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FEI Company (NASDAQ:FEIC)

Q2 2011 Earnings Conference Call

August 2, 2011 17:00 ET

Executives

Fletcher Chamberlin – Treasurer and Communications Director

Ray Link – Executive Vice President and Chief Financial Officer

Don Kania – President and Chief Executive Officer

Analysts

Jim Ricchiuti – Needham & Company

Patrick Ho

Mark Miller

Tom Diffely

David Duley

Sid Parakh

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the FEI second quarter earnings conference call. During today’s presentation, all participants will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions) This conference is being recorded today, August 2, 2011.

I would now like to turn the conference over to Mr. Fletcher Chamberlin. Please go ahead.

Fletcher Chamberlin – Treasurer and Communications Director

Thank you, John. Good afternoon, ladies and gentlemen. As the operator said, I am Fletcher Chamberlin, FEI’s Treasurer and Communications Director. With me today at our headquarters in Oregon are Don Kania, our President and CEO; and Ray Link, Executive Vice President and Chief Financial Officer.

We have again posted some slides under the Events & Presentations section of our Investor Relations part of our website, fei.com. We will refer to these slides during today’s call. We hope having these slides will make it easier for you to listen to our comments rather than just focusing on getting the numbers recorded.

While you are pulling up the slides and before we get into the presentations, we also have to do the regular housekeeping matters. This call contains forward-looking statements. To the extent that we discussed expectations about future corporate financial performance and goals, future customer orders, performance by product and market, the outlook for margins and revenue, market developments and opportunities, future product and technological developments, the effects of future movements in exchange rates, future hiring plans, expected government spending for research, our expected effective tax rate, and other future events and plans, these statements are considered forward-looking subject to risks and uncertainties that could cause our actual results to differ from the forward-looking statements made.

These and other risk factors are cited in today’s press release on slide two of the slides posted for this call and in FEI’s most recent 10-K, 10-Q and 8-K documents and other filings with the SEC. Investors are urged to read these documents. Copies of the SEC filings are available free of charge on the commissions website at sec.gov on our website or from our Investor Relations Department at 503-726-7710.

The company assumes no duty to update forward-looking statements set out in those documents or made on this call. This call is the property of FEI Company. It will be archived in the Investor Relations section of our corporate website at www.fei.com.

I’ll now turn the call over to Ray for a review of the financials and then Don will comment on our markets and the business environment.

Ray Link – Executive Vice President and Chief Financial Officer

Thank you Fletcher and good afternoon everyone. I’ll go through the financial report and guidance in detail and then turn the call over to Don. We had another very good quarter. Orders remained strong and are above the high end of our guidance range. Revenue was another record ahead of our guidance up 45% from last year’s second quarter and up 7% from the first quarter. Operating margins at 17.3% or up 1.1 percentage points in the first quarter and up over seven times from a year ago. EPS was the highest in our history and ahead of our guidance and consensus estimates. All the growth in 2011 has been organic with no additions from acquisitions. We have now recorded 21 consecutive quarters of GAAP profitability demonstrating both consistency in the downturn as well as growth in a better market environment.

Turning now to the details on slide three, if you are following along, net bookings for the second quarter were $204.5 million, up 7% from the first quarter and up 17% from last year’s second quarter. That’s our highest second quarter total in our history and the second highest of any quarter ever. Book-to-bill ratio for the quarter was 0.97 to 1. The backlog at the end of the quarter was $459.1 million and represents over six months of backlog at our current revenue run rate. Don will talk more in a moment about the composition of our bookings and our market outlook.

Moving to slide four. The total revenue growth was led by Electronics revenue of $87 million, making up 41% of the total. It is up 42% from the first quarter and up 53% from last year’s second quarter, as the highest quarterly total for the segment since we have begin our segment reporting in the configuration and well above the prior cyclical peak.

Research and industry revenue of $55.1 million was down 22% from the first quarter record, but up a substantial 47% from last year’s second quarter. It made up 26% in the total. We built backlog in the segment during the quarter and expect additional revenue growth in the second half of the year. Life Sciences revenue of $26.8 million made up 13% of the total. It was up 11% from the first quarter and up 83% from last year’s second quarter. Service and components revenue was $42.2 million for the quarter, up 3% from the first quarter and 14% form last year’s second quarter.

Turing to slide five, our revenues were balanced geographically with North America making up 35% for the quarter, Europe and the Middle East making up 28% and Asia, Japan and rest of the world making up 37%. The substantial growth we experienced outside the U.S. and Europe reflects both the market opportunity and our successful execution in Asia.

Now looking at slide six, gross margins in the quarter was 45.3% above 45% as we forecast, above 43.6% for the first quarter and well above the 41% recorded in the last year’s second quarter. Each of our product market segments recorded increase gross margins both sequentially in compared with last year’s second quarter. The improvement came from higher volume, improved product mix driven in part by an increase portion of new products across all divisions including the very successful Helios small dual beams and more Titan Krios revenue and continued manufacture improvements.

