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Veeco Instruments Inc. (NASDAQ:VECO)

Q3 2007 Earnings Call

October 22, 2007 5 pm ET

Executives

Debra Wasser - Senior Vice President of Corporate Communications and Investor Relations

John Peeler - Chief Executive Officer

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Analysts

Bill Ong - American Technology Research

Timothy Arcuri - Citigroup

Robert Maire - Needham & Company

Brett Hodess - Merrill Lynch

David Duley - Merriman Curhan Ford

Mark Miller - Brean Murray, Carret

Mark Fitzgerald - Banc of America Securities

Matt Petkun - D.A. Davidson & Company

Doug Reid - Thomas Weisel Partners

Operator

Good day, and welcome to Veeco Instruments Third Quarter 2007 Results Conference Call. Today's call is being recorded.

For opening remarks and introductions, I'd like to turn the conference over to Senior Vice President of Corporate Communications and Investor Relations, Ms. Debra Wasser. Ms. Wasser, please go ahead.

Debra Wasser - Senior Vice President of Corporate Communications and Investor Relations

Thank you, operator. Thank you all for joining today's third quarter 2007 results conference call. I'm Deb Wasser, Veeco's Senior Vice President of IR. Joining me today are John Peeler, our Chief Executive Office; and Jack Rein, our Chief Financial Officer.

Today's earnings release was distributed at 4 PM this afternoon. If you haven't yet received a copy, please visit the veeco.com website or call 516-677-0200, extension 1305, to get a copy. As announced previously, we have prepared a slide presentation to accompany today's conference call and webcast, which you can follow along with on our website. This call is being recorded by Veeco Instruments and is copyrighted material. It cannot be recorded or rebroadcast without Veeco's expressed permission. Your participation implies consent to our taping.

To the extent this call discusses expectations about market conditions, market acceptance and future sales of the company's products, future disclosures, future earnings expectations or otherwise make statements about the future, such statements are forward-looking and are subject to a number of risks and uncertainties that could cause actual results to differ materially from the statements made. These factors are discussed in the business description in management's discussion and analysis sections of the company's report on Form 10-K and any report to shareholders, and in our subsequent quarterly reports on Form 10-Q, current reports on Form 8-K and press releases. Veeco does not undertake any obligation to update any forward-looking statements, including those made on this call, to reflect future events or circumstances after the date of such statements.

During this call, management may address non-GAAP financial measures. Information regarding such non-GAAP financial measures, including reconciliation to GAAP measures of performance, is available on our website.

I'd now like to turn the call over to John for opening remarks.

John Peeler - Chief Executive Officer

Thanks, Deb, and thank you all for joining us today. Our agenda for the call is to review the third quarter 2007 results, provide outlook and guidance for the fourth quarter, and review our plans to improve Veeco's performance. I will also cover market trends that are currently impacting Veeco and provide some thoughts on next steps for the company.

As stated in our press release, Veeco reported revenue of $98 million, which is in line with our guidance of $92 million to $97 million. Revenues were flat on a sequential basis and down 13% from the $112 million reported in the third quarter of 2006.

We are pleased that our third quarter bookings were ahead of our guidance at $118 million. This improved bookings result in what is normally a seasonally weak quarter for Veeco speaks to our unique breadth of technologies and market opportunities. Third quarter bookings were up 3% versus the third quarter of 2006 and up 5% sequentially.

The strength in bookings was primarily due to the strength in high-brightness LED and wireless and scientific research markets. We had sequential bookings declines in both data storage and semiconductor, but we believe these markets have stabilized. Veeco's loss per share, excluding certain items, was $0.05 compared to the earnings per share last year of $0.21. This was in line with our guidance.

I'll now turn the call over to Jack to review further details of Veeco's third quarter results and the fourth quarter outlook. I'll come back afterwards to discuss our plans to improve Veeco's performance.

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Thank you, John. Since three months ended September 30, 2007, sales were $98 million, a decrease of 13% versus the third quarter of 2006. The decrease was due to $8.5 million or 11.8% decrease in process equipment sales due to delayed sales of new products to data storage market.

Metrology sales were $34.8 million, a decrease of $6.2 million or 15.1% versus the third quarter of 2006, mainly due to lower sales of optical metrology products to the data storage market as well as lower automated AFM product sales to the semiconductor market.

By market, data storage was 30% of revenues, semiconductor was 12%, high-brightness LED/wireless was 32% and scientific research was 26%. Sales were up compared to the prior year by 14% in LED/wireless and up 8% in research, but down 35% in data storage and down 26% in semiconductor. Sequentially, sales declined $1.1 million.

By region, North America represented 30% of our sales, APAC 38%, Europe 19% and Japan 13%. Third quarter 2007 orders improved to 118 million or up 5% sequentially from the second quarter of 2007 and also were up 3% from the third quarter of 2006.

Process equipment represented 68% of the orders at $80.9 million and metrology represented 32% of the orders at $37 million. By market, high-brightness LED/wireless represented 37% of orders, data storage was 30%, scientific research was 28%, and semiconductor was 5%.

By region, North America was 41% of orders, Asia Pacific was 30%, Europe 19%, and Japan 10%. Veeco's book-to-bill ratio was 1.21 to 1 for the quarter. Gross profit was $35.9 million for the quarter or 36.7% of sales compared to $47.9 million or 42.6% of sales for the third quarter of 2006. We had previously forecasted difficult gross margins in the third quarter due to delivery of beta version of new products.

