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Executives

Claire McAdams – IR

Dr. Timothy Stultz - President & CEO

Jim Moniz - CFO

Analysts

Weston Twigg – Pacific Crest Securities

Auguste Richard – Piper Jaffray

Patrick Olsen [ph] – Stifel Nicolaus

Grant [ph] Tanaka – Tanaka Capital Management

Nanometrics, Inc. (NANO) Q4 2010 Earnings Call February 10, 2011 5:00 PM ET

Operator

Good afternoon and welcome to Nanometrics’ fourth quarter and full-year 2010 Financial Results Conference Call. A Q&A session will be held at the end of the call. Until that time, all participants will be in a listen-only mode. Please note that this conference call is being recorded today, February 10, 2010.

At this time, I would like to turn the call over to Claire McAdams, Investor Relations Counsel for Nanometrics. Ma’am you may begin.

Claire McAdams

Thank you and good afternoon, everyone. Welcome to the Nanometrics fourth quarter and full-year 2010 Financial Results Conference Call. On today’s call are Dr. Timothy Stultz, President and Chief Executive Officer, and Jim Moniz, Chief Financial Officer.

Before we get started, I would like to call your attention to the following Safe Harbor statement. This conference call contains certain forward-looking statements, including, but not limited to, statements regarding financial results for the company’s most recently completed fiscal quarter and full-year, which remains subject to adjustment in connection with the preparation of our financial statements and periodic report on Form 10-K for the fiscal year 2010; the continued adoption and competitiveness of its products; the expansion of the company’s served markets; and future revenue growth, profitability and cash flow.

Although Nanometrics believes that the expectations reflected in the forward-looking statements are reasonable, actual results could differ materially from the expectations due to a variety of factors, including a contraction in current levels of industry spending, shifts in the timing of customer orders and product shipments, slower-than-anticipated market adoption, changes in product mix, and fees operating expenses and the additional risk factors and cautionary statements set forth in this company’s Form 10-K for fiscal year 2009 as well as other periodic reports filed with the SEC from time to time. Nanometrics disclaims any obligation to update information contained in any forward-looking statement.

I will now turn the call to Tim Stultz. Tim?

Dr. Timothy Stultz

Thank you, Claire, and good afternoon, everyone, and thank you for joining us today.

In my remarks this afternoon, I will discuss the business and financial highlights for the fourth quarter and fiscal year 2010, and our view of the current and near-term industry environment. Following that, Jim Moniz, our Chief Financial Officer, will provide a closer review of our financial performance, after which, I will return to provide you with guidance for the fourth coming quarter.

It is with no small measure of pride that I’m able to announce that Nanometrics just completed the best year in its 35-year history. Our record revenue of $188 million were up 145% versus 2009, and 29% higher than 2007, which was our previous record year and the last peak year in industry spending.

A particular note, our year-on-year revenue growth significantly exceeded industry growth of approximately 100%. Highlighting the progress we have made in strengthening our position with key customers, expending our served markets and gaining market share.

We also have emerged as the market leader in optical critical dimension or OCD metrology, which we believe is the highest growth segment of inline process control metrology as it systematically surplants the role of CD-SEM technology for the most advanced process notes.

Our operating profitability of 22% is also [inaudible], likewise, net income and earnings per share for the year. Even when we exclude the $18.2 million benefit recorded for the release of our tax asset valuation allowances, were also company records.

While we did experience some shifts in the timing of orders and shipments in the fourth quarter, leading to a decline in revenues compared to our record $54 million third quarter, Q4 was still the third best quarter in our history with revenues up 75% year-over-year and 19% higher than the peak quarter of 2007.

Notably, the fourth quarter marked our sixth straight quarter of profitable operations. Our sixth straight quarter of gross margins exceeding by 50% and our sixth straight quarter of positive cash flow demonstrating continued strength in our business model and overall execution.

Taking a closer look at our fourth quarter results, we experienced increase contributions and growth from our Wafer-Scale packaging business unit, which serves a market that is experiencing high growth and increasing focus by nearly every major chip manufacturer.

