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VeecoInstruments Inc. (NASDAQ:VECO)

Q3 2007 Earnings Call

October 22, 2007 5 pm ET

Executives

Debra Wasser - Senior VicePresident of Corporate Communications and Investor Relations

John Peeler - Chief ExecutiveOfficer

Jack Rein - Executive VicePresident, Chief Financial Officer and Secretary

Analysts

Bill Ong - American TechnologyResearch

Timothy Arcuri - Citigroup

Robert Maire - Needham& Company

Brett Hodess - Merrill Lynch

David Duley - Merriman CurhanFord

Mark Miller - Brean Murray,Carret

Mark Fitzgerald - Banc of AmericaSecurities

Matt Petkun - D.A. Davidson &Company

Doug Reid - Thomas WeiselPartners

Operator

Good day, and welcome to VeecoInstruments Third Quarter 2007 Results Conference Call. Today's call is beingrecorded.

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

Debra Wasser - Senior Vice President of Corporate Communications andInvestor Relations

Thank you, operator. Thank youall for joining today's third quarter 2007 results conference call. I'm DebWasser, 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 wasdistributed at 4 PM this afternoon. If you haven't yet received a copy, pleasevisit the veeco.com website or call 516-677-0200, extension 1305, to get acopy. As announced previously, we have prepared a slide presentation toaccompany today's conference call and webcast, which you can follow along withon our website. This call is being recorded by Veeco Instruments and iscopyrighted material. It cannot be recorded or rebroadcast without Veeco'sexpressed permission. Your participation implies consent to our taping.

To the extent this call discussesexpectations about market conditions, market acceptance and future sales of thecompany's products, future disclosures, future earnings expectations orotherwise make statements about the future, such statements are forward-lookingand are subject to a number of risks and uncertainties that could cause actualresults to differ materially from the statements made. These factors arediscussed in the business description in management's discussion and analysissections 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 Form8-K and press releases. Veeco does not undertake any obligation to update anyforward-looking statements, including those made on this call, to reflectfuture events or circumstances after the date of such statements.

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

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

John Peeler - Chief Executive Officer

Thanks, Deb, and thank you allfor joining us today. Our agenda for the call is to review the third quarter2007 results, provide outlook and guidance for the fourth quarter, and reviewour plans to improve Veeco's performance. I will also cover market trends thatare currently impacting Veeco and provide some thoughts on next steps for thecompany.

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 down13% from the $112 million reported in the third quarter of 2006.

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

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

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

Thank you, John. Since threemonths 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 todata storage market.

Metrology sales were $34.8million, 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 storagemarket as well as lower automated AFM product sales to the semiconductormarket.

By market, data storage was 30%of revenues, semiconductor was 12%, high-brightness LED/wireless was 32% andscientific research was 26%. Sales were up compared to the prior year by 14% inLED/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 Americarepresented 30% of our sales, APAC 38%, Europe 19% and Japan13%. Third quarter 2007 orders improved to 118 million or up 5% sequentiallyfrom the second quarter of 2007 and also were up 3% from the third quarter of2006.

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 Japan10%. 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 or42.6% of sales for the third quarter of 2006. We had previously forecasteddifficult gross margins in the third quarter due to delivery of beta version ofnew products.

Products equipments marginsdeclined 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 numberof bifurcated product acceptances, which normally have 100% gross profit, andother unfavorable overhead and material variances related to quarter end conversionof certain products.

We had 42.6% gross margin inmetrology compared to 50.3% in the third quarter of '06 due to lower salesvolume of optical metrology and automated AFM products, and a less favorableproduct mix and overhead spending variances in the AFM products sold to scientificand research customers.

SG&A was $22.7 million or23.1% of sales compared to $22.3 million or 19.6% of sales in the third quarterof '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 salescompared 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 areduction in personnel costs of $1.3 million from vacation taken during thesummer, a favorable fringe adjustment to accrual, 20% lower employment leveland a reduction in commissions, and lower consulting and outside services.Partially offsetting this spending reduction was $1 million of highercompensation expense associated with the cash compensation and equity costsassociated with the new separate CEO and chairman of the board positions.

Amortization expense totaled $2million in the third quarter of 2007 versus $4 million in the third quarter of2006. This decrease was mainly due to certain technology-based intangiblesbecoming 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 costsassociated with the cost reduction plan. We anticipate that there will beadditional restructuring expense in the fourth quarter of 2007 as we furtherreduce employment levels by approximately 7.5%.