We saw significant important benefits adversely all of our high-end small dual beams were built in the Czech Republic in the quarter. The strength the euro and the Czech koruna during the quarter had a negative impact on gross margins, offset in part the hedge gains. While mix with decreased gross margins in the third quarter, we continue to target our long run goal or gross margins of 47.5% by the end of 2012. A number of factors were driving towards that long-term target is outlined in detail in our June 2nd investor meeting, is included revenue growth, product mix and pricing and operational improvements including further product transitions from the Netherlands to our facility in the Czech Republic.

Turning to the next slide seven and moving down the income statements, operating expenses excluding restructuring were $58.4 million, up from $53.7 million in Q1 and $47.2 million in last year’s second quarter. Year-over-year operating expenses grew 24%, while revenue grew by 45%, given a significant operating leverage.

R&D expenses were increased as we made investment to build the growth in 2012 and beyond. Just over half of the sequential increase in operating expenses came from currency and increase in employee profit-sharing compensation. We had 1,957 employees at the end of the quarter, up 6% for the quarter and up 9% from year ago. Restructuring expenses were $783,000 in the quarter compared with $285,000 in the first quarter. That reduced earnings per share by about 10. We are projecting restructuring expenses of less than $250,000 for the third quarter.

The increase in revenue, improved gross margin and leverage on our operating expenses led to another increase in operating income for the second quarter to $36.5 million, or 17.3% of revenue compared to $31.9 million in the first quarter and $3.5 million in last year’s second quarter. That be highest quarterly dollar total in the company’s history and is in the range of our long-term model of 16% to 19% operating margins.

Last year’s operating income and margin was decreased by $9.1 million of restructuring expenses incurred as a result of our now complete move of our Helios small dual beam product line from the Netherlands to the Czech Republic. Excluding restructuring costs, operating income was $37.3 million compared to $12.6 million in the second quarter of 2010. Below the operating income line, total other expense was $893,000 compared with $222,000 in the first quarter and $900,000 a year ago. We expect non-operating expense will be between $500,000 and $1 million for the next several quarters. The tax rate in the quarter was 26.9% compared with 29.6% in the first quarter.

Last year’s second quarter included a tax benefit of $13.5 million due to the advance pricing agreement completed in that quarter between the Dutch and U.S. taxing authorities. This led to GAAP net income of $26.1 million or $0.62 per diluted share for the second quarter. That compares with earnings in the first quarter of $22.3 million or $0.54 per diluted share and $16.2 million or $0.40 per diluted share a year ago.

The diluted share count was 42.6 million in the quarter. This includes 3 million shares attributable to our 2.78% convertible notes, which are included in the count because they are dilutive at this income level, with an interest add back to net income of approximately $500,000.

As you can see on slide eight, our balance sheet and cash flow remain very strong. Total cash and investments at the end of the quarter included restricted cash and long-term investments was $471.3 million and net cash after subtracting debt was $382.3 million, up $19.5 million in the quarter and $47.5 million since the beginning of the year.

Net cash at the end of the quarter was $9.77 per share. Day sales outstanding were the lowest for second quarter in the last decade. EBITDA was $40.8 million in the quarter compared with $36.9 million in the first quarter and $7.5 million in the last year’s second quarter.

Slide nine is a summary of our guidance. We expect revenue for Q3 to be in the range of $195 million to $210 million. Earnings per share are expected to be in the range of $0.51 to $0.57. The tax rate is expected to be around 26%. Restructuring charges are estimated to be under $250,000 and are included in the GAAP EPS guidance. We are guiding Q3 bookings in the range of $175 million to $195 million.

With that, I will turn the call over to Don, for additional comments.

Don Kania – President and Chief Executive Officer

Thank you, Ray, and good afternoon, everyone. It was another very good quarter. We delivered record revenue and earnings for the third quarter in a row or this with the second highest in our history and highest ever for second quarter, with 17% year-over-year growth and 7% sequential growth. We saw particular strength in our research and electronics markets. Geographically, we saw growth in Asia and in Europe.

We are pleased with our progress in margins. Our gross margin was 45.3% for the quarter, up 41% from a year ago and our operating margin for this quarter was over 17%. Given this uncertain environment, our substantial backlog gives us confidence in our revenue outlook for 2011. Even with nominal seasonal dip in revenue in the third quarter, we expect full year revenue to be approximately 30% above last year’s total of $634 million.

Our investment in R&D is lagged the increased revenue and profitability. Even though R&D spending in the quarter was up 26% over the same quarter a year ago, it was still below 10% of sales. As the year progresses, we expect R&D spending to expand to our target of 11%. We believe this level of spending is matched to our strategy to double our served available market by 2014, as we discussed in our June investor meeting.

Turning to our geographic bookings on slide 10, our year-over-year growth in orders showed strength in Europe and Asia, with North America down slightly compared with the first quarter. Orders were well diversified regionally, with 23% of bookings from North America, 37% from Europe and the Middle East, and 40% from Asia including Japan.