Our Materials Characterization business unit which includes high-brightness LED, solar photovoltaics and bare silicon wafer metrology, and our Integrated Metrology business unit which is largely driven by capacity spending and where we gaining market share.

We also saw a shift in memory spending from DRAM to NAND as any market demand for flash continues to grow. These are all favorable trends, they expect to continue in the near future.

Turning to the demand side and industry trends going forward, it is pretty evident to industry observers that fundamental demands for digital [inaudible] and [inaudible] components just continued to rise. Driven by smartphones, tablets, tablets, IT spending, cloud computing, and network storage. In order to benefit from these trends and meet highly competitive market price and performance requirements, our customers are focused on continuing to push technology through shrinks, increasing their yields, and developing new device architectures such as stacked-3D packaging.

Over the last couple of years we have aligned our product development roadmaps with these customers and have strategically focused on the areas of process control that are increasingly crucial for the 3X, 2X, and 1X nodes.

As evidence by our series of competitive wins, such as our recently-announced tool of record selection by a major Japanese semiconductor company for our suite of OCD products, we have emerged as a critical leading supplier for the majority of the world leading [inaudible] manufacturers.

From a more macro view, I’d like to help put the phenomenal industry growth in 2010 into perspective.

Even though industry investment in capital equipment roughly doubled over 2009 levels, we still have not returned to the level of spending and capital intensity seen in 2006 and 2007. The fast majority of industry analysts predict 2011 will be another growth year for semiconductor capital spending in a range of 10 to 15%. This view is supported by recent CapEx forecast provided a number of the world’s leading CHIP companies.

Our curb perspective is consistent with those estimates and thus our outlook for 2011 is quite optimistic. We have consistently emphasized our objective to outperform the world industry.

As we enter 2011, we believe we will be able to continue the outperform the industry leveraging our improved competitive position to benefit from the increasing adoption of OCD for critical dimension applications, expanding implementation of wafer-scale packaging and 3-device architecture – 3D-device architectures and growth in adjacent markets such as high-brightness LED, solar and bare-wafer metrology.

All taken, and borrowing a global economy dislocation, we expect these factors, combined with execution and operational excellence will lead to another year of solid growth for Nanometrics in 2011.

I will now turn the conference over to Jim, who will provide you with details on our financial performance; following which I will return to give next quarter guidance. Jim.

Jim Moniz

Thank you, Tim, and good afternoon everyone. Nanometrics press release containing a fiscal fourth quarter and full-year 2010 results was sent out by business wire today, February 10, around 1:30 p.m. Pacific Time. The press release may also be found on our website at nanometrics.com.

In our release and on our website our reconciliations to non-GAAP operating income which is management’s measure of cash flow generation from the P&L. That being said, all the figures referred to in my comments are GAAP unless otherwise noted.

Starting off with a review of the full-year, 2010 was the strongest year in the company history. Record revenues of $188.1 million were up 145% compared to $76.7 million in fiscal 2009. Our gross margin increased from 47.1 to 54.4% and notably our product gross margin increased from 45.9 to 57% for the year.

In support of this strong growth, our operating expenses net of impairment and restructuring charges increased by just 30% year over year. The result was record operating profitability with the record income from operations of $41.3 million and record operating profit of 22%.

2010 was also a record earnings year. We recorded net income of $55.9 million or $2.43 per share. This includes the release of a tax valuation allowance in the fourth quarter in the amount of $18.2 million equivalent to $0.79 per share.

On the balance sheet, we increased cash and investments by $22.9 million in 2010, ending the year with $66.5 million or approximately $3 per share up from $2 per share at the end of 2009.

Our tangible book value per share increased to $7.38 per share up from $4.64 per share last year.

Now I will provide more detail on our fourth quarter results.

Fourth quarter revenues of $46.1 million were down 14% from the previous quarter and were up 75% from the fourth quarter of 2009. Product revenues of $38.2 million decreased 14% quarter on quarter but increased 91% year on year.