Net interest expense was $700,000compared to $1.1 million in the comparable 2006 quarter, primarily due torepayment of $56 million of our convertible notes during the first quarter of2007.

Third quarter 2007 GAAP net losswas $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 excludingamortization expense of certain items and using a 35% tax rate was a $0.05 losscompared to earnings of $0.21 for the third quarter of 2006.

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

The nine months of 2007 salestotaled $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 loweroptical metrology sales to the data storage market and automated AFM sales tothe semiconductor market. Process equipment sales also decreased by $10.9million, mainly as a result of slower customer demand in the data storageindustry.

By market, nine months revenueswere 33% data storage, 26% high-brightness LED/wireless, 30% scientificresearch and 11% semiconductor. By region, North America represented 32% ofsales, APAC was 35%, Europe 18% and Japan15%. For the nine months orders of $336.7 million, which were down 12% fromlast year.

Process equipment represented $227million with 68% of the orders in metrology was $109 million or 32% of theorders. By market, high-brightness LED/wireless was our largest segment at 35%,data storage was 31%, scientific research 26% and semiconductor was 8%. Byregion, North America was 36%, APAC 32%, Europe 19% and Japan13%. Veeco's nine-month book-to-bill ratio was 1.14 to 1.

Gross margin for the nine monthsof 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 AFMand optical metrology products and less favorable product mix in AFM products. Processequipment margins remain flat compared to the prior year nine-month period.

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

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

Restructuring expense of $2million for the first nine months of 2007 was related to personnel andseverance costs associated with the restructuring and cost reduction plan. Netinterest expense totaled $2.3 million compared to $3.6 million in comparable2006 period due to repurchase of $56 million of our convertible notes duringthe first quarter of 2007.

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

Earnings per diluted share,excluding certain items, for the first nine months of 2007 were $0.10 comparedto $0.48 for the nine months of 2006. The items excluded from this calculation aregain on extinguishment of debt in 2007 and 2006, the $2 million restructuringcharge for the first nine months of 2007, and amortization expense. We utilizedthe 35% tax rate for these numbers. Backlog at September 30, 2007 wasapproximately $182 million.

I would like to now comment onour 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 firstnine months of 2007.

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

Capital expenditures were $1million for the third quarter of 2007 and $6.9 million for the nine-monthperiod 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, weexchanged approximately $118 million of convertible notes for new notes, whichextended maturities by 3.25 years. Coupled with the retirement of $56 millionof our convertible notes during the first quarter of '07, our capital structurehas been significantly improved.

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

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

While third quarter '07 orderscame in above expectation, data storage customers have requested longer thanexpected delivery dates due to their continued CapEx management, the industryconsolidation and customer facility readiness issues. Over 16 million of our thirdquarter '07 data storage orders are for deliveries in late second quarter '08and more likely the third quarter of '08 to support advance technologyprograms.

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

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

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

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

Gross margin should improve to40% level with process equipment in the high 30% range and metrology in the mid40% range. Given what we anticipate will be a strong end-of-year back backlogof approximately $180 million, we currently believe that 2008 should be agrowth year for Veeco, but will start off slowly due to the movement of datastorage revenues as described earlier. We, therefore, expect only modestlyimproved revenues in the first half of '08 compared to the second half of '07.

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

Expenses associated with hiringof our new CEO and the transition and retention of our former CEO to chairmanresulted in significant year-over-year increases. The proposed FASB staffposition, which is referred to as FSP APB 14-a regulation changes interestexpense related to convertible securities and has the potential to increaseinterest expense in 2008.

We are currently planning for2008 to be a recovery year for Veeco where we will return to better revenuegrowth and profitability performance. There will, however, be a second half2008 recovery.

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

John Peeler - Chief Executive Officer

Thanks, Jack. I've learned a lotduring my first hundred days at Veeco. At the onset of joining the company inJuly, I established a timeline for getting to know our employees, ourtechnologies and our customers, and I've also spent time with our seniormanagement team to assess Veeco's strengths and weaknesses and to identify thetop opportunities, issues and resource priorities.

In my assessment of Veeco, Ifound the following. We have a very impressive products and technology. We haveleading market positions in all of our major markets. We have strong customerrelationships in a solid global sales and support network. We have attractivegrowth opportunities in several markets, a motivated and committed work force,excellent teamwork between engineering, marketing and operations, and asignificant number of new products coming from our R&D programs.