Asian bookings were particularly strong in Electronics. Research and Life Sciences showed solid year-over-year growth. In the United States, our pipeline remains strong, despite lackluster demand in recent quarters. We believe the U.S. budget uncertainty is causing some delay in demand. With the robust pipeline and need our customers to invest, we expect some bookings improvement in the second half.

Looking at slide 11, you can see that the largest booking segment of our business in the quarter was Electronics at $76.1 million or 37% of the total. That’s up 18% from Q1 and is our second highest quarterly total ever for Electronics barely topped by our record fourth quarter of last year a $76.2 million that also yields a trailing 12-month total of over $276 million, which is over 33% higher than our peak in the 2006/2007 time period. At the same time, Q2 Electronics revenue of $87 million was 42% higher than our last cyclical peak in June of 2007. This growth is substantially greater than most other semiconductor equipment companies indicating that we are increasing our share of industry spending through the cycle. Geographically, Electronics orders were strong in Asia including Korea, Taiwan, Singapore, and Thailand.

Most of the strength in Electronics came from semiconductor customers as the consolidating data storage customers focused on integrating their acquisitions. We continued to be the leader as the industry expands demand for TEMs and dual beams to support process development, ramps, and excursion control in manufacturing. Looking forward, prospects remain good as the technical demands are shrinking devices and 3G structures continued to increase the share spend for FEI’s products.

Our major customers are pulling us to deliver more productivity positions near the manufacturing line. During the quarter, we introduced the new Vion plasma focused ion beam tool for 3D packaging applications. Incorporating powerful new milling capability, this product is consistent with our strategy of expanding our served available market and driving our technology to solve customer-specific problems.

Along with other industry observers and in light of our near record Q2 bookings, we are prudently planning for Electronics orders to be down in the third quarter. Based on discussions with customers, we expect the rebound in the fourth quarter as substantial technology challenges continue to face the industry.

Research and industry, with total bookings of $64.5 million was up 60% from the second quarter of 2010 and up 17% from the first quarter. This business continues to benefit from both established economies and from the emerging part of the globe. European business was particularly strong contributor this quarter.

As we have noted before, governments in Europe have reaffirmed their commitment to technology infrastructure spending for future economic development and we are benefiting from that commitment. We expect the strong second half for research bookings similar to what we saw last year, with particular strength in Europe and Asia.

As we highlighted at our June 2 meeting in New York, the natural resources business is a small, but fast growing high-margin portion of our research and industry segment. Bookings were up over 40% from last year’s second quarter primarily based on mining customers. In the emerging oil and gas segment, we have three development agreements in place for well site, surface logging, and conventional oil and gas. That is measuring the mineral content of the drilled rock at the well site.

One agreement is with the major international oil services provider who has been testing our system and a remote site in Asia. The second is at an offshore site in conjunction with an oil company in the Middle East. And the third is with the midsize European based service provider. Early results and learning from this work have been positive. We believe we have the partnerships in place to achieve our objective of establishing the value and market size of our well site surface logging solution during 2012 positioning us for future growth. We expect to be able to announce a move from development agreements to commercial services for the end of the year.

In addition to conventional oil and gas solutions, we are seeing interest in the use of FEI tools and software for the characterization of unconventional sources of oil and gas, such as shale formations. We believe our tools can provide critical information as this emerging area matures. The mineralogy measurements relate to critical parameters that characterize the reservoir and can help us optimize strategies to maximize extraction of oil and gas. During the second quarter, we increased our investment at R&D and distribution for this business to take advantage of the opportunities we see in 2012 and 2013.

Turning now to Life Sciences. Orders of $18.7 million were down from Q1 and last year’s second quarter. As you have said before, this business will be variable from quarter-to-quarter when we expect to continue the double-digit long-run growth trend that we have seen in recent years. We made good progress during the quarter on two important life science initiatives. The first is our living lab, which will be an on-site collaboration with a major search institution to further develop the credibility, capability, and the complementary nature of electron microscopy with the large market for established techniques such as NMR and XRD for structural biology research.

The second is the partnership in correlative microscopy, which will expand our presence in cellular biology. Our goal is to provide a seamless linkage between optical and electron imaging. We expect to finalize these agreements in the next few months. Both are important for the long run expansion of our served available market that I mentioned earlier.

I also want to highlight the gross margin performance in Life Sciences that we’ve reported. At 47.7%, it is up over 6 percentage points from the first quarter and over 13points from last year’s second quarter. As the Titan Krios has matured in the marketplace and has proved its value, margins in this business unit have gone up.

Finally, our service bookings were up 27% compared to last year. Orders were down 6% sequentially in our normal seasonal pattern, as the number of annual service contracts are renewed in the first quarter.

Now, I want to put the pieces together for you to give you a sense of how FEIC is the second half of 2011. While we will likely see a dip in electronics bookings in the third quarter, we expect a rebound in the fourth quarter driven by technology investment. We also expect the strong second half for Research and Life Sciences similar to last year and supported by our global reach. There are uncertainties out there regarding the semiconductor cycle, the macroeconomic environment, and government fiscal plans in the U.S. and parts of Europe, but we have substantial backlog and our order pipeline continues to grow.