The sequential decline in product revenues was primarily due to a reduced level of sales to our logic and data storage customers in the fourth quarter. Service revenues of $7.9 million down 17% from $9.5 million at prior quarter and up 26% compared to the fourth quarter of 2009.

Revenues for both upgrades and core service declined sequentially, largely driven by lower level of upgrade revenue and lower revenue from parts replacement sales in the field.

Fourth quarter revenues broke out as follows: revenue by geographic region is based upon the ship-to or first-in-use destination and during the quarter of the breakdown was South Korea at 29%, U.S. at 17%, Japan at 14%, Singapore at 12%, Taiwan at 10%, and Rest of World at 18%. Revenue by product type was automated metrology at 46%, materials, characterization at 20%, integration metrology at 17%, and service and upgrades at 17%.

Gross margin in the fourth quarter was 52.7%, compared to 54.5% in the third quarter as a result mainly of lower service margins. Product gross margins were 57% compared to 56.9% in the prior quarter and 53.3% in the fourth quarter of 2009. Service gross margins came in at 32.1% in Q4 compared to 43.6% in the prior quarter reflecting lower revenues as well as continued investment in service personnel gearing up for increased installation and supportive systems in 2011.

Total operating expenses were $15.6 million, an increase of $100,000 over the prior quarter. We maintained tight control of expenses in response to the decrease in sales volume yet still increased our investment in R&D by 6% over the third quarter.

Operating income was $8.7 million in Q4 compared with $13. [inaudible] million in the prior quarter, and $.7 million in the fourth quarter of 2009. Our operating margin was 18.8%. Net interest and other expense in the fourth quarter was a net expense of $0.2 million which compares to the prior quarter’s net expense of $0.4 million and net expenses of $1.1 million in the year ago period.

Before I get to net income let me explain the release of our valuation allowance appearing as a favorable adjustment to our income tax expense. As a result of the amount of profit the company achieved in 2010 and the expectation of continued profitability on an ongoing basis, management has concluded that it is more likely than not that we will realize the benefit of certain deferred tax assets. Therefore, we have recorded those deferred tax assets back onto our books by releasing the valuation allowance which had been carrying against them.

The amount of this valuation allowance was $18.2 million, equivalent to an EPS benefit of $0.78 per share in the fourth quarter. Our GAAP EPS for the fourth quarter was $1.12 per share including the benefit of releasing the valuation allowance that I just went over. This compares to net income of $0.53 per share in Q3 and a net loss of $0.02 per share in Q4 2009.

Because we have reversed the valuation allowance and we have also substantially used up in 2010 all of our NOLs, as we go into 2011 we are projecting a 35% tax rate and we are currently evaluating restructuring changes that might enable us to reduce that rate in the future.

Now, let me turn to the balance sheet. Cash came in $66.5 million, an increase of $2.5 million above the previous quarter. This marked the sixth straight quarter of positive cash flow from operations. In November, we initiated a stock repurchase plan of $10 million, and in the fourth quarter purchased and retired 65,000 shares using about $0.8 million of that plan.

Accounts receivable of $44.5 million increased $2.8 million from last quarter driven largely by our customer’s end-of-the-year cash management practices. As a result, DSO is at 87 days, which is up from last quarter and above our target of 70 days. We expect this trend to reverse in the first quarter of 2011.

Inventory of $44.6 million was up $6.1 million from the prior quarter as we prepare for a strong ramp going into 2011. As a result, inventory turns of 2.0 were down from turns of 2.6 last quarter.

We ended the year with headcount of 456 employees. Net [inaudible] of 14 from last year-end. Since year-end 2009, headcount has increased by 57 employees or by 14% for the year. That concludes my prepared remarks, and now I would like to turn the call back to Tim.

Dr. Timothy Stultz

Thank you, Jim. I’d like to make a couple of comments before giving you specific guidance on the quarter. In 2007, we made the decision to discontinue giving guidance based on a number of factors. Not the least of which was our own uncertainty of our business outlook and our inconsistent business performance and execution.

