Cabot Microelectronics' (CCMP) CEO Bill Noglows on Q3 2014 Results - Earnings Call Transcript

Jul.25.14 | About: Cabot Microelectronics (CCMP)

Cabot Microelectronics Corporation (NASDAQ:CCMP)

Q3 2014 Results Earnings Conference Call

July 24, 2014 10:00 AM ET

Executives

Trisha Tuntland - Manager of IR

Bill Noglows - Chairman and CEO

Bill Johnson - Executive Vice President and CFO

Analysts

Dmitry Silversteyn - Longbow Research

Jason Ursaner - CJ Securities

Edwin Mok - Needham

Avinash Kant - D. A. Davidson & Company

Chris Kapsch - Topeka Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to Cabot Microelectronics' Third Quarter Fiscal 2014 Earnings Conference Call. At this time all participants are in a listen only mode, later we will conduct a question and answer session and instructions will be given at that time. (Operator Instructions).

And as a reminder, this conference call is being recorded. I would now like to hand the conference over to Trisha Tuntland, Manager of Investor Relations. Ma’am you may begin.

Trisha Tuntland

Good morning. With me today are Bill Noglows, Chairman and CEO; and Bill Johnson, Executive Vice President and CFO.

This morning we reported results for our third quarter of fiscal year 2014, which ended June 30th. A copy of our earnings release is available in the Investor Relations section of our website, cabotcmp.com, or by calling our investor relations office at 630-499-2600. A webcast of today’s conference call and the script of this morning’s formal comments will also be available on our website.

Please remember that our discussions today may include forward-looking statements that involve a number of risks, uncertainties and other factors that could cause actual results to differ materially from these forward-looking statements. These risk factors are discussed in our SEC filings, including our report filed on Form 10-K for the fiscal year ended September 30, 2013. We assume no obligation to update any of this forward looking information.

I’ll now turn the call over to Bill Noglows.

Bill Noglows

Thanks, Trisha. Good morning, everyone, and thanks for joining us. This morning we announced solid financial results for our third fiscal quarter of 2014, including total company revenue of $108.4 million, a gross profit margin of 47.7% of revenue and earnings per share of $0.53 all of which are higher than the previous quarter’s results. Our gross margin this quarter was lower than we expected due to certain higher costs we experienced during the quarter. Bill Johnson will provide more detail on our financial results later in the call.

Revenue from our CMP consumables products increased by approximately 9% sequentially, reflecting the seasonal strengthening of the demand environment that we have seen in recent years. Notably, we also achieved record revenue in our Tungsten and Advanced Dielectrics slurry businesses this quarter and nearly 40% year-over-year revenue growth in China.

Let me start this morning by providing some general comments on conditions we are seeing within the semiconductor industry. Industry reports suggest that most IC inventories are on the lean side of normal levels. This is likely due to the continued conservative management of IC device inventory in the supply chain coupled with capacity constraints and limitations in availability of advanced node technologies. Many customers have commented that supply for memory ICs, especially DRAM, will likely fall short of demand through the end of this calendar year and into 2015.

Industry sources are forecasting demand growth for tablets and smartphones of 20% to 30% during the calendar year with smartphone growth in China in particular at the very high end of this range. Growth of these mobile internet devices seems to be slowing at the high end of the market, but it is still quite robust overall.

Furthermore it appears we are now seeing a slowdown in the rate of decline of PC sales in 2014 after eight consecutive quarters of contraction. Gartner reports that after declining over 9% in 2013, the global PC market is on pace to contract only 3% in 2014. In addition, some significant PC manufacturers have recently made public statements indicating that enterprise demand continues to improve thus potentially enabling some growth in 2014. Gartner’s growth forecast for enterprise IT spend is around 2%.

In response to these trends, it appears that fab utilization rates at our customers are generally increasing with capacity at leading edge technology nodes at or near full utilization. Certain industry analysts’ consensus for digital IC unit growth during the third calendar quarter is between 4% and 5%. Other reports and comments from customers generally indicate a firm outlook for demand in the September quarter.

With the continuation of positive trends in mobile connectivity and some recovery within the PC market, this would imply sustained semiconductor demand and accompanying demand for our CMP consumables products.

This industry outlook was further supported during our company’s participation at Semicon West, earlier this month in San Francisco. The overall tone at the conference was generally optimistic for the longer term, driven by a number of technology inflection points such as 3D NAND, FinFet and multi-patterning. These emerging applications have introduced technical challenges. However, we believe they represent business growth opportunities for a company like ours.

These new device architectures have driven the need for new innovations in fab materials and should drive increased demand for our CMP consumables. Despite a somewhat cautious near-term outlook, as 3D NAND and FinFet have seen relatively slow ramp primarily due to technical challenges, we remain confident about the important role highly engineered materials and highly formulated CMP solutions like ours are likely to play going forward.

Turning now to company related matters, we are pleased that our CMP polishing pads business achieved year-over-year revenue growth of approximately 4% during the quarter. This represents the second consecutive quarter of year-over-year revenue growth.