We demonstrated a nearly unique resilience in the last downturn and expect to be able to prosper in the current uncertain environment. QT revenue is expect to be down slightly from the record second quarter level due to normal seasonal factors and we expect an increase in the fourth quarter. We expect annual growth of approximately 30% for the full year and we are delivering meaningful leverage to the bottom line. All supported by a strong balance sheet that holds nearly $10 per share of cash net of debt.

We continue to upgrade our operations with good spending discipline and we are seeing the benefits of our restructuring in investments and new products and new geographies. It’s too early to speculate on 2012, but I want to reiterate the message that we delivered at our June meeting in New York and in our discussions of the Life Sciences and natural resources businesses. We are making investments for growth and significant expansion of our served available market over the next few years creating substantial opportunities for FEI to grow.

We appreciate your support and I also want to take this opportunity to express my thanks to the company’s employees for applying their tremendous talents and skills to grow FEI. With that operator, we are now ready for questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) Our first question will be from the line of Jim Ricchiuti with Needham & Company. Please go ahead.

Jim Ricchiuti – Needham & Company

Hi, thank you. Good afternoon. The first question I have is just with respect to the comments you made about mix in the quarter and the potential impact that could have on gross margins. So it sounds like you are assuming gross margins come down sequentially in Q3. Can you talk a little bit about mix, particularly at the low end and at the high end of your revenue guidance?

Ray Link

Jim, this is Ray.

Jim Ricchiuti – Needham & Company

Hi Ray.

Ray Link

As we look at Q3, you really have to look at Q2, first of all. We had tremendous revenue and our electronics market division driven largely by significant increase of revenue from our small grouping markets where we get good margins and we got great margins because we make a product transition from the Netherlands to the Czech Republic. We had really strong bookings in our Research market division in the past quarter, but our revenue was down relative to previous quarter and that’s turning around. So when we look at Q3, we would expect to have slightly more Research revenue, which tends to be more SEMs and mid-range PEM products and slightly less electronics which tends to be more of our dual-based products. So when you factor that in, we are anticipating that margins will be slightly below Q2 levels, but above Q1 levels.

Jim Ricchiuti – Needham & Company

And Ray with respect to just the range you are providing for revenues, it sounds like even the delta is going to be effected by shipments in the research market?

Don Kania

Well, if we – the range is essentially the same range as we had last quarter from a guidance standpoint, but if we do hit the midpoint we would have less revenue and generally less revenue would drive certainly less margin. I am not certain, if I am answering the questions maybe.

Jim Ricchiuti – Needham & Company

No, I am just – as it’s more of just again on the issue of gross margins, I was just wondering if there is much, it sounds like you are clearly assuming margins come down in this quarter, but I am just wondering what kind of decline we might see at the low end and potentially what kind of decline we might see at the high end? I might also add just curious about your margins on the service side of the business, do you see that remaining at the Q2 level in this quarter?

Don Kania

Let me answer the first question first. I think we want to bound it. We currently expect Q3 margins to be above Q1 and Q1 flat drop from Q4 even through we have slightly more revenues. So, mix and you have to remember where sort of a deal-specific company, too. You can have some deals that are more higher end tools versus the different mix from quarter-to-quarter. And then on the high end, if we hit the high end of guidance, I would expect margins not be much more than Q2, but once again it depends on mix, but I think you need to kind of use that as the range slightly lower than Q2 with the high end and higher than Q1 at the low end.

Jim Ricchiuti – Needham & Company

Okay. And on the….

Don Kania

Service margins, I expect them to rebound. Service margins, we’ve had a really good track record of that. We had some profit-sharing cost accruals than our – the way that gets allocated to the individual divisions that follows the employee and we have lot of employees in our service division. So, they were turned a little bit more with our success by having more profit-sharing cost accruals flowing through that. We expect that to normalize in Q3. And as a result, margins should bounce back in our service business and I would like to also point out that Q3 generally is a pretty good quarter for our service business, because we have a lot of people on service contracts and people tend to go way and not call us, so we have more profits in the quarter.

Jim Ricchiuti – Needham & Company

Got it. And then finally and I’ll jump back in the queue, tax rate coming down a little bit in Q3, I wonder is what should we assume for the year as a whole?

Don Kania

I think you should consider about the same rate 26% for Q4. We’ll be updating our Q3 – our Q4 tax rate next quarter. We’re working on some initiatives, that’s too early to talk about those, but for now, I would just keep the same 26% rate about Q3 and Q4.

Jim Ricchiuti – Needham & Company

Okay, thanks a lot.

Operator

Thank you. And our next question will come from the line of Patrick Ho. Please go ahead.

Patrick Ho

Thanks a lot and congratulations on a nice quarter. Don, with lot of the moving parts in semiconductor worlds right now and with process technology transition is going on as we move down the technology notes. As you look at the back half of the year as well as into 2012, can you just detail some of the process technology changes that are driving increased usages of your tools and maybe a little bit of color on the customer segment and whether you are seeing any changes in mixed air, because you traditionally have some good exposure on the advanced logic side. Are you seeing the mix of customers change as we go down these technology notes?