However, even with all of thesepositives, as today's results show, we need increased and more consistentgrowth, increased profitability and better predictability of our revenuestream. It's my short-term goal to help Veeco get both its growth andprofitability up and, to accomplish this, we have initiated a performanceimprovement plan that's focused on five areas that I'll take you throughshortly.

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

Let me give you a little moredetail on each of these five points. I think that one of Veeco's challenges isthat 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 thebest growth opportunities.

We'll align our 2008 R&Dspending to the following areas. In high-brightness LED, we see a significantlong-term growth opportunity with deep end market applications and plan toincrease our investment to advance technology, improve our customers' cost ofownership and gain market share. Our goal is a multi-generational process intechnology improvements to drive forward the solid state lighting industryroadmap.

In scientific research, we'llfund development of the next generation nano materials tool and increase ourinvestment in new life science instrumentation capabilities. Both of theseapplications hold significant promise for Veeco's unique AFM technology. We'llalso continue to fund important technology advances in optical metrology foremerging applications.

In the semiconductor market,we'll invest in the launch and global support of our new automated AFM. In datastorage, we'll focus our R&D efforts on those technology areas which offerus the best growth potential and are aligned to our customers' reduced cost ofownership requirements. These include alumina deposition applications, PVDresearch applications, and specific product lines tied to our customers plannedwafer-sized changes.

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

The second element of ourperformance improvement plan is to strengthen our global sales and serviceorganization. We're structuring our organization to focus selling effortsaround our key product lines, data storage, auto AFM, metrology instrumentationand MOCVD and MBE products. Each of these four areas has different customerprofiles and competitive environments and, therefore, will have different sellingstrategies and structures.

My first move was to recruit ahighly 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 techmanagement and sales experience from companies like JDSU, Agilent and HP. I'veknown Bill for many years and I'm excited to bring his dynamic sales leadershipto the company. Under Bill's leadership, we'll build a world-class organizationthat's a competitive advantage for Veeco.

We've also made some additionalchanges in the sales organization, including appointing new heads of VeecoAsia-Pacific and Veeco Europe. These were internal promotions of key businessexecutives with proven track records and they are already making a positiveimpact. We've also restructured our organization to eliminate duplicationbetween field and factory resources.

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

The fourth area of focus is to ensurethat each of our product businesses is competent executing well and this beginswith the effective conceptualization, development and commercialization ofleadership products. Within Veeco process equipment, we'll focus onstreamlining the number of data storage products and customer commitments, andwe'll align our MOCVD and MBE operations for growth.

Within Veeco metrology andinstrumentation, I will have each of the three metrology business units reportdirectly to me, while we'll recruit a new leader for all of metrology. I thinkI can be more helpful to the leaders of these businesses by working with themdirectly.

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

The last element of our plan isto improve our business processes, including a drive for better linearity oforders and revenue, and a new discipline surrounding the product lifecycleprocess, headcount additions, quarterly forecasting, and customer commitments. We'llalso complete our implementation of SAP in Asia-Pacific and Japan,and this will give us more visibility worldwide and help us drive towardsgreater efficiency levels.

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

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

We also recently launched our nextgeneration E475 arsenic phosphide tool for red, orange and yellow LEDs, whichhas a 15% greater capacity compared to our previous tool. Another excitingdevelopment is that orders from the solar market total approximately $5 millionin the third quarter, including strong interest in our new six thermal depositionsources.

We believe that the data storagemarket has stabilized. Our described unit growth is forecasted to be highsingle digits and PMR investment continues by our key customers. A criticalgrowth driver for Veeco in 2008 will be the retooling of process equipmentrequired for 8-inch wafers, which is currently being planned at some of our keycustomers.

While industry health overall appearsto be improving, evidenced by recent positive industry commentary, we remaincautious on the data storage industry due to the potential for further industryconsolidation 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 ratehit a historically low level in Q3. However, in this quarter, we willofficially introduce our new automated AFM platform, which features 45 and 32nanometer capability, three times the throughput and two times the accuracy ofour legacy product line. We have two beta tools in the field and believe thisis a significant multi-year per fab opportunity for Veeco.

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

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

We will continue to refine ourrevenue growth and profit improvement plan through more thorough reviews of ourdomestic and international organizations and cost structures and furtherevaluation of sites and infrastructure. You can expect to hear more from me onmy ideas for improving Veeco's performance on our next earnings call inFebruary.

So, thank you for your patienceduring 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 aquestion, 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'llproceed in the order that you signal us. Again, that's "*, 1" forquestions. And if you found your question has been answered, you may removeyourself from the queue by pressing the "#" key.