Customers continue to actively sample our D100 and D200 pad products for new business opportunities and we believe our expanding high quality pipeline of evaluations underway with our customers underscores our attractive pad value proposition of longer pad life and lower defectivity.

Roughly 20% of our pipeline of pads business opportunities is specific to evaluations and qualifications of our D200 platform, including several technology leading customers where we believe our tunable platform can provide particular value. Our global business teams continue to partner with existing and new customers. And as a result of these collaborations we won new D100 and D200 business for shallow trench isolation and advanced node applications during the quarter.

Furthermore, our product development teams are actively working to expand our product portfolio to address market needs and our customers’ evolving performance and cost of ownership requirements. We believe, we continue to believe our pads business represents a significant growth opportunity for our company.

Turning to our IC slurry business, our tungsten and advanced dielectrics businesses achieved record revenue in the quarter and year-over-year revenue growth for the second consecutive quarter. We are also pleased with the continued growth we are experiencing with our slurry products for polishing aluminum, as we assist our customers with their ramp of advanced technology nodes.

Year-to-date revenue from our aluminum business is up approximately 25% year-over-year. Additionally, during the quarter, we won new business for tungsten and copper applications including legacy and advanced node technologies. As we have discussed in the past, we are focusing our research and development activity much more heavily on innovating game changing technology for leading edge applications with technology leading customers.

Our CMP solutions for polishing tungsten, advanced dielectrics, and aluminum are specific examples of our ability to innovate to meet our customers’ challenging product performance requirements.

Concluding my remarks this morning, we continue to navigate this challenging growth environment while helping to enable our customers, transition to more advanced technology nodes. Technology node transitions are becoming more challenging with the ongoing introduction of new materials to be polished and evolving device architectures. As a key technology enabler, we believe broad and deep technical capabilities as well as our global supply chain management and advance quality systems differentiate us from our competitors and position us well to continue to successfully partner with our customers to consistently deliver high performing and high quality products and services.

And with that I will turn call over to Bill.

Bill Johnson

Thanks, Bill and good morning everyone. Revenue for the third quarter of fiscal 2014 was $108.4 million. We generated 2.5% revenue growth from our CMP consumables products for semiconductor applications over the prior year. However, lower revenue from our QED technologies business which is capital equipment oriented primarily drove the overall 1.5% year-over-year decline in total revenue.

As Bill mentioned, revenue from our CMP consumables products increased by approximately 9% sequentially which is higher than the 7% increase we had been seeing for the first several weeks of April that we mentioned when we reported results for our second fiscal quarter.

Year-to-date, revenue of $308.3 million represents a decrease of 2.7% from the prior year reflecting lower revenue from QED technologies and also including a $2.7 million adverse impact associated with foreign exchange rate changes primarily the weaker Japanese Yen versus the U.S. dollar.

Drilling down to revenue by business area, Tungsten slurries contributed 38.9% of total quarterly revenue, with revenue up 9.1% from the same quarter a year ago. Our Tungsten business achieved record revenue during the quarter reflecting strong demand from the memory and foundry segments and year-over-year revenue growth for the second consecutive quarter. Dielectric slurries provided 27.4% of our revenue this quarter, with sales down 3% compared to the last year. Within Dielectrics, revenue from our Advanced Dielectrics business represents a record level this quarter, and a second consecutive quarter of year-over-year revenue growth.

Sales of slurries for polishing metals other than Tungsten, including Copper, Aluminum and Barrier, represented 18.1% of our total revenue, and decreased 2.3% from the same quarter last year. Revenue from our Aluminum business reflects an increase of 3.5% from the same quarter last year.

Sales of our polishing pads represented 8.1% of our total revenue for the quarter and reflect an increase of 3.7% from the same quarter last year. Revenue from our pads business increased year-over-year for the second consecutive quarter. Data Storage products represented 3.9% of our quarterly revenue, down 19.8% from the same quarter last year.

Finally, revenue from our Engineered Surface Finishes business, which includes QED generated 3.6% of our total sales, and was down 44% from the same quarter last year. Volatility in our QED revenue is common, given that it's primarily a capital equipment oriented business.

Our gross profit this quarter represented 47.7% of revenue, this is down from 49.7% in the same quarter a year ago, and was lower than we expected. Compared to the year ago quarter, gross profit percentage decreased primarily due to higher variable manufacturing costs, including higher raw material costs, and higher logistics costs. In particular, during the quarter we experienced lower slurry manufacturing yields. In addition, this quarter we sold some inventory that was produced last quarter in a lower production environment, and so it carried higher unit costs. We've seen this transitory cost impact in the past.

Year-to-date gross profit represented 47.3% of revenue, which includes a 70 basis point adverse impact of the asset impairment charge we recorded during the second fiscal quarter related to certain manufacturing assets. We expect gross profit for the full fiscal year to be around the lower end of our guidance range of 48% to 50% of revenue.