Underlining that decision was the strong belief that our focus needed to be on improving the fundamentals of our business with the long-term perspective for our stakeholders and not to compromise those efforts for the sake of meeting short-term performance metrics. Our performance over the last two years has demonstrated this unwavering belief in focus.

Today, we are highly confident in our ability to [inaudible] and have significantly improved position of relationship with the leading customers in our industry. Consequently, we have a much better visibility on our business outlook and feel comfortable sharing that with you. But I must add an important caveat before going forward, and that is although we are initiating guidance, we will not alter the way we run the business. We will give you our best perspective of a near-term business outlook, and we will do our best to perform towards those levels, but we will not compromise our future growth or profitability simply to meet the guidance or consensus estimates.

There are occasions when, just as we saw at both year end of 2009 and 2010, our customers asked for commercial concessions in order to hasten tool delivery and revenue recognition within the quarter.

We will continue to refuse these concessions in every case, irrespective of quarterly guidance. This is how we have done business since 2007 and we firmly believe it is in the best interest of our shareholders to continue doing so going forward.

That being said, our outlook for Q1 is very strong. We see revenues growing more than 20% over Q4 levels coming in between 56 and $60 million, with gross margins of 54 to 55%.

With regard to Q1 earnings, we expect our operating income to be between 24% and 27%, and our earnings per share to be between $0.36 and $0.44 with a tax rate of 35%.

In conclusion, we are more confident and enthusiastic about our business and a business balance for Nanometrics than ever before. The improvements we have made to [inaudible] especially in OCD, advanced wafer scale packaging, and LEDs, our strong competitive position, our demonstrated ability to execute, and a positive outlook on industry fundamentals and spending, we are looking forward to filling new performance records in 2011.

With that operator, we will now open up the line for question.

Question-and-Answer Session

Operator

Thank you. (Operator instructions). One moment, for the first question. Our first question comes from Weston Twigg from Pacific Crest.

Weston Twigg – Pacific Crest Securities

Hi, thank you taking my question. I have a couple of questions here. One, I just wanted to get an idea on the 3D packaging opportunity in 2011 to 2012. I was wondering if could maybe help size it terms of revenue.

Dr. Timothy Stultz

So – hi, Wes, good to hear from you first of all. We’re not ready to break that out yet in terms of sizes for you, in absolute numbers. You know, we’ve got some announced positions that I think you’re aware as to tool record, they didn’t tell which actually announced publically by Zygo when it was first won, and we’ve got a number of new installations that we believe are going to lead to quite appreciable growth in that space. When we started having consistent levels above the 10% which is kind of our nominal cutoff point, then we’ll start breaking that out and sharing with you in more detail.

Weston Twigg – Pacific Crest Securities

Okay. Also, earlier on the call you said they expected to outperform the industry this year. I know that historically your market share position at foundarys has been a little bit light, do you expect that share position to improve meaningfully this year to allow you to outperform the market?

Dr. Timothy Stultz

Yes, so that was really polite for you to say that our foundry position was light, it’s actually been quite weak. But as we have announced over the last year or so we’ve been using the strength of our balance sheet to put tools in to the key accounts for evaluation in order to penetrate those markets. We’ve got some initial traction and I believe that pretty soon we’re going to segmenting that into – and showing you growth in pretty significant ways.

Weston Twigg – Pacific Crest Securities

Okay, that’d be growth that would hit the topline in 2011 or would that be something a little bit further out, maybe 2012?

Dr. Timothy Stultz

No, I think we’ll – I think in 2011, it’s going to be a nice contributor to our overall revenues and be above the 10% mark which will allow us to share with you.

Weston Twigg – Pacific Crest Securities

Okay, great. And then just one more question on upgrades, with the service line down a million and a half this quarter, does that go back up in Q1? I guess, in other words do you expect upgrades to pick back up in Q1?