Don Kania

Okay. So, I’ll try to start at the beginning and ask even if I don’t touch on everything. So, in terms of the technology drivers, smaller is certainly more beneficial for FEI and particularly kind of draw a line in the sand, and you see people starting to push 22 nanometers forward, in particular, that the adoption rate of what FEI provides the customers seems to go up in a meaningful way. And that’s of course a good thing and a lot it is still pending to flow-through to operations at our customer base. And then in addition to just shrinkage you have the introduction of FinFETs or other 3D type structures in the transistors, more complexity, more difficult to measure and again feeds to our strength and at the same time if you look at the process for traditionally the emphasis for FEI’s tools has been in process development to qualification and somewhat in supporting many expression and I think the third leg of the trend is that we are seeing more and more involvement in FEI’s tools being used to help run manufacturing more effectively.

I want to be real clear we are not going inline, but nonetheless the people that are interacting with us directly today are closer or in many manufacturing as opposed to the past they were involved in the development labs. We have certainly targeted strategically to improve the productivity of the tools that feeds nicely to what this group of customers is search for and so. If you look at this data and I think maybe at our investor conference call I will show.

I’m pleasure to get some more first looking at our peak to peak membranes and we have seen a large increase. We did some comparison to peers and we feel with that is definitely evidence here that we are getting share spend increase as we go through the cycles and we expect that to get further enhance as we go in to the future.

So, life is pretty good there. Yes, we will talk about the cyclicality we have been saying for several quarters. There can be a couple of bad quarters in the next six or whatever. I think for FEI, yes, it will be down, but come in off the record quarter customers are indicating that they still the technology and so we are feeling that or will be rebound. Tough to make the call how big it will be at this point.

Let’s get through three, we will tell you about four. 12 is the tough call, I don’t see there is a disaster right now. I think some people out there calling it disaster I do not see it that way. I think there is a lot of pending capacity coming on, switches going on, and again the technology trail underneath all of this, it doesn’t change when you get in to the 12.

Patrick Ho

Okay. So you have seen any of the customer mix change, whether its going from Advance Logic has been the most aggressive obviously 222 nanometer in the back half of this year. Do you see I guess increased foundry and memory needs for your tools?

Don Kania

If you look over the past few quarters you certainly see enhanced spending by the foundries in particular, as the competition at the smaller nodes gets piercer and piercer as people try and prepare for that. Also memory, memory continues to invest the kind of a little bit behind Logic, but the cutting edge providers of memory and the associated technologies have also I think we would say ramped up their investment in the past two quarters.

Patrick Ho

Great. And final question form me, on the Research and Industry side, obviously a lot it is dependent on the government subsidies in the respective regions. You have mentioned that you are seeing strength in both Asia and Europe, I guess what gives us confidence that those governments spending programs will continue that gives again the confidence that will be coming in over the next couple of quarters?

Don Kania

The big driver in Asia is China, which is can be (indiscernible) of our deal flow. They have committed to their five year plan we talked about this in the last call a little bit. And the content of their commitment, which they seem to stay the course on the historically feeds well to the kind of technology that we provide to the region. So, we think China demand remains robust both on research and life sciences that looks good. And also in the other parts of the emerging world in Asia, all indications are like is remains good and this is again back to investment, training the workforce, creating differentiated industries over time.

In Europe you have sort of the same thematically is that there is a continued willingness to invest with long-term view in science and technology, infrastructure, the Germans have identified they need to upgrade and have a special program. The French has done the same thing. We see the Northern European countries are continuing to invest. Yes, the south will be spotty and UK has been spotty. So, we don’t feel there is a net is down especially a few factors in Eastern Europe and the Middle East in to that region.

I think there is enough emerging drivers that keeps that growing pretty quickly. Asia growing and the U.S. yes, U.S. has been slow and as it said, we expect some uptick in the second half, but this business is not going to be driven by the United States at least for the next couple of quarters with the rest of the world.

Patrick Ho

Great. Thanks a lot, guys.

Don Kania

Thank you, sir.

Operator

Thank you. And our next question will be from the line of Mark Miller. Please go ahead.

Mark Miller

Let me add my congratulations for another great quarter. Just wondering some of the people in China are reporting namely (indiscernible) trying to reporting credit tightening might be impacting some of their ability to take an orders and I’m just under wondered are you seeing anything like that?

Ray Link

For us, China is primarily a research marketplace both for the Life Sciences, Research based customers any research the customers are not industrial generally. So, the bulk of the purchases are made with government type grants money that available and so if we don’t see those types of transactions very much at all and in the once we see and looking at raised and we just haven’t seen any evidence of any issues here. So, that’s not affecting FEI’s business.

Mark Miller

Okay. I’m just wondering for the same thing in Europe because there was some reports still ups in another people weakening industrial conditions, but you’re expecting strong same reasons there?