Now I will turn to operating expenses which include research development and technical, selling and marketing, and general and administrative costs. Operating expenses this quarter of $33.2 million were 2.6% higher than in the third quarter of fiscal 2013. The increase was primarily due to higher travel costs and professional fees associated with amending our existing credit agreement which we completed this quarter.

Year-to-date total operating expenses were $97.2 million, which is 3% lower than the same period last year. We continue to expect operating expenses for the full fiscal year to be between $127 million and $131 million. Diluted earnings per share were $0.53 this quarter compared to $0.65 cents recorded in the third quarter of fiscal 2013 which included a $0.05 benefit associated with our permanent reinvestment election in Japan.

Year-to-date diluted earnings per share were $1.39 which includes a $0.06 adverse impact of the asset impairment charge, compared to $1.46 last year. Our year-to-date effective income tax rate was 25.9$. We continue to benefit from increased pretax profits in certain foreign jurisdictions. We now expect our effective tax rate for full fiscal year 2014 to be within the range of 26% to 28% which is lower than our previous estimate of 27% to 29%.

Turning now to cash and balance sheet related items. Capital investments for the quarter were $2.9 million bringing our year-to-date capital spending to $10.2 million. For full fiscal year 2014 we continue to expect capital spending to be approximately $15 million. Depreciation and amortization expense for the quarter was $5 million. In addition we purchased $18.6 million of our stock during the quarter under our share repurchase program compared to $10 million in the same quarter last year. As of the end of the quarter there was approximately $131 million of authorization remaining in our share repurchase program.

In late June we amended our existing credit agreement. The amendment improves certain pricing and covenant terms brings the total term loan commitment back to its original amount and extends the maturity date to 2019. We ended the quarter with a cash balance of $265.5 million and have $175 million of debt outstanding.

I will conclude my remarks with a few comments on recent sales and order patterns. During the third fiscal quarter we saw an increase in revenue for our CMP consumables products of approximately 9% compared to the prior quarter. As we observe orders for our CMP consumables products received to date in July that we expect to ship by the end of the month, we see July results trending roughly in line with the average rate in our third fiscal quarter.

However I would caution as I always do that several weeks of CMP related orders out of a quarter represent only a limited window on full quarter results.

Now I’ll turn the call back to the operator as we prepare to take your questions.

Question-and-Answer Session

Operator

Thank you sir. (Operator Instructions). Your first question comes from Dmitry Silversteyn from Longbow Research. Your line is open. Please go ahead.

Dmitry Silversteyn - Longbow Research

Good morning, guys. I just want to get a little bit more clarification on sort of what demand in your revenues in that demand environment were like in this quarter and what does it say about the balance of the year. Outside of Tungsten in some areas and other businesses most of your slurry sales were down year-over-year.

You keep talking about innovation and more sophisticated products needed, but we're not seeing it in your results. So how would you characterize where we are in the cycle right now? Is there a semiconductor cycle, are we in early stages of it, is it as good as it gets? Can you talk a little bit about the expectations as you see your end market evolving?

Bill Noglows

In terms of industry cycle, we've talked recently about semiconductor industry becoming less cyclical and more seasonal. As you have the top five semiconductor manufacturers in the world representing, I am speaking for memory 65% of capital spending of the industry. The industry capital investment has become much more rational. So we think we're going to see less cyclicality and the industry than we having in the past and more seasonality.

And so consisted with that, this is a third year in a row where we have had sort of soft demand environment in the first half of the year and then stronger in the second half of the year. We saw that in the third fiscal quarter and then we would expect continued strength in the second, the fourth fiscal quarter.

Bill Johnson

Dmitry coming to the second part of your question, I'm not sure I agree with your statement. I mean we saw a record sales on our Advanced [Dielectricals], record sales and our aluminum product line. We saw a growth in our pads business in our Tungsten has grown as well. So we feel like we are doing pretty well at the leading edge technologies events, node technologies in growing fairly rapidly in the areas we focused on. Dmitry, are you still there?

Dmitry Silversteyn - Longbow Research

Yes, I am still here. I guess I am looking at how you guys report the results. And your results were down 3% in dielectric; it was down to 2.3% in copper and other metals; it was down 20% in data storage. So, I understand the cyclicality versus seasonality, but I am just trying to understand, are we looking at a flat market basically and flat business that is just going to vary seasonally with back-to-school and Christmas demand? Is that the environment that we are in?

Bill Noglows

Let me address dielectric specifically and then I will ask Bill to address data storage after that and then we can talk about -- we will try to answer question about the overall market fall in that Dmitry. We think of the dielectrics market really in three different ways. We think about our legacy dielectrics business which is the oldest and perhaps the most commoditized of the dielectric applications. We think of advanced technology and advanced node dielectric, singular dielectrics business and then we think of advanced dielectrics.