Products equipments margins declined to 33.5%, down from 38.1% in the third quarter of '06. This 4.6% margin decrease was due to the shipment of low margin beta tools, a low number of bifurcated product acceptances, which normally have 100% gross profit, and other unfavorable overhead and material variances related to quarter end conversion of certain products.

We had 42.6% gross margin in metrology compared to 50.3% in the third quarter of '06 due to lower sales volume of optical metrology and automated AFM products, and a less favorable product mix and overhead spending variances in the AFM products sold to scientific and research customers.

SG&A was $22.7 million or 23.1% of sales compared to $22.3 million or 19.6% of sales in the third quarter of '06 and $23.5 million in the second quarter of '07. R&D expense totaled $15 million, a decrease of $700,000 from the third quarter of '06.

Overall operating expenses, excluding restructuring charges, totaled $37.6 million or 38.5% of sales compared to $37.7 million or 33.6% of sales in the third quarter of 2006 and $39.4 million in the second quarter of '07.

Sequential decrease is due to a reduction in personnel costs of $1.3 million from vacation taken during the summer, a favorable fringe adjustment to accrual, 20% lower employment level and a reduction in commissions, and lower consulting and outside services. Partially offsetting this spending reduction was $1 million of higher compensation expense associated with the cash compensation and equity costs associated with the new separate CEO and chairman of the board positions.

Amortization expense totaled $2 million in the third quarter of 2007 versus $4 million in the third quarter of 2006. This decrease was mainly due to certain technology-based intangibles becoming fully amortized during the second quarter of 2007.

The restructuring expense of $500,000 in the third quarter of 2007 was related to personnel severance costs associated with the cost reduction plan. We anticipate that there will be additional restructuring expense in the fourth quarter of 2007 as we further reduce employment levels by approximately 7.5%.

Net interest expense was $700,000 compared to $1.1 million in the comparable 2006 quarter, primarily due to repayment of $56 million of our convertible notes during the first quarter of 2007.

Third quarter 2007 GAAP net loss was $5.7 million or $0.18 per share, compared to net income of $4.5 million or $0.14 per share, in the third quarter of 2006. EPS for the quarter excluding amortization expense of certain items and using a 35% tax rate was a $0.05 loss compared to earnings of $0.21 for the third quarter of 2006.

Our guidance for the third quarter of '07 was a per share loss of $0.25 to $0.18 on a GAAP basis and a loss per share of $0.09 to $0.05 excluding amortization and certain items utilizing a 35% tax rate, and our results were within the guidance range.

The nine months of 2007 sales totaled $296 million or a 7% decrease from 2006, primarily due to a decrease of $11.4 million in metrology sales. This decrease was principally from lower optical metrology sales to the data storage market and automated AFM sales to the semiconductor market. Process equipment sales also decreased by $10.9 million, mainly as a result of slower customer demand in the data storage industry.

By market, nine months revenues were 33% data storage, 26% high-brightness LED/wireless, 30% scientific research and 11% semiconductor. By region, North America represented 32% of sales, APAC was 35%, Europe 18% and Japan 15%. For the nine months orders of $336.7 million, which were down 12% from last year.

Process equipment represented $227 million with 68% of the orders in metrology was $109 million or 32% of the orders. By market, high-brightness LED/wireless was our largest segment at 35%, data storage was 31%, scientific research 26% and semiconductor was 8%. By region, North America was 36%, APAC 32%, Europe 19% and Japan 13%. Veeco's nine-month book-to-bill ratio was 1.14 to 1.

Gross margin for the nine months of 2007 was 41.2% of sales compared to 43.8% for the comparable 2006 period, primarily due to lower sales volumes. Metrology gross margins were 45.6% compared to 61.4% in 2006 as a result of lower sales volume of automated AFM and optical metrology products and less favorable product mix in AFM products. Process equipment margins remain flat compared to the prior year nine-month period.

SG&A was flat at $69.3 million compared to $68.6 million in the first nine months of 2006. R&D expense totaled $46.3 million, an increase of $800,000 in 2006, primarily due to the investment in K-Series Next Generation MOCVD tools as well as new automated AFM products for the semiconductor industry and new Nano-Bio AFM products.

Amortization expense totaled $8.2 million in the first nine months of 2007 versus $12 million in 2006 comparable period. Again, the decrease was due to certain technology-based intangibles becoming fully amortized during the second quarter 2007. We expect amortization expense to be approximately $1.9 million in the fourth quarter of '07.

Restructuring expense of $2 million for the first nine months of 2007 was related to personnel and severance costs associated with the restructuring and cost reduction plan. Net interest expense totaled $2.3 million compared to $3.6 million in comparable 2006 period due to repurchase of $56 million of our convertible notes during the first quarter of 2007.

Veeco's nine-month 2007 GAAP net loss was $8 million or $0.26 per share compared to net income of $7.3 million or $0.23 per share in the first nine months of 2006. The 2007 GAAP net loss was impacted by income tax expense of $3.5 million primarily from foreign taxes compared to $2.9 million in 2006.

Earnings per diluted share, excluding certain items, for the first nine months of 2007 were $0.10 compared to $0.48 for the nine months of 2006. The items excluded from this calculation are gain on extinguishment of debt in 2007 and 2006, the $2 million restructuring charge for the first nine months of 2007, and amortization expense. We utilized the 35% tax rate for these numbers. Backlog at September 30, 2007 was approximately $182 million.