Ray Link

I think the same answer applies semiconductor obviously has it own pattern. We talked extensively about that. And then the natural resources business although small, we still see a generally robust opportunity for us in that area. Mining continues to be good, but oil and gas of course it’s the future, but its looks very, very compelling to us and so the story it seems to hold together across the board.

Mark Miller

Okay. You mentioned natural resources from the three developmental programs you have there or are they going to be resulting in a net profited company or there are going to be associated with cost burden?

Ray Link

In the short-term it’s cost. They are putting in resources. We are putting in resources to learn and understand, but we think these both big all of these potentially become springboards for as becoming a service provider in '12, '13 time frame. So, those are in the P&L as we say, we ramp up spending a little up in the natural resources area because our expectations are improving or I guess our view of our expectations are improving. So, confidence is going up. There is a good business here.

Mark Miller

Thank you.

Ray Link

Thanks Mark.

Operator

Thank you. And our next question will be from the line of Tom Diffely. Please go ahead.

Tom Diffely

Yes, good afternoon. Hey Don, I was wondering if you learned anything today from the budget. At one point the president said that he was able to preserve the research budget as one of his comments and I’m just curious if you heard anything at all about what past today?

Don Kania

I think, that's what you're asked me what we've learned our government period. I'm glad you asked me that question. I think we don’t have any insights right now, but benefits the levels that you talked about and I think I was recently at the NIH talking to people. I know how this works are used to be one of those people, when you are uncertain about they budget what you do, you don’t spend, protect the people and still things get stabilized and so. I think right now we are getting into the mood where people are understanding that at least for '11 life is probably okay given the President’s comments, but we can reverse the right to listen more carefully.

Tom Diffely

Yeah.

Don Kania

And then of course concert will shift to 2012 pretty quick as we go into that budget cycle.

Tom Diffely

Okay, all right. Maybe an update on the data storage side, we haven’t seen that for a couple quarters it seems like and it looks there should be some pent-up demand at some point over the next couple of quarters?

Don Kania

I think its good observation to run 10% orders.

Ray Link

Slightly more than 10% of the electronics.

Don Kania

The electronics business and we are seeing very selective investments because the both of major players in the area are still focused on the consolidation aspect overall, but the technology activity there remains a little less this is well in terms of effectively same things showing in semi. It remains sort of accidental or the right word to get, we still opportunistically we will see orders, we will see bumps. I think it’s a good chance we will see some stuff in the second half just because you got to stay on the competitive trail here as people understand and justify what they if stuck together in these larger companies are now. And, believe on both sides here are very good customers, Seagate and WD are both great customers for FEI, in the second half very difficult to quantify.

Tom Diffely

Okay that’s typically the dual beam type product that’s pretty (indiscernible).

Don Kania

We largely for dual beams are the big player there everybody used everyway for data storage, touches one at least once. There is a generational rotation going on going on over the next it’s harder to find the period, but there is a more advanced capability requirement coming and we are able to provide that.

Tom Diffely

Okay and then when you look at the bookings drop off in the third quarter as most of that driven by electronics at this point?

Don Kania

Yes. I think we try to describe we will be improved our electronics first. Obviously Research and Industry and Life Sciences is going to pick up a bit in the quarter. I guess what I highlight to everybody to our guidance is essentially same as the order guidance we gave last quarter. So, seasonal we got some of that large Europe continent timing on that stuff. Yes, we see that the drop off is seasonal some kind of episode.

Tom Diffely

Yes, okay. And then finally when you look at the new technology centers, what type of cost we’re looking over the next year or two in that?

Ray Link

Meaning all these like the living lab and things like that. It’s pretty much built in our planning in to our R&D levels that we have described. So, you just think about that way.

Tom Diffely

Okay.

Ray Link

I’m not going to give you the specific cost, but we don’t expect to go beyond our 11% target.

Tom Diffely

Okay, great. Thank you.

Ray Link

Thanks a lot Tom.

Operator

Thank you. And our next question will be from the line of David Duley. Please go ahead.

David Duley

Yes, most of my questions have been answered, but just once quick question on the electronic business. Don, you mentioned how that orders was rebound in Q3 and then bounce back in Q4. Should we assume that revenue has been down both in Q3 and Q4 in that segment?

Don Kania

There would be granular on the revenue guidance, but I think historically in electronics the revenue ramps quarter to quarter and half lag from orders. So, you can do the math.

Ray Link

It’s quicker than in research and life sciences.

Don Kania

The cycle times were shorter.

David Duley

And that whatever you are seeing in electronics business is mostly declined coming from the foundry sector like a lot of the other semi guys are seeing?

Don Kania

For us is more broad based, I think don’t think there is any particular sector you can point to and it’s more question from FEI’s perspective of who has made how much investment to this point. And we had a couple of really strong quarters here, so a lot of monies flowed for the other people to spend. So, it’s more that it is the sector.

David Duley

That wasn’t me by the way. As far as the bookings guidance I would assume most of the decline in the bookings that you are going to see in Q3 is coming from the electronics sector?