We have put our focus over the last several on advanced dielectrics as well as sort of advanced what I would call advanced technology in our dielectric nodes. And we have been managing the legacy business for profitability, not necessarily for growth. And when I talk legacy, I tend to mean 8-inch wafers, and older less demanding, lower performing technologies are used on 8-inch wafers and there is puts and takes in that part of the business Dimitry, there is times when we walk away from business because we don’t like the profitability of it. And this is one of those times we have walked away from a little piece of business because as I said earlier we are managing profitability and we're also, we are focused at leading edge technologies. And for instance the areas of advanced dielectrics is an area where we see a lot of opportunity to extend our reach and grow our margins.

We’re in the process of introducing a new family of products that we think and believe is going to offer our customers much higher performance and much lower cost. And we just think that's a better way to run our business, continue to stay on the leading edge, continue to introduce innovating new products.

So the dielectrics, we feel comfortable about the dielectrics position and how we are managing that business and we are excited about our new introduction. Bill, you talk about data storage.

Bill Johnson

Yes. Data storage is an area where we went very down about 20% year-over-year and that's an area where we've talked about in the past, as there is quite a bit of volatility in that business because unlike the semiconductor industry, design changes happen pretty frequently. And now it's difficult for customers to change their CMP solutions, so there is -- tend to be more trading around of CMP positions than in the IC applications.

And so this current quarter reflects a loss of a business position in that area, which we're actively working on to regain. So, that explains data storage, which again is not IC CMP. Within the IC CMP business, we have seen some growth year-over-year.

There is another aspect of the business that we've talked about in the past and we're seeing it now in some of our business and that's efficiency gains by customers. So when a customer introduces a new process and as they ramp that and gain confidence and stability in it, then they look for efficiency opportunities. And we've seen that in our pads, where we talked about the customer, our customers extending pad life beyond kind of original expectations which has an impact, adverse impact on number of pads that we sell that maintains loyalty with the customer. We've also seen that in some relatively leading edge slurry applications where as customer gains stability in a relatively new process, they are able to either turn down flow rates or dilute and that sort of thing and we're seeing a bit of that in some of our more advanced products also.

Dmitry Silversteyn - Longbow Research

Okay. All right. Well, I appreciate the granularity. I guess let me ask the question may be little bit differently, in how you perceive your industry or your end markets where your customers have grown in the June quarter versus the rates of growth. And I am assuming your average selling pricing hasn't changed that much, so let's say ex-FX revenue growth. Do you feel like you are keeping up with the market or leading the market or trailing the way the industry is growing?

Bill Noglows

Well I think we think and believe we're keeping up with the market with the exception of those areas we've already talked about aluminum, advanced dielectrics and tungsten. And we think we've had some disproportionate positive growth in those areas relative to rest of the market. But we think, we don't believe we've lost any share and we think we've gained positions in those three areas that I just mentioned.

Dmitry Silversteyn - Longbow Research

All right, thank you.

Trisha Tuntland

Thank you, Dmitry. We'll take our next question please?

Operator

Thank you. Our next question comes from Jason Ursaner from CJ Securities. Your line is open. Please go head.

Jason Ursaner - CJ Securities

Good morning.

Trisha Tuntland

Good morning, Jason.

Jason Ursaner - CJ Securities

Just a couple of questions on the slurry business. First, if you could just repeat the percent of total for tungsten and dielectric, I just didn’t hear the exact number there?

Bill Johnson

Tungsten is 38.9% and dielectrics was 27.4%.

Jason Ursaner - CJ Securities

Okay. And then just a follow up a bit on the discussion you are just having for the slurries with some of them at record levels, the last time in the industry without these levels in May 2012 for you, it wasn't really able to sustain the overall industry utilization level. So, just what’s driving confidence in production growth from this point? You’d mentioned mobile growth you mentioned the comeback in PCs. Just where do you see the market continuing to gather strength from?

Bill Noglows

Well, we look at the same thing Patrick that we follow the some of the industry experts that that’s what they do. They’re talking some continued robust cellphone and mobile device growth on the order of 20% to 30%. And I think we’ve been living with almost three years of the decline in the PC and the impact that’s had on the semiconductor demand, which we believe and what we read in here is that that rate of decline is slowing and maybe bottom in this calendar year maybe not. I think I said in my prepared comments I thought I was talking decline of 3% or something like that.

I think as we talk to our customers I think there is a fair bit of optimism about the remainder of this year and next year in terms of demand. The leading edge technologies 28 and 20 nanometer those plants are running almost at capacity or they’re ramping to capacity is probably better way to go real leading edge technology. So, we think and we hear when we read that people are relatively optimistic about the end of the year, and that growth is driven by continue to be driven by mobile internet devices and connectivity.

Jason Ursaner - CJ Securities

Okay. And the consolidated gross margin hitting the low end of the range is sort of implying closer to 50% for the fourth quarter. So, if July orders for the slurries business trending in line so far, just what do you see driving that sequential increase, is it a just a little bit of volume leverage later in the quarter. Where do you get that growth?

Bill Noglows

Right. If you look at nine in the last 14 years, we've had sequential revenue growth from the third quarter to the fourth quarter and the signs from the industry would indicated some continue seasonal strength, we haven’t seen it through that we're tracking through three weeks of orders in July, but than this is quite about more of the quarter less when we could see some more that ramp.