Dr. Timothy Stultz

Yeah, you know, as you know, for the last several years our upgrades have been kind of between ½- $2 million and up as high as 4 and as low as 1, and bouncing around about a $1 million a pop. I think that – I think it will all average all. At one time we shared that we thought that upgrades would be 7 or 8% of revenues, but the revenues have grown more than we had projected at that time and I think we see that kind of leveling off right around 5% going forward.

Weston Twigg – Pacific Crest Securities

Okay, perfect, thank you very much.

Dr. Timothy Stultz

You bet.

Operator

Thank you. Our next question comes from Gus Richards from Piper Jaffray.

Auguste Richard – Piper Jaffray

Thanks sir, for taking my question. Just following on to that question on service. What was upgrades in the fourth quarter?

Dr. Timothy Stultz

We don’t break that out, Gus. Thanks for calling, Gus. No, we don’t break that out from the service.

Auguste Richard – Piper Jaffray

Okay. And then you know, the gross margins clearly in the fourth quarter on the service side came down, you sort of indicated you hired a bunch of people, and you know, the revenue there was a little bit lower, should we expect service gross margins to stay in this low-30s or will it creep back up into the 40s?

Dr. Timothy Stultz

So the – you know, the decline in the margins s really came in three areas. One being able to upgrade revenues. We did front-end load some hiring to prepare for the ramp in 2011 because it takes anywhere from 3 to 6 months to properly train the folks that are going to be deployed on the international basis. And overall service revenues actually had declined primarily on the parts side. I think that you’ll see as the ramps go, then we’ll do a better job of fully absorbing our service personnel and we would expect some recovery in the overall service revenues on the parts side as well as on the upgrades.

Auguste Richard – Piper Jaffray

Got it. And then just to be clear on the tax side, you basically had to take your reserve in the fourth quarter giving you the you know, giving you that pop in revenue, and then you’ve essentially taken off all your NOLs and then going forward, we should assume a 35% tax rate, is that correct?

Jim Moniz

Yeah, Gus, that’s correct. This one application, you said we took a pop in our revenues. We took a pop in the income because income…

Auguste Richard – Piper Jaffray

I’m sorry, I misspoke.

Jim Moniz

No, no, I knew what you meant. So yes, that is correct because we essentially now have determined that it’s more likely than not that we’ll continue the profitability, we had to reverse the evaluation allowance and give the benefit all at one time, which happened in Q4 and we’re projecting right now, 35% tax rate as we go into 2011.

Auguste Richard – Piper Jaffray

Okay, and then just a couple of product questions, or do you have a sense of what your marketshare is CD-SEM, and sort of what the market size is in 10?

Dr. Timothy Stultz

We have a sense but I wouldn’t tell you that. We have that down to a science. It’s a little hard because the various analysts and reports don’t really capture all the elements of OCD. You know, we believe – you know, we’ve shared some numbers on our IR presentation showing there’s been a change from kind of a mid-teens of market share of OCD against CD-SEMs in the total CD market, showing up into like 30-35% and we think that’s going to continue to grow pretty substantially. We’re seeing over 100% compound annual growth rate in the application space of OCD which is coming largely at the expense of the CD-SEM market.

Auguste Richard – Piper Jaffray

And then last one for me just on the overlay market, any you know, in the update on how you’re doing with your newer tools?

Dr. Timothy Stultz

We’ve got some tools that have – were taken in that we talked about I think last quarter, they’re in place.

Auguste Richard – Piper Jaffray

Okay, great. Thanks, thanks for taking my questions.

Dr. Timothy Stultz

Thanks, Gus.

Operator

Thank you, our next question comes from Patrick Olsen [ph], Stifel Nicolaus.

Patrick Olsen [ph] – Stifel Nicolaus

Thanks a lot, and congratulations on a great quarter and a great year. Tim, maybe – can you give a little bit of color on your progress with the foundry customer segment and I guess where I’m trying to get with that is you know, you guys have made significant inroads in both logic as well as memory based on you know, the nodes shrinks. Given some of the technology challenges that foundries have experienced, particularly last year, year and half, how has that opened up some opportunities for you guys on a going forward basis?