Don Kania

It’s the only segment we got it down. That’s a good logic. Okay.

David Duley

Finally question from me, can you give us an idea is there size of the natural resource business at this time?

Ray Link

We think on an annual run rate we are seeing few tens of millions right now.

David Duley

Okay. Thank you.

Ray Link

I think giving more colored naturally grows up a little bit more.

Operator

Thank you. And our next question will be from the line of Jim Ricchuiti and this is a follow-up.

Jim Ricchiuti – Needham & Company

Don, on the margin it sound like you are a little bit more positive about the natural resources market even maybe perhaps more or so then you guys talked about in early June. Are these things happening in the market that you are seeing that gives you a little bit more optimism as you look out to 2012 in this market?

Don Kania

I think just two things going on. One we are getting data and we are seeing how the customers react to the information that we are getting and then understanding that. Our tools are up to the task because you may appreciate either working in more difficult environment than any of other tools working. And as we understand the value that can be generated and this is in conventional oil and gas. We are getting more confident that they are roots and I will just say that in discussions with partners we are seeing that they also are beginning to believe the subsequent nature of the opportunity.

Part two, the unconventional stuff is coming to us after than we had expected. As we have learned more I think we get a better feeling for how we can add value there. Much earlier I would think there is more is a research activity today, but it has the same 10 or to it that. If you can actually measure these things, wow we could do this more efficiently. There would be a great return on investment on this measurement. So, therefore we are feeling best at least potentially another leg to this business about conventional oil and gas. Put all that together, yes our confidence level is up.

Jim Ricchiuti – Needham & Company

Okay. And just with respect to the margin target, the outlined gross margin target looking out to 2012, can you talk a little bit about the milestones that we need to see as we go out over the next two to three quarters to maybe get a senses to that target and your success, your progress along those lines and hitting the kind of Q4 2012 target that you mentioned.

Don Kania

This will be a precipitous event as you might appreciate. There are multiple levels of activity going on, but one of the things I'm sure we will update everybody on, as we move this small dual beam product line to lower cost. We are moving our mid range TEM products to a lower cost. So, that will be the significant contributor to margin expansion over the next few quarters that probably doesn’t really start to have big effect till next year, but that’s another activity, low-risk from our perspective, because we have done this before, we have a good understanding of the benefits that we can garner by that transition. So, that’s one activity. And I think the other thing that we keep watching and we keep measuring more and more carefully and more actively is the order flow and the backlog. And in terms of the margin contents of that against standards and mentioned – we hadn’t mentioned of the call, but in fact in this last quarter that’s improved – our backlog margins have improved as we went through the quarter.

And given that we relieved a fair amount of electronics revenue, that’s a good time overall. So, those are things that we take a look at which essentially is a version of pricing. Are we getting good pricing for the new products and the old products for that matter? So, watch that, watch this we have internal targets on cost reductions across the board that we continue in terms of supply chain management. So we’ve got quantitative activities on manufacturing cost reductions that are in moves. We have cost reduction activities associated with the supply chain and watching you might argue it’s a product marketing approach, but we are doing a much better job of pricing our products. Krios is a good example of getting that in the much better shape and the data this segment shows.

So, again a lot of little things, but I think you should expect to see slow progress not any kind of big step functions as we move towards the end of ’12.

Jim Ricchiuti – Needham & Company

Then actually let into my next question, just with respect to pricing in the competitive environment that you are seeing out there in the Research market as well as in the electronics market?

Don Kania

Yeah. Electronics, I think, is being great. I mean, we’ve done a – we’ve right products, right time, better technology than the bad guys and we feel pretty good about our pricing environment there. We are seeing I would say a mixed bag depending on where the products position in the Research market and regionally a little bit, but that’s kind of been ongoing. And I would – looking at the data we are doing a better job now managing that. And so the margins in those areas are going up internally. So, I don’t think the environments changed. I think our managing of the environments improved.

Jim Ricchiuti – Needham & Company

Okay, thanks a lot.

Operator

Thank you. And our next question will be from the line of Sid Parakh. Please go ahead.

Sid Parakh

Hey, good afternoon gentleman. Question here on the balance sheet, can you help us understand increase or the sequential increase in the inventories? I think they were up about 13% quarter-over-over.

Ray Link

Yeah, this is Ray. You are absolutely right. They were up – they are up primarily for our second half builds. On the call, Don talked about the expectations for revenue for the year looking to be up about 30% over last year. So, that would indicate that overall second half revenue will be up over first half. With that said, we now believe we ran through revenues t a level that is satisfactory and our goal is to not increase revenues and hopefully not increase inventories. Thank you. And to get a better turns as we go forward.

Sid Parakh

Okay. So, I mean, generally speaking, I mean, we shouldn’t expect inventory to grow much from here, I mean, probably stay flat to down for the second half, okay?

Ray Link

Right.

Sid Parakh

And then in the past you have indicated that you do want to go on and acquire companies that might help you get into adjacent markets or some other reason, but valuation has been a big concern, I mean, are you seeing where the markets down here? I mean, are you starting to see some softening in what companies think they are all worth and what you might be able to pay for somebody across the board?