From a gross margin standpoint, gross margin was lower than we expect at this time at 47.7%. And there are a couple of I things we think we're sort of transitory that not necessarily long recurring that depress the margin at quarter and to extent we didn't see recurring for that, we could see balance back in margin. And we said, we expect those margins full year to be around the lower-end of the range where, our ability to forecast that is precisely is somewhat limited just because things like capacity utilization and product mix and things like that.

But if we saw the kind of normal seasonal increase in revenue in the second quarter – sorry the fourth quarter absence of some of these transitory cost effects we saw in the third quarter, then we could get a margin left in the fourth quarter.

Jason Ursaner - CJ Securities

Okay. And the step-up in R&D was about a million dollar sequentially. Any specific large projects in that to some of the qualification or wins for the pad line impact the R&D spending?

Bill Noglows

That bitterest part of that was clean room materials. And one other things, we seeing this before there is nothing structurally the change in R&D between second and third quarter but we have wafers that we use within our clean rooms, within our three clean rooms and other R&D laboratory supplies we don’t inventory these we expense them as we buy them so the definitive kind of order pattern and receipt of those kind of things you can see some fluctuations in the R&D line and that’s kind of what you saw this time I think doesn’t structurally changed about how we are doing our business and R&D.

Jason Ursaner - CJ Securities

Okay. And QED obviously it has been down. I mean, I don't think it is really too unexpected given the backlog position you had starting the year. Can you maybe talk about where orders and backlog are for that business now just because it is heading into a much tougher comp for the fourth quarter and when we think about sequential revenue growth?

Bill Noglows

The order book is a little bit better than when we started the year. We are expecting a little bit stronger results in the fourth quarter it’s still soft -- it’s hard for us to predict the sort of order pattern and the buying patterns of our customer for this equipment but the book is a little healthier than it was at the start of year. Any more color on that?

Bill Johnson

Now when you think about QED, there are couple of things. Depending upon where we are selling sometimes there are export license issues so you could be ready to ship the machine, but until you have the export license for the local jurisdiction than you are not able to ship and recognize the revenue. So there are a couple wrinkles but we do have a stronger order book. But you are right we are comparing against I think what was close to a record revenue last fourth quarter and that order book is not as strong as that.

Jason Ursaner - CJ Securities

Okay. Just overall, when I look back the last year and the second half, was it just a one-shot capital equipment cycle, are you having trouble breaking into some of the niche applications that might require more of a dedicated sales effort there? Or just how should we think about that business longer term from a growth perspective?

Bill Noglows

Well, I think we -- there is a cycle in this business and we've seen it repeat itself. And last year was a good year for QED, fourth quarter was really strong, I think Bill said it was at or near record revenue for the company.

The sales activity that we've taken kind of a dual focus there, we provide services, we provide spare parts and replacement fluids and then we sell the equipment. And we've been building the services business and then we're optimistic that that's a good will. So, when I say services we polish things for the people in our facility in Rochester, New York and with the equipment that we market them.

So it's a long sale, I mean these are very technical pieces of equipment and it's a long selling process. But we have confidence in our team and Rochester has confidence that the equipment that we've traditionally sold as well as some of the new tools that we've developed, we'll do well on our marketplace.

And I just think we live into a cycle now that hopefully will repeat itself and we will get back on our growth cycle. So, we like that business and we think it has a future.

Jason Ursaner - CJ Securities

Okay. And just last question from me. What are you seeing in terms of acquisitions and the acquisition environment? Obviously you upsized or resized the credit agreement back to what it was. You have some net cash at this point. So just generally how do you feel about that market?

Bill Noglows

Well, we're going to say the same thing that we've been saying for the last five years is our number one priorities for the cash we generate, the rich cash flow we generate is that look for ways to profitably grow the company and one of those ways is in acquisition or merger.

The scope of what we think are opportunities for our company is relatively narrow. We tend to look at materials companies or material oriented kind of companies that either have some capability we don't have or we can bring capabilities to them. And we haven't come out with a reach field of companies like that that we think we can add value to them and they can add value to us so we've been cautious and careful.

The activity like you guys know there has been a lot of activity M&A activity (inaudible) semi cap equipment as consolidated very quickly. We're seeing several let's call them acquisitions and mergers in the material side, there is the integrals, APMI and there was the [Merc AZ]. So I think activities are I don't relatively higher levels.

But our focus, I just reiterate, our focus for our cash is number one look for ways to grow the company in a profitable way where we can add value or someone can add value to us. And our second priority is look for create ways to return that cash for shareholders in that. And that's kind of what we've been doing and how we've been doing managing the business.

Jason Ursaner - CJ Securities

Okay, great appreciate those details. Thanks.

Trisha Tuntland

Thanks Jason. We'll take our next question please.

Operator

Thank you. Our next question comes from Edwin Mok from Needham. Your line is open. Please go head.

Trisha Tuntland

Good morning Edwin.