I would like to now comment on our balance sheet. Cash and equivalents totaled $108.4 million at September 30th. We are pleased that we generated $15.9 million in free cash flow for the first nine months of 2007.

Accounts receivable DSOs for the quarter were 63 days, up from 59 days at June 30. During the quarter, inventory increased by $1 million to $105.7 million with a turnover of 2.3 times. The increase was due to delayed data storage revenue referred to earlier.

Capital expenditures were $1 million for the third quarter of 2007 and $6.9 million for the nine-month period in 2007. Depreciation expense was $3.6 million in the third quarter and $10.2 million for the nine-month period in 2007.

As previously reported, we exchanged approximately $118 million of convertible notes for new notes, which extended maturities by 3.25 years. Coupled with the retirement of $56 million of our convertible notes during the first quarter of '07, our capital structure has been significantly improved.

Before turning the call over to John, let me review our guidance for the fourth quarter. Veeco currently expects fourth quarter 2007 revenues to be in the range of $104 million to $112 million with a loss per share of $0.26 to $0.14 on a GAAP basis and earnings per share of breakeven to $0.06, excluding amortization of $1.9 million and restructuring charges of $5 million related to severance and utilizing a 35% tax rate.

In addition to the $5 million of severance charges, additional restructuring charges in the range of $8 million to $13 million could potentially impact fourth quarter 2007 and first quarter '08 earnings, depending upon timing and the of additional actions under consideration. These potential additional restructuring charges relate to activities under consideration for the fourth quarter, during the fourth quarter, including consolidation of our corporate headquarters, potential real estate sales, potential rationalization of certain data storage product lines and the buyout of a previously frozen pension plan related to the CBC acquisition.

While third quarter '07 orders came in above expectation, data storage customers have requested longer than expected delivery dates due to their continued CapEx management, the industry consolidation and customer facility readiness issues. Over 16 million of our third quarter '07 data storage orders are for deliveries in late second quarter '08 and more likely the third quarter of '08 to support advance technology programs.

We are also impacted by delaying of more than $15 million in revenue previously expected to be shipped in the fourth quarter of '07 and the first quarter of '08, and those will be now revenue recognized in the latter part of 2008 due to customer-specific requirement changes.

Fourth quarter '07 orders are currently expected to be between $105 million and $115 million. We are providing this cautious order outlook based upon continued lack of visibility in data storage and very strong Q3 we have recently completed in high-brightness LED/wireless, which may be hard to repeat on a sequential basis.

We currently expect that fourth quarter '07 operating expense will decrease as a percentage of sales, but will increase in absolute dollars to approximately $40 million to $41 million. The low level of operating expense in the third quarter '07 was an anomaly because of a reversal of bonus and other compensation accruals.

These fourth quarter '07 spending increases will result from the conclusion of funding on certain technology research grants as well as onetime costs associated with hiring key executives, including search fees, relocation and other transition costs. Those costs represent approximately $1 million.

Gross margin should improve to 40% level with process equipment in the high 30% range and metrology in the mid 40% range. Given what we anticipate will be a strong end-of-year back backlog of approximately $180 million, we currently believe that 2008 should be a growth year for Veeco, but will start off slowly due to the movement of data storage revenues as described earlier. We, therefore, expect only modestly improved revenues in the first half of '08 compared to the second half of '07.

Despite short-term spending actions that John will describe, 2008 spending could increase overall for Veeco due to the following factors. There were minimal payouts in 2007 in our incentive compensation based on the low operating profit. The 2008 plan will include target payouts that may increase expense, but only to the extent that profit targets are actually reached.

Expenses associated with hiring of our new CEO and the transition and retention of our former CEO to chairman resulted in significant year-over-year increases. The proposed FASB staff position, which is referred to as FSP APB 14-a regulation changes interest expense related to convertible securities and has the potential to increase interest expense in 2008.

We are currently planning for 2008 to be a recovery year for Veeco where we will return to better revenue growth and profitability performance. There will, however, be a second half 2008 recovery.

I'll now turn the call back over to John to discuss our specific action plans and to take your questions.

John Peeler - Chief Executive Officer

Thanks, Jack. I've learned a lot during my first hundred days at Veeco. At the onset of joining the company in July, I established a timeline for getting to know our employees, our technologies and our customers, and I've also spent time with our senior management team to assess Veeco's strengths and weaknesses and to identify the top opportunities, issues and resource priorities.

In my assessment of Veeco, I found the following. We have a very impressive products and technology. We have leading market positions in all of our major markets. We have strong customer relationships in a solid global sales and support network. We have attractive growth opportunities in several markets, a motivated and committed work force, excellent teamwork between engineering, marketing and operations, and a significant number of new products coming from our R&D programs.

However, even with all of these positives, as today's results show, we need increased and more consistent growth, increased profitability and better predictability of our revenue stream. It's my short-term goal to help Veeco get both its growth and profitability up and, to accomplish this, we have initiated a performance improvement plan that's focused on five areas that I'll take you through shortly.