Don Kania

Yes, but I would say is where we have identified some opportunities that we feel are priced appropriately and stay tuned. (indiscernible) so, yeah, I think our target list looks richer and more achievable than it has in couple of years.

Sid Parakh

Okay. And then finally just on the hiring front, you did pricing over 100 people sequentially, is it fair to say that most of the employee additions are in the R&D line which is kind of where we are starting to see some of the OpEx growth there?

Don Kania

No, I think lot of the hiring has been in operations as well. You can imagine, if you ramp 30% revenue – more people to both will stuck together. And…

Sid Parakh

Service?

Don Kania

So, we have service as well. We have added the service and that’s also – that’s march upwards in terms of revenue, but we’ve also needed to make sure that we could make sure that we get install and support the growth over time which will convert to more service revenues delayed by about a year right, because the first year is under warranty, so we’ve had the ramp people in that area. We are ramping at R&D and we judiciously adding in other areas marketing and sales, sales support, particularly in the new segments and natural resources we mentioned that we have added some people there as well. So, that’s more prudent. The other stuff is scaling with the growth of the business in sub-scaling because we are getting good leverage on it.

Sid Parakh

And then just to be clear, you said that for 2011, R&D as a percent of sales should be about 11%, is that?

Don Kania

As we exit the year, our target is to get to 11%.

Sid Parakh

Okay, not for the full year right?

Don Kania

Correct, there would be no, no…

Sid Parakh

Yeah, yeah, yeah. That’s great. Thank you.

Operator

Thank you. And our next question will be a follow-up from Patrick Ho. Please go ahead.

Patrick Ho

Don, on the natural resources side, I think you mentioned on the unconventional methods, I think you mentioned shale, can you just give a little color, again, I am not an expert on this, but is it something like surface mining or strip mining what exactly is some of the initial I guess data points and pull that you are getting from potential customers on the shale side?

Don Kania

Right. Well, we have sold some units that are part of the business that makes us more real is the fact we’ve sold units to oil companies and service providers. This is the dual-beam tool. It’s very different from the well side application for people to expand their understanding of shales. And so maybe I’ll give you 30-second view of what we do. And it’s a shale is typically drilled into just like conventional oil well with a lot of lateral drilling and drill sideways. And the oil and gas is stored in pores in rock, but the pores aren’t connected. So we have the ability to measure what’s called porosity, which is how big – how much wood volume as a whole, so how much stuff could there be and whether it’s connected or not? So is it permeable, can the stuff come out? So that’s interesting, so that’s to characterize for how much is in this thing and can we get it out easily. And that’s the part two which is how do you exploit something where the problem with shales is the holes aren’t connected, so the oil doesn’t flow out. So what they do is they do this thing called fracing which many of us have read about in paper, where they crack the rock with explosives. But the strategies that they use, this is a very expensive process are very immature.

And if you understand which rock is where in your well, you can conceivably – this is in the future reduce your cost of fracing, because you understand where to put your explosives and more efficiently access the oil and gas that’s available to you. So, we seem companies articulate this argument to us both we want to understand what’s in there, characterize the reservoir, and we understand how to get it out better by understanding with the rocks, what kind of rocks or where. And some of the stuff actually turns out to be quite subtle in terms of which rocks or where, we are learning with our customers on this line, but what we like to see in these emerging segments is to replicable solution that has a return on investment. And these both smell like they have that capability to them.

Patrick Ho

Right. Thanks a lot guys.

Don Kania

Thank you, sir.

Operator

Thank you. And our next question will be another follow-up from Mark Miller. Please go ahead.

Mark Miller

Just briefly if you can just give us an overview of the competitive situation in terms of pricing especially at the lower end and anything you are seeing that might be of interest to investors?

Don Kania

Yeah, I don’t think, low end is not big for us. We pretty much have downsized that segment over the years, but we do participate in it. If anything pricing there has been comfortable, maybe that’s the right word. We’re seeing not a cutthroat environment like perhaps we saw during the worse part of the downturn, it seems to be pretty stable. If anything, we’re probably being more selective in the deals that we do, which is a good thing. We try to only go after strategic things that built for the future as opposed to just transactions. And so I think our business margin profile is improving in that segment, not degrading.

Mark Miller

Thank you.

Don Kania

Thank you, sir.

Operator

Thank you. And at this time, I am showing no further questions. Please continue with any closing remarks.

Fletcher Chamberlin – Treasurer and Communications Director

Thank you very much everyone for staying through the whole call. We appreciate your interest. I am available immediately for call back then we will try and fit in Don and Ray although they have a string of meetings for the rest of the week, but we appreciate your interest. Thanks for calling. This concludes the call.

Operator

Thank you ladies and gentlemen. This concludes the FEI second quarter earnings conference call. If you would like to listen to the replay of today’s conference, please dial 1-800-406-7325 and use the access code 4459281. ACT would like to thank you for your participation. You may now disconnect.

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