Edwin Mok - Needham

Hey good morning thanks for taking my questions. So first question is just talk about kind of reaffirm you mentioned that July is roughly in line with the last quarter level. Have you seen similar trend last year where you start off the quarter come in line eventually grow that’s why you still can't highlight it back that 40 years your fiscal fourth quarter growing.

Bill Noglows

Last quarter if you remember Bill talked about sales where after four weeks of the first month of the quarter we saw sales up 7% and we ended up 9%. So it's not unusual for us to not get it right. I think we have some numbers here somewhere but our fourth quarter fiscal quarter tends to be our strongest quarter historically. And we would expect no different in the coming quarter. I think the number that’s already reported this morning was three weeks of visibility into a full quarter and he always says that only offers a limited window and what we think a full quarter will be and three weeks out of a quarter is not a whole lot.

Bill Johnson

If you look at what customers are saying, TSMC was talking about 13% revenue growth September to June. I think the consensus on IC units digital IC units is probably 4% to 5% growth sequentially from the June to September, other customers are talking about some growth as well. So, we would expect seasonal strength, but we haven’t seen it yet through three weeks of orders.

Edwin Mok - Needham

Okay. Great. That’s fair. Can I ask you a little bit about competition, you mentioned that you walked away from a legacy business? Is that coming from just some of those local suppliers because this is lower end opportunity there or is it -- are you seeing even the large competitors like Hitachi, Dell will coming back and be more aggressive in those businesses?

Bill Noglows

I don’t know if I want to quantify that deeply, Edwin. In that business there is really only -- and let me go back to what I said before what I described is the legacy dielectric [intra-layer] dielectric CMP business, there is really only three of us left that compete there. And we tend to use that business sort of as we manage our portfolio of products to specific customers. That’s a product that is one of the things we offer our customers and so the full slate of products for all CMP applications and so we’ve been willing to accept sort of lower margins in our portfolio specific customers, because it aids our business, overall business. But again it's one of those things we've rather focused our quality support or supply chain support, our R&D support on the leading hedge and so the higher performing, higher value solutions than these older legacy products. So there is always been puts and takes in this business and this is just one of those times when there is a take and we're comfortable with it.

Bill Noglows

We've talked about this is the legacy business is highly price competitive and there is a point at which you say, it's not worth going after or competing. In this case there is a better business where we've decided that.

Edwin Mok - Needham

Great. It leads to my next question. So on gross margin that came in below what you guys are expecting? You mentioned that to a some deal issue but can you give you some more color on that? Just continuing in the fiscal first quarter and as you mentioned, is there any pricing pressure that is contributing to the weaker margin?

Bill Noglows

No, our ASPs actually went up marginally in the quarter. So our ASPs have been relatively flat for a very long period of time, several years now. Bill mentioned three specific things that affected our gross margin in the quarter. You talked about, I call them so that capacity variances, I'm sure that's not the current accounting term, but when manufacture products in a quarter like last quarter where we had low utilization rates, those products carry higher unit costs with them in the next quarter. And we saw that this quarter. And we’ve seen that happen before. You talked about some increased logistics expense and then you mentioned lower yields. In any quarter, we generate a bit of off quality and this quarter was no different, we had a certain level of off quality and it's a very low level.

We did, in the quarter -- we did have an opportunity to work very closely with one of our customers who is doing a node transition. And what typically happens with our customers is they like to extend the existing products that we have been them node to node to node and almost at every node transition, we both us and the customers learn something about the CMT application that we either couldn’t discern or we didn’t see at the prior node. And we have one of those situations this quarter where we had to work very closely to sort of reformulate one of our slurries, not a big reformulation but a reformulation to help them be successful with their node transition. It’s a tribute to our teams and it’s a credit to our company that that’s one of the things that we are really good at and muster our resources and we get up and we really show, we show our customers the value of Cabot Microelectronics brand because we can bring so much power up there to help them stay on their mode trajectories and get things moving.

So we had a bit of cost associated with that this quarter but we are happy to bear those costs because it’s cements our relationship and cements our products in those advanced node technologies.

Edwin Mok - Needham

Okay. Actually that was good color. And then last question, just a quick follow-up on R&D. If I understand correctly, you mentioned that you have some wafer expenses. And is that -- do we expect that R&D to revert back to what we saw in fiscal second quarter by the fourth quarter, or is the 15.4 the current run rate for R&D?

Bill Johnson

If we think about operating expense more in total, then sort of a particular line item but you have seen this in the past where depending upon wafers, we replenish our internal stock of test wafers that we use in our labs and we expense those as we order them. So depending upon the order pattern, you can see some lumpiness in wafer expense. I don’t have a specific forecast on the quarter but I would point you to the overall guidance for operating expense of $127 million to $131 million. And there is no structural change that we would expect going into the fourth quarter versus the first three quarters.

Edwin Mok - Needham

Great. That's all I have. Thank you.

Trisha Tuntland

Thank you Edwin.

Operator

Thank you. (Operator Instructions). And our next question comes from Avinash Kant from D. A. Davidson & Company. Your line is open, please go ahead.