Our plan will focus on, first, directing our resources to the best growth opportunities; second, strengthening our global sales and services organization so that it's a competitive advantage for Veeco and an engine for growth; third, improving profitability in the short-term from the levels that we're experiencing in the third and fourth quarters, and this will include both expense reduction, gross margin improvement and cost containment; fourth, ensuring that each of our product businesses within process equipment and metrology is executing well; and finally, fifth, at improving our business processes to increase effectiveness, predictability and profitability.

Let me give you a little more detail on each of these five points. I think that one of Veeco's challenges is that our breadth of technology can make it difficult to focus our resources, and a key priority for me is to help the company direct our resources to the best growth opportunities.

We'll align our 2008 R&D spending to the following areas. In high-brightness LED, we see a significant long-term growth opportunity with deep end market applications and plan to increase our investment to advance technology, improve our customers' cost of ownership and gain market share. Our goal is a multi-generational process in technology improvements to drive forward the solid state lighting industry roadmap.

In scientific research, we'll fund development of the next generation nano materials tool and increase our investment in new life science instrumentation capabilities. Both of these applications hold significant promise for Veeco's unique AFM technology. We'll also continue to fund important technology advances in optical metrology for emerging applications.

In the semiconductor market, we'll invest in the launch and global support of our new automated AFM. In data storage, we'll focus our R&D efforts on those technology areas which offer us the best growth potential and are aligned to our customers' reduced cost of ownership requirements. These include alumina deposition applications, PVD research applications, and specific product lines tied to our customers planned wafer-sized changes.

And in solar, which is an emerging market opportunity for Veeco, we'll begin with a greater focus on our existing product lines, the MOCVD, CIGS deposition sources and metrology tools, and we'll also complete a thorough business assessment of how to apply Veeco's unique deposition and measurement technology expertise to this exciting market opportunity.

The second element of our performance improvement plan is to strengthen our global sales and service organization. We're structuring our organization to focus selling efforts around our key product lines, data storage, auto AFM, metrology instrumentation and MOCVD and MBE products. Each of these four areas has different customer profiles and competitive environments and, therefore, will have different selling strategies and structures.

My first move was to recruit a highly talented new Head of Global Sales and Services. As previously announced, Bill Tomeo joined Veeco last week and brings to us over 30 years of high tech management and sales experience from companies like JDSU, Agilent and HP. I've known Bill for many years and I'm excited to bring his dynamic sales leadership to the company. Under Bill's leadership, we'll build a world-class organization that's a competitive advantage for Veeco.

We've also made some additional changes in the sales organization, including appointing new heads of Veeco Asia-Pacific and Veeco Europe. These were internal promotions of key business executives with proven track records and they are already making a positive impact. We've also restructured our organization to eliminate duplication between field and factory resources.

Our third area of focus is to take immediate steps to improve Veeco's profitability. These include 100-person reduction in force, which is underway, including employees, consultants and temporary workers, a reduction in discretionary expenses, consolidation of certain engineering groups, specifically PVD and ion beam, downsizing and consolidation of our corporate headquarters facility in Woodbury, New York. We are also taking a very close look at the company's travel expense with a goal of a 15% savings next year, and finally, we're restructuring our finance and information technology organizations.

The fourth area of focus is to ensure that each of our product businesses is competent executing well and this begins with the effective conceptualization, development and commercialization of leadership products. Within Veeco process equipment, we'll focus on streamlining the number of data storage products and customer commitments, and we'll align our MOCVD and MBE operations for growth.

Within Veeco metrology and instrumentation, I will have each of the three metrology business units report directly to me, while we'll recruit a new leader for all of metrology. I think I can be more helpful to the leaders of these businesses by working with them directly.

We will deliver on our new auto AFM technology so that it can be a meaningful contributor to our 2008 orders and revenues. And we will drive new features and applications in our Nano-Bio AFM and optical product lines.

The last element of our plan is to improve our business processes, including a drive for better linearity of orders and revenue, and a new discipline surrounding the product lifecycle process, headcount additions, quarterly forecasting, and customer commitments. We'll also complete our implementation of SAP in Asia-Pacific and Japan, and this will give us more visibility worldwide and help us drive towards greater efficiency levels.

Going forward, we have a lot of work to do to improve our performance, but I am encouraged that the management team and employees have already shown that they are committed to the process.

So, let me move on to provide you with a brief overview of some of the trends in our end markets. In high-brightness LED and wireless, our orders were up 45% through the first nine months of the year. Our new K-Series gallium nitride MOCVD tools are penetrating key accounts worldwide. Q3 orders included multi-unit orders from four key customers.

We also recently launched our next generation E475 arsenic phosphide tool for red, orange and yellow LEDs, which has a 15% greater capacity compared to our previous tool. Another exciting development is that orders from the solar market total approximately $5 million in the third quarter, including strong interest in our new six thermal deposition sources.

We believe that the data storage market has stabilized. Our described unit growth is forecasted to be high single digits and PMR investment continues by our key customers. A critical growth driver for Veeco in 2008 will be the retooling of process equipment required for 8-inch wafers, which is currently being planned at some of our key customers.

While industry health overall appears to be improving, evidenced by recent positive industry commentary, we remain cautious on the data storage industry due to the potential for further industry consolidation and our customers overall restraint on CapEx. In particular, their longer than expected delivery schedules impact our Q4 and Q1 revenue expectations, as Jack explained.