Dr. Timothy Stultz

That’s a good question Patrick, and thanks for calling. You know, we’ve made good progress as you’ve point out in logic and memory, but we really have not established a strong market-leading position in the foundry space, and it’s a part that we’ve put a lot of energy into. In particular over the last year, were we placed some tools, used our balance sheet, put some resources on site to try to open those accounts. The other part of that equation besides being – trying to put our tools in, is to have a pool from the customer side. If they don’t have a problem, they’re willing to look at your tool but they’re not willing to buy a bunch of tools, they’re not willing to make a change. As the foundries are pushing down in the 2x nodes, they are running into some technology issues, as you point out. And it does open the door for us to demonstrate what we can do and how we compare our vis-via our competition. So that’s a crack we needed, and I think that that’s going to play out nicely in 2011 and 2012.

Patrick Olsen [ph] – Stifel Nicolaus

Great, thanks a lot guys.

Dr. Timothy Stultz

All right.

Operator

Thank you, our next question comes from Grant Tanaka from Tanaka Capital Management.

Grant [ph] Tanaka – Tanaka Capital Management

Tim and Jim, congratulations. Just wondering how many evaluation tools you have out now roughly versus a year ago?

Dr. Timothy Stultz

We don’t count the total number of tools, but last time I think we had about $8 million in finished goods and an overwhelming majority of it was represented by tools that are installed in different locations.

Grant [ph] Tanaka – Tanaka Capital Management

And these are – are the concentrated in any one particular type of IC manufacturing process?

Dr. Timothy Stultz

Well, not so much. Well, they’re all in the – they all addressing – well, I should say they all. The overwhelming majority of them are addressing the 2X nodes and the overwhelming majority of the are addressed at the foundries.

Grant [ph] Tanaka – Tanaka Capital Management

How about launches, new product launches and revenues recognition? Is there anything in terms of lumpiness in revenue recognition versus shipments of either the recent quarter or quarters coming up?

Dr. Timothy Stultz

That’s a good question. I’ll let Jim talk to you about rev rec and what we’re doing there.

Jim Moniz

Okay. And then Tim can talk about product launches. No, we – as you can imagine, rev rec is really, really important for an equipment manufacturer like us. And so we have not had any problems. We have not had any issues. Certainly, if you look at our deferred revenue in Q4, it went up a little bit from Q3 because we do have some equipment out there that we don’t have an acceptance for at the end of Q4 but there’s nothing abnormal. It’s kind of the normal course of business and we have a very strict revenue recognition policy that we follow very carefully.

Grant [ph] Tanaka – Tanaka Capital Management

And launches, that might be more a rev rec expansion for the second and third quarter?

Jim Moniz

So we certainly are going to be doing some combination of new products and product reprices, which we will be announcing as the year goes on. But we generally – nodes going to locations that, you know, that do not impact what our outlook on our revenue and our revenue recognition, but more strategic placements, address more – the 1X nodes, in fact.

Operator

Thank you. (Operator Instructions). I’m showing no questions at this time. I would now like to turn the call over to Dr. Stultz for concluding remarks.

Dr. Timothy Stultz

Thank you, Operator. As many of you probably know, this is Jim Moniz’s last earnings call with Nanometrics. It has been a genuine pleasure working with Jim over the last couple of years and I will tell you without reservation that he was a key factor in contributing to the turnaround of the company and helping Nano achieve new levels of operational excellence. All of us here at Nano thank Jim for his contributions and wish him the very best with his planned retirement.

And last but not least, I want to once again gratefully acknowledge the outstanding performance and contributions of the global Nanometrics work force, who are directly responsible for all the reports we report on. Thank you once again for joining our call and we look forward to reporting to you on our first quarter results in April.

Operator

Thank you. Ladies and gentlemen, thank you for participating in today’s conference. This concludes our program for today. You may all disconnect and have a wonderful day.

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