Trisha Tuntland

Good morning Avinash.

Avinash Kant - D. A. Davidson & Company

Good morning Trisha, everybody else.

Bill Noglows

Good morning.

Avinash Kant - D. A. Davidson & Company

The first question, of course, you could talk a little bit about -- you talked about the material pricing issue in the quarter leading to somewhat lower margins, could you specify which segment did that impact? And what exactly happened?

Bill Noglows

We had a -- we talked about this a few quarters ago where we have a new supply contract with an existing supplier and there is some transition issues associated with that. There is some higher cost and we talked about working to mitigate some of those higher costs through product formulation or price increases to customers, things like that.

And then there is also just some other sourcing initiatives we have underway that I wouldn’t want to go into a great detail that's caused one, a bit higher inventory in raw materials and you can see that in our balance sheet but also there is higher raw material cost. We're continuing to work on mitigating that, but that's something that came with this new contract and we've been in transition I think since January 1, 2013, I believe.

Avinash Kant - D. A. Davidson & Company

So the high material costs were more impactful a quarter or two ago than they are now or the impact continued to be the same?

Bill Noglows

It's probably been the same, because there is nothing structurally different. But it's just given the supply chain, the long pipeline and it's something that we have to manage over a number of quarters. But nothing significantly different this time versus the previous quarter. But as we look our gross margin this quarter it's lower than in the past and we look at what's caused that and we see three different items none of which themselves are great big but each have been contributed and the higher raw material cost was one that we called out. Not a big change from prior quarters but it's one of the factors that caused the change this quarter.

Avinash Kant - D. A. Davidson & Company

Okay. And talking a little bit ASP I think Bill already talked he said that your ASPs have been kind of flat for a very long time. Could you give some color on product segment like do you think that the ASPs have been flat in every product segment including the pad business?

Bill Noglows

No, we've had movement in the segments. We have not talked about pricing on the individual segment. So we certainly we've seen the pricing in the pad side decline. But however, many of the new products we introduced tend to have higher price points than the sort of average ASPs if you will.

So we've been all these years able to manage the declining price of some of our products with increasing price and some of newer -- newly introduced products. So I think that's what resulted in our ASP staying relatively flat over the period of time that I mentioned before.

Avinash Kant - D. A. Davidson & Company

And on the slurry side, like whether it would Tungsten or Dielectric and all those they have been stable individually too?

Bill Noglows

When we talk about ASPs we talk about aggregate. And if our customers have their wish they would see significant price reductions year-on-year given that we don't have a high fixed cost structure. We don’t have significant economies, we can't deliver that through price reductions we don't lead with that. But you would see those occasionally price down roadmap with the customer based on volume or commitment evaluations of new materials things like that. But we don’t lead with price. We are the premium price player and we want to maintain that. We want our price for value. So, if you look at individual products particularly at the leading edge we’ve tried to price those up and grab, earn a significant margin covering the technology behind that. So when we talk about ASP trends we’re talking about an aggregate, not about individual product lines.

Avinash Kant - D. A. Davidson & Company

Okay. And then talking little bit about the pads business of course, could you give us some color in terms of how many customers are using your pads in volume production right now?

Bill Noglows

I think the number is somewhat little north of 30 Avinash that are either using D100 or D200 or both. And as I said in my earlier comments, we remain excited and optimistic about our pad business that level of activity continues to be very high. The level of activity around our D200 technology this new technology that we’ve talked about is high. It’s been a long road and we’ve missed on that but we continue to stay on it and this is going to be a marathon for us and more than a mile too and we want that finish this one and be a meaningful supplier of pads to this industry. So we think we have a unique technology and new emerging technologies to follow and it looks good to us.

Bill Johnson

And revenue this quarter was the highest in the quarter compared -- you have to go back to the fourth quarter of fiscal 2012 they have a higher revenue level. So during that time we’ve grown pad units and also now revenue. This is an area where we talked in the past about efficiencies our customers are gaining in particular, we have a value proposition that gets to our longer pad life and we see customers that really and stable process start to really push the pad life and extent it beyond the original expectations.

Avinash Kant - D. A. Davidson & Company

Now talking as a number of customers have gone up much more significantly than the revenue percentage has gone up. Revenue has not gone up in a commensurate fashion, primarily because its either come down or the other customers are not using it is a same volume as one or two?

Bill Noglows

I think as Bill mentioned our units have gone up. So that implies that our prices have gone down. So you got that one right. There are, in this industry there are big customers and then are little customers and I think we have a situation where the smaller customers will provide support and help but they are really aggressive about making this change but they get the cost savings associated with longer pad life as well as the benefit of lower defects.

I think one of the things that we're kind of happy about is, we were out with the value proposition that we suggested or had data to support that you could run these pad, it twice is longer, twice as many wafers than the incumbent technology and that as far as we will low into sort of pads if you will, our customers have found ways to push that pad life further than we expected which although it dampens our revenue growth we're delighted that our customers can get additional value in the form of cost savings from pads and it's goes that before kind of makes loyal to our technology and interested in our next generation technology.