In semiconductor, our order rate hit a historically low level in Q3. However, in this quarter, we will officially introduce our new automated AFM platform, which features 45 and 32 nanometer capability, three times the throughput and two times the accuracy of our legacy product line. We have two beta tools in the field and believe this is a significant multi-year per fab opportunity for Veeco.

Veeco scientific research orders were up 17% sequentially, and nine-month orders increased 20% versus last year. Two products, which have contributed to this success, include our Innova Scanning Probe Microscope, which is a lower cost option to our MultiMode and Dimension lines; and our Dektak 150 high-performance stylus profiler. We're also getting good traction from our NT series optical profilers.

So, overall, in summary, I believe the opportunities for Veeco are great. I have learned a lot and with the team have started executing on our performance improvement plan. It will take multiple quarters to complete.

We will continue to refine our revenue growth and profit improvement plan through more thorough reviews of our domestic and international organizations and cost structures and further evaluation of sites and infrastructure. You can expect to hear more from me on my ideas for improving Veeco's performance on our next earnings call in February.

So, thank you for your patience during these remarks. Operator, we'd like to start the Q&A session.

Question-and-Answer Session

Operator

Thank you. If you'd like to ask a question, please press "*, 1" on your telephone keypad at this time. If you are using a speakerphone, please pick up your handset before pressing "*, 1" today. We'll take as many questions as time permits and we'll proceed in the order that you signal us. Again, that's "*, 1" for questions. And if you found your question has been answered, you may remove yourself from the queue by pressing the "#" key.

We'll go first to Bill Ong from American Technology Research.

Bill Ong - American Technology Research

Yes, hi. You talked about a slow recovery in the first half of '08. As you start to see the business pick up again, what type of growth rates are you expecting over the four business units over the next, say, 18 to 24 months?

John Peeler - Chief Executive Officer

Bill, we're not ready to give guidance on 2008 yet. What you do see in our numbers is that we have been significantly building our backlog. We do expect 2008 to be a growth year. It will ramp up through the year, because we're already building and taking orders for products in the second half. So, it will be a growth year; too early to call it in absolute numbers.

Bill Ong - American Technology Research

Okay. Do you have any operating margin targets given that you already starting to layout some initiatives in both sales and R&D?

John Peeler - Chief Executive Officer

Well, we did indicate that operating expense would improve as a percentage of sales, but we're not at this point, since we've got a variety of categories that we're still studying in the fourth quarter. It's a little bit premature to give that guidance. But we certainly are looking at reducing spending and improving the percentage of operating expenses as a metric compared to sales. So, that certainly is an objective. But, as I said, we've got a lot of pieces in motion, and we want to complete our analysis before we give you guidance on that.

Bill Ong - American Technology Research

Sure. That's fair. And then my last question is the MOCVD market. We're clearly seeing a lot of activity in the white LEDs with a lot of the municipalities upgrading garages and building lighting and so on. Are you seeing a lot more strength coming out from the gallium nitride tools versus the also phosphate, red versus blue, maybe a little bit of color, would you see that trending over the next year-and-a-half to two years?

John Peeler - Chief Executive Officer

We're seeing a really strong growth in both areas.

Bill Ong - American Technology Research

Okay. Thank you very much.

Operator

Our next question will come from Timothy Arcuri from City.

Timothy Arcuri - Citigroup

Hi. A couple of things. Jack, can you walk me through some of the deferrals? I guess I had in my model that there was $21 million of deferred revenue that had already shipped that was sitting in backlog at the end of September. So I'm a little surprised that the revenue guidance in December is not a little better and that the commentary in the Q1 is not better either. So it sounds like there was two different pushouts. There was some of the deferred pushed out and then there was some other that also pushed out. Is that right?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

There were some deferrals that we did not recognize in the third quarter. We did have a relatively low number of bifurcation acceptance in the quarter. We expect those to come in, in the fourth quarter. There are, I would say, probably $31 million of backlog at this point related to data storage. That's really half of which is earmarked for the second half of 2008, and the other half of which still represents new products that we're still working on final specifications with the customers on. So, the data is not completely known as to when the revenue will be recognized, and that's the reason for our caution at this point.

Timothy Arcuri - Citigroup

Okay. So the product is still changing, but it's still sitting in backlog?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

The final specs are changing. In other words, the customer have a specific spec that they're requesting, and we're still working through those final issues on new products, certain new products.

Timothy Arcuri - Citigroup

Okay. So, how much of the $21 million that was supposedly shipped as of the end of September, how much of that is still left in deferred revenue?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

I think there is about $5 million of that.

Timothy Arcuri - Citigroup

Okay. So, most of that flowed through revenue. So now, the pushouts are related to bookings that you booked this quarter that the shipment date is out into the back half of next year. Is that the issue?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

That's true. There is $15 million in that of the bookings that we got in the third quarter, that are second half revenue in 2008.

Timothy Arcuri - Citigroup

Okay, okay. Is that an industry issue or is that specific to the product itself or is that customer specific?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

I believe it's really customer specific, and I can't go into the details of the customers. I'll say it's a new technology, and it has to do with them getting their facility ready and being ready to accept the product.