So that's kind of the story we see and we continue to get wins so we like to see win some more that really big customers and we're working very hard on it and we think we'll get there Avinash.

Avinash Kant - D. A. Davidson & Company

Okay. Thank you so much, Bill.

Trisha Tuntland

Thank you, Avinash. We will take our next question please?

Operator

Thank you. And our next question comes from Chris Kapsch, Topeka Capital Markets. Your line is open, please go ahead.

Trisha Tuntland

Good morning, Chris.

Chris Kapsch - Topeka Capital Markets

Good morning. Hey, I wanted to follow up on this variance in the gross margin. I know you mentioned several contributors, including the sequential cost accounting issue and raw materials and then the slurry yields. I am just wondering if mix is also contributing there. Because you mentioned that for example the tungsten was at record sales or at least up year-over-year and traditionally we think of tungsten as being one of your higher-margin products. I am just wondering if with QED sales being sharply down even though it is a small piece of the overall sales number, and with the hard disk drive slurries being down, do those carry with them higher gross margins and therefore is contributing to the year-over-year variance here?

Bill Noglows

Yes that’s you have that pretty close to right. We have always talked about our strength in tungsten and the market also that’s a higher than company average gross margin product. Likewise when QED sales are high that’s also a higher than average gross margin product. So we had strengthened the mix through the high, relatively high tungsten revenue but partially offset by the QED, lower revenue in QED. And so on balance, mix was slightly favorable but these other factors more than overcame those -- that favorability.

Chris Kapsch - Topeka Capital Markets

Well, then if your comments about QED being higher margin when the sales are strong, I mean looking to the fiscal fourth quarter that tough comp, given we are likely to be down in QED sales this fourth quarter so some mix drag there. Will these other -- the diminished effect of some of these other issues going into the fiscal fourth quarter be enough for you to get to that, call it 50%, to get to the low end of your full-year guide on gross margin?

Bill Noglows

It is full year guidance and we’ve seen fluctuation quarter-to-quarter on gross margin, like we did this time. But then as we look at the cost drivers that decreased gross profit this quarter, they seem to be sort of transitory and episodic. And so we would still point you to around the low end of the full year guidance, for the full year.

Chris Kapsch - Topeka Capital Markets

Okay. Well, I mean maybe transitory and episodic for maybe the yield, but like it seems like the raw material cost might persist. And on the cost accounting, was the production, your inventory building rate, your production rate, strong enough during this quarter to help the cost accounting, the unit cost issue going into the September quarter?

Bill Noglows

Yes. So since we see no strength in the second half of the year, what we would be selling now will be produced in a higher production environment the third quarter and into the fourth quarter. So, that the cost accounting, the way you refer to it, you wouldn't expect that to persist.

The slurry manufacturing variances, that is kind of episodic, it depends upon kind of activity with customers and in the quarter. So, but it was higher than it has been and we wouldn't expect necessarily increasing trend there.

Chris Kapsch - Topeka Capital Markets

Okay, thank you for that. And then just wanted to follow-up on the comment about your customers achieving efficiency once they get a stable process up and going. I'm assuming that refers mostly to leading-edge node applications, like for example, 28, 20-nanometer nodes. And so I'm just wondering like to the extent that your sales mix has skewed towards obviously some of these bigger semiconductor producers who are most advanced in terms of launching those sorts of nodes I am just wondering how long does that process sort of play out in terms of them gaining efficiency does it take them is it more like couple of months or couple of quarters for them to sort of get that those nodes up to kind of steady, stable I guess production yields where you would see that and then gain those efficiencies where you would see kind of a dampening in your demand before sort of more normal demand pattern. Just wondering how acute that sort of issue was and kind of what most would probably view as a soft top line against compared to the revenues of some of your key customers.

Bill Noglows

Well I think I mean I’d start up by saying this drive for efficiency is not something that's new I mean this has been around since CMP first started our customers are very aggressive about finding ways to minimize the spend in one area that they focus on CMP and CMP consumables. Your question is specific to how long does it take, I think it's very customer dependent and process dependent. I think it's orders of quarters now months Chris it takes a lot of – they vary fabs and many when then we work with the fabs tend to be very cautious and very risk averse. So they sort of step into these things if a flow rate of 300 liters per minute works about 380 milliliters per minute. That kind of stuff they just back it down little by little by little until they feel like they can't go any further and that takes quarters.

But like I said this is nothing new to something it's been part of our business since we started and it's going to be around forever. I think what we’re seeing is on the formulation side, we are selling concentrates now and we work really hard to try to understand how far you can dilute those concentrates and then we try to price accordingly and sort of capture the value of the performance we’re bringing in the form of those concentrates. So on our side, we’re trying to manage that efficiency best we can. But it’s in our interest to help our customers run their process as efficiently as they can as well so that’s part of something we do at the same time.

Chris Kapsch - Topeka Capital Markets

Okay. Thank you for the color on that. I appreciate it.

Trisha Tuntland

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

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