Timothy Arcuri - Citigroup

I see. Okay. And then, I guess this is probably a tough question to answer. But I know that there are some actions that you are not even sure that you'll take in December. But knowing what you know now, if you take the risk you did in September and kind of the midpoint of what you think you'll do in December and if we look out into the back half of next year when you'd get most of the benefits from whatever is done by the end of December, what would your operating margin look like at, say, the midpoint of your revenue guidance? So, like 108. What would the incremental benefit be based upon what is already kind of in the pipeline to be done?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

I'm not going to speculate at this point on actions that we haven't decided upon, but the actions that we've outlined that we have determined, it's probably $2.5 to $3 million a quarter in terms of benefit.

Timothy Arcuri - Citigroup

Okay. And then last question, process equipment margins were kind of 33%, is there some way to segment that out between storage and LED? Were they meaningfully different in the storage market versus the LED market?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

No, they were remarkably similar.

Timothy Arcuri - Citigroup

Okay. Thanks.

Operator

We'll move on to Robert Maire from Needham & Company.

Robert Maire - Needham & Company

Yes. A couple of questions. In looking through the presentation, I didn't see any mention of a sort of target financial model. Is there a target or perhaps you could give us some sort of a range you're looking at in terms of gross margin, SG&A, R&D or is that still sort of a work in progress?

And second question, in terms of rolling out of the plans and the changes, is this two or three quarters, three or four quarters? When are you looking to sort of get to sort of a steady state, I guess, is the question?

And, in terms of solar, it sounds like the initial reaction was fairly good to the solar stuff, and maybe you could give us a little more details as to your expectations for that part of the market.

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

I'll take the first part of that, Robert. I would say that since we are working through a lot of additional cost reductions and structural things, it's a little bit premature to talk at the model. But suffice it to say, we want to make progress in each quarter starting in the fourth quarter, and certainly not satisfied with the 40% gross margin or a single-digit operating margin. So, we'll give further guidance as we develop the specific activities and then develop the model that sort of is predicated upon those actions.

Robert Maire - Needham & Company

Does that mean that businesses have some minimal gross margin in terms of what they should be doing in order to continue to get funding or continue to get internal support?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

I think we are encouraged that with the new products that we see, although some of them are, as we indicated, coming in the second half of the year that there is improvement in gross margin. And we did have, as I outlined, anomalies in the third quarter, so certainly 40% is kind of minimal margin that we would like to see.

Robert Maire - Needham & Company

Okay.

John Peeler - Chief Executive Officer

So, Robert, regarding how many quarters, this is a multi-quarter plan. We rolled out the first wave of items here. There are some items related to real estate and other things that will take longer, and we've put some ranges in for those items. So, it is going to take several quarters.

On the solar market, we have been doing quite well with our category 3-5 solar cells, our new thermal sources for the CIGS market and metrology products for the solar market. So, our key product lines are seeing some good growth here. We did do about $5 million in orders this quarter. So, we think there is a lot of opportunity and we're looking for more ways to capitalize on that.

Robert Maire - Needham & Company

Okay. Thank you.

Operator

Brett Hodess from Merrill Lynch has our next question.

Brett Hodess - Merrill Lynch

I know you don't want to give targets yet, but I was wondering if you could talk a little bit about what kind of gross margins the two different product areas, metrology and process equipment, should be able to get if you were past the beta stage and you're executing the way you think you ultimately can? What type of gross margin entitlement might these product lines see?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Well, Brett, I would certainly use last year, 2006, as a benchmark of the minimal acceptable gross margin that we would like to see in equipment. We're about a 40% margin. Certainly, that would be where we at a minimum would like to get to. And on the metrology side, I think that high 40s to 50 is really where we want to be. But, again, we haven't finished the activities that we've outlined today. We haven't looked at, in complete detail, a bottoms-up 2008 plan. So, it's really a bit premature to give more granular guidance at this point.

Brett Hodess - Merrill Lynch

Maybe returning to those kind of 2006 kind of numbers is achievable, given the market environment and the product technologies and what not?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

We certainly hope so, yes.

Brett Hodess - Merrill Lynch

And then my next question was, when you talked about refocusing R&D, you gave some specific areas you'd look at. Could that mean that you might move away from some of the things like lapping and dicing and maybe PVD or things like that that might not be quite as differentiated or something like that? Could those be areas that you could even divest of over time?

John Peeler - Chief Executive Officer

Well, we are focusing our product lines within data storage. We're focusing on the alumina applications. We're focusing on PVD research, and we'll continue to do lapping and dicing. So, we are focusing. We're being more careful with customer commitments, and we're working to do a smaller number of things really well rather than do a whole lot of things and not quite get some of them done.

Brett Hodess - Merrill Lynch

And then my final question was, if you look on the LED side with the two product lines, the case areas for the gallium nitride type of products and the new E series, I believe it is, for the older red, yellow, orange type of LEDs, how similar are those systems? Are you able to drive as they both start to ramp up? Are they going to give some leverage to you in terms of commonality of systems and manufacturing commonality and what not to be able to drive the profitability in that business?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

There is some level of commonalty, but there is a fair amount of difference also.

Brett Hodess - Merrill Lynch

Thank you.

Operator

Our next question will come from David Duley with Merriman.

David Duley - Merriman Curhan Ford

Yes. I have two simple questions. And I'm afraid the answers will probably be detailed. But the first one is, could you give me the detail, as largest to smallest, the several things that impacted the gross margin percentage this quarter as it went down 600 basis points? And then to get it back to 40%, what are the two or three most important things for us to monitor to make sure that you can achieve that progress you're talking about?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Okay, Dave. Obviously, we indicated both on this call and in prior guidance that we had some lower margin new beta tools that impacted margin. And so, that probably took us from a 42% or 43% gross margin in the second quarter down to, let's say, 39%. So, that was probably three points on the decline. There were also things like delayed acceptances of bifurcated products and that was a number that was probably $2.5 million, in terms of gross margin.

In addition, we had some, what I would call, after manufacturing variances, material, labor and overhead related to reconfiguring of product to try to maximize the revenue in the quarter, and there was some inefficiencies in those type of things.

So, I think we've seen certainly within the data storage world the management of CapEx, and that has impacted sort of the timing of acceptance of new products, as I indicated earlier, the scheduling of products in the second half of the year, and also just the sign off of products that we have currently in the mix.

So, I think that that might be an indicator as we start to see more aggressive pursuit of acceptances by the data storage industry, that would be an indicator that we'll get back to more normal gross margins in that sector.

David Duley - Merriman Curhan Ford

And so the things that will, like you're articulating, I think a 40% margin target for this current quarter, which is up 3.5 points.

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Right.

David Duley - Merriman Curhan Ford

And the reasons why you're confident that you can get that improvement immediately are -- what are the three biggest reasons? I imagine this 2.5 million of revenue bifurcation, I'm sure that's a couple of million bucks that's going to come through with no costs next quarter. So it sounds like the biggest impact?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

That's a big impact, and we've also given revenue guidance of $104 million to $112 million. So obviously, there is a volume impact, up from roughly $98 million that we did in the third quarter. So that and some better margins in the backlog that we see now, those are, I'd say, the three things that we would point to.

David Duley - Merriman Curhan Ford

Okay. I guess I do have one other question. You talked about the restructuring and emphasizing certain things less and reinvesting more money in certain areas that you think are worthwhile and you went through and talked about the areas that you're going to continue to invest in.

I'm just wondering, for end markets and the many products in all those end markets, what is something you're definitely not going to be investing in going in the future and where can we expect you to cut back your R&D dollars to refocus them to more respectable areas?

John Peeler - Chief Executive Officer

First of all, we have combined several different engineering groups in the data storage process equipment group. We believe there are some significant efficiencies to be gained by combining those engineering groups. We have focused on the PVD research applications and the alumina applications.

David Duley - Merriman Curhan Ford

And when you mean PVD research, that means that you're no longer trying to get the production PVD business, which you have low market share in now?

John Peeler - Chief Executive Officer

We are not trying to get it when it doesn't relate to areas of strength in our core competency, in our market share position. So, we are specifically targeting areas where we have a strong core competency and not chasing market share in areas that have very, very low gross margins.

David Duley - Merriman Curhan Ford

Okay, great.

Operator

And we'll move on to Mark Miller from Brean Murray, Carret.

Mark Miller - Brean Murray, Carret

Good afternoon. I see you just reported a record quarter. I think units were up 17%. Western Digital is expected to have a similar result, plus they are expanding their wafer fab. How do we reconcile that in relation to what you're seeing in terms of your orders? Is there something going on? I think you mentioned maybe some technology changes, some process changes. Is that what's causing some of the weakness we're seeing short term?

John Peeler - Chief Executive Officer

Mark, there is clearly growth in unit demand, and you can read the press releases. As you, as you said, there are some good trends. We have not seen a strength in orders for near-term product to support these.

We believe that some of our key customers are focusing their investment on improving their technology and moving their capability up over a little bit of the longer term and are holding back on some near-term capacity expansion due to that.

So, we have not seen as much near-term growth activity as we would have expected from the news. We do believe the growth is there, and we are getting orders for six and nine months out.

Mark Miller - Brean Murray, Carret

Where are we at on the conversion? I know it's still early. As the conversion 8-inch wafers are going to really start to power up sometime in '08? If so, is that first half, second half?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Several of our customers are planning conversions in '08. Mostly later in the year.

Mark Miller - Brean Murray, Carret

Finally, recently there has been some product announcements about organic LEDs. Is there any threat or opportunity there for you guys in relation to your high-brightness business?

John Peeler - Chief Executive Officer

We think it's a different market and a different application, probably has a good place, but we don't see it as a threat. And the real key for our business is getting the cost down to make high-quality LEDs, high quality, high-brightness LEDs. And we will continue to provide the tools that enable that cost to continue going down.

Mark Miller - Brean Murray, Carret

Thank you.

Operator

Next we'll hear from Mark Fitzgerald from Banc of America Securities.

Mark Fitzgerald - Banc of America Securities

Thank you. I'm a little confused in terms of the restructuring here relative to what the previous management's restructuring over the last 18 months had accomplished. So, I guess the basic question is, has something dramatically changed in terms of business fundamentals at where the previous management was shooting after a year's worth of restructuring for mid kind of 40% type of gross margins, and now we're down at much lower levels again, and it sounds like we're shooting again for mid-40s type of gross margin. So, what happened here that made all those cost cuts over the last 18 months kind of irrelevant?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Mark, I don't think they are irrelevant at this point. I think what's happened is that there has been, as we've indicated, a slowed down in the data storage market. We've got obviously a new CEO that's come in to take a look at the cost structure and is attempting to align the cost of the business with the current revenue levels of the business.

We have full expectations that the second half of the year, as we indicated, we will have a growth year in '08. We will have a profitable year. We will be back-end loaded. So we're dealing with trying to restructure and trying to get costs in line for the short term here. And that's really what, I guess, the difference is.

Mark Fitzgerald - Banc of America Securities

With the cost cuts that were made over the last year or so, and these additional cost cuts, I mean if nothing has really changed, then we should be looking for something far better than the mid-40s type of gross margins. I mean is that a fair thing to start building into our models here when you do get a recovery? I mean you don't seem to have garnered anything from that 18 months of cost cutting.

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Again, we're looking at our cost structure and we'll give guidance as we go forward. But at this point, we're not going to give a model. We just don't have that guidance to give at this point.

Mark Fitzgerald - Banc of America Securities

But, I mean is it fair to say nothing has changed in terms of pricing environment or something that's deteriorated gross margins?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

No, I don't think that the pricing environment has changed, no.

Mark Fitzgerald - Banc of America Securities

Okay. Thank you.

John Peeler - Chief Executive Officer

Still, Mark, the data storage market is substantially smaller for our business area than it was a year ago or 18 months ago. And the semiconductor markets for our auto AFM business is in a very different state, and we are awaiting our new product year to really hit the revenue ramp-up. It is doing well, but those two factors drive a large change in the business versus where it was 18 months ago.

Mark Fitzgerald - Banc of America Securities

But if those were to come back to more normalized levels, then given additional cost cuts, again, I would argue we should, if the math works here properly, get much better margins than we originally targeted?

John Peeler - Chief Executive Officer

We would hope so.

Mark Fitzgerald - Banc of America Securities

Okay. Thank you.

Operator

We'll move on to Matt Petkun from D.A. Davidson & Company.

Matt Petkun - D.A. Davidson & Company

Hi there. I think in one of your previous comments you said that the margin was pretty similar in the data storage, and in the bright LED business or more specifically looking at ion beam equipment versus epi equipment. So, I understand the significant falloff in revenues in the ion beam area, but by my math, this is a record quarter for epitaxial deposition and your margins were significantly lower than the 40% run rate you had had there. So, what specifically was going on in that product group or those two product groups to reduce the gross margin this quarter?

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Again, we had some bifurcation acceptance issues in that particular group of products. We also had, as I indicated in general comments, some end of quarter activities in restructuring some products, material variances in labor and overhead variances in trying to get maximum sales up for the quarter. So, there were some inefficiencies that we hope wouldn't recur in the fourth quarter.

Matt Petkun - D.A. Davidson & Company

So do you think that you can be -- you said I think next quarter you expect margins closer to 40%.

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

That's correct.

Matt Petkun - D.A. Davidson & Company

In that business.

Jack Rein - Executive Vice President, Chief Financial Officer and Secretary

Overall, we said 40%, yes.

Matt Petkun - D.A. Davidson & Company

Okay, okay. And then in your semi business specifically, and you may have commented on this earlier, when would you expect, especially talking to your customers, some volume orders for the [Hawk]?

John Peeler - Chief Executive Officer

You know, that's a little hard to tell. We have two units in beta. They are doing well. And as I've talked to customers, I've received some good feedback. It is a whole next generation platform with substantially better performance, but the semiconductor market is in a very much down stage. So it is all dependent on timing of gaining acceptance and revenue ramp. We would expect to see a substantially different level of business in the second half of 2008.

Matt Petkun - D.A. Davidson & Company

Okay. Recognizing that the equipment market is a little bit softer than it has been, your orders are obviously well below that, and some of that has to do with just the lack of availability of the Hawk until now. What are your customers doing that had been using, you, say, at 90 nanometers for AFM metrology. Do you know what they're doing for the similar process steps now for metrology, 65?

John Peeler - Chief Executive Officer

They're using alternate technologies in some cases or postponing buying decisions where they can.

Matt Petkun - D.A. Davidson & Company

Okay, okay. Well, thanks so much.

John Peeler - Chief Executive Officer

Thank you.

Operator

Doug Reid from Thomas Weisel Partners has our next question.

Doug Reid - Thomas Weisel Partners

Thanks. Two questions. First, trying to get a better sense of what your assumptions are in the comment you made that the second half of '08 would be much stronger than first half '08, some enhanced visibility there would be helpful.

And the second question is on the new auto AFM. I want to understand how extendible or how much, rather, additional improvement you can get in throughput beyond the 3x you're delivering with this iteration? Does this platform rather have a life beyond this iteration is the question?

John Peeler - Chief Executive Officer

Well, the, the second half revenue improvement is really auto AFM ramp-up and buys for the data storage business to support new technologies. So, on one hand, we have orders for products in the second half. And on the other hand, we have a new platform that's in beta now, seems to be getting good reviews and has real concrete performance and productivity improvements.

So, we believe that that will ramp in the second half. So those are the two things that are driving our view there. We put a lot of work into this platform, from both the software and a hardware point of view. It is an entirely next generation product, and we expect it to have a long lifetime. That's probably about as far as I can reasonably go until we are really seeing the business ramp.

Doug Reid - Thomas Weisel Partners

Thank you.

John Peeler - Chief Executive Officer

Okay. I think we'll close it off at this point. I want to thank you all for joining us today. Jack, Debra and I are planning to attend several investor conferences in the coming months, and I look forward to meeting many of you at that time.

Operator, that concludes our call.

Operator

Thank you. Thank you, everyone, for joining us today. That does conclude our conference.

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