We'll go first to Bill Ong fromAmerican Technology Research.

Bill Ong - American Technology Research

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

John Peeler - Chief Executive Officer

Bill, we're not ready to giveguidance on 2008 yet. What you do see in our numbers is that we have beensignificantly building our backlog. We do expect 2008 to be a growth year. Itwill ramp up through the year, because we're already building and taking ordersfor products in the second half. So, it will be a growth year; too early tocall it in absolute numbers.

Bill Ong - American Technology Research

Okay. Do you have any operatingmargin targets given that you already starting to layout some initiatives inboth sales and R&D?

John Peeler - Chief Executive Officer

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

Bill Ong - American Technology Research

Sure. That's fair. And then mylast question is the MOCVD market. We're clearly seeing a lot of activity inthe white LEDs with a lot of the municipalities upgrading garages and buildinglighting and so on. Are you seeing a lot more strength coming out from thegallium nitride tools versus the also phosphate, red versus blue, maybe alittle bit of color, would you see that trending over the next year-and-a-halfto two years?

John Peeler - Chief Executive Officer

We're seeing a really stronggrowth in both areas.

Bill Ong - American Technology Research

Okay. Thank you very much.

Operator

Our next question will come fromTimothy Arcuri from City.

Timothy Arcuri - Citigroup

Hi. A couple of things. Jack, canyou walk me through some of the deferrals? I guess I had in my model that therewas $21 million of deferred revenue that had already shipped that was sittingin backlog at the end of September. So I'm a little surprised that the revenueguidance in December is not a little better and that the commentary in the Q1is not better either. So it sounds like there was two different pushouts. Therewas some of the deferred pushed out and then there was some other that alsopushed out. Is that right?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

Timothy Arcuri - Citigroup

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

Timothy Arcuri - Citigroup

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

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

I think there is about $5 millionof that.

Timothy Arcuri - Citigroup

Okay. So, most of that flowedthrough revenue. So now, the pushouts are related to bookings that you bookedthis quarter that the shipment date is out into the back half of next year. Isthat the issue?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

Timothy Arcuri - Citigroup

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

I believe it's really customerspecific, and I can't go into the details of the customers. I'll say it's a newtechnology, and it has to do with them getting their facility ready and beingready to accept the product.

Timothy Arcuri - Citigroup

I see. Okay. And then, I guessthis is probably a tough question to answer. But I know that there are someactions that you are not even sure that you'll take in December. But knowingwhat you know now, if you take the risk you did in September and kind of themidpoint of what you think you'll do in December and if we look out into theback half of next year when you'd get most of the benefits from whatever isdone 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 theincremental benefit be based upon what is already kind of in the pipeline to bedone?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

I'm not going to speculate atthis point on actions that we haven't decided upon, but the actions that we'veoutlined that we have determined, it's probably $2.5 to $3 million a quarter interms of benefit.

Timothy Arcuri - Citigroup

Okay. And then last question, processequipment margins were kind of 33%, is there some way to segment that outbetween storage and LED? Were they meaningfully different in the storage marketversus the LED market?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

No, they were remarkably similar.

Timothy Arcuri - Citigroup

Okay. Thanks.

Operator

We'll move on to Robert Mairefrom Needham & Company.

Robert Maire - Needham & Company

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

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

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

Robert Maire - Needham & Company

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

I think we are encouraged thatwith 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 grossmargin. And we did have, as I outlined, anomalies in the third quarter, socertainly 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 manyquarters, this is a multi-quarter plan. We rolled out the first wave of itemshere. There are some items related to real estate and other things that willtake longer, and we've put some ranges in for those items. So, it is going totake several quarters.

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

Robert Maire - Needham & Company

Okay. Thank you.

Operator

Brett Hodess from Merrill Lynchhas our next question.

Brett Hodess - Merrill Lynch

I know you don't want to givetargets yet, but I was wondering if you could talk a little bit about what kindof gross margins the two different product areas, metrology and processequipment, should be able to get if you were past the beta stage and you'reexecuting the way you think you ultimately can? What type of gross marginentitlement might these product lines see?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

Well, Brett, I would certainlyuse last year, 2006, as a benchmark of the minimal acceptable gross margin thatwe would like to see in equipment. We're about a 40% margin. Certainly, thatwould 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, wehaven't finished the activities that we've outlined today. We haven't lookedat, in complete detail, a bottoms-up 2008 plan. So, it's really a bit prematureto give more granular guidance at this point.

Brett Hodess - Merrill Lynch

Maybe returning to those kind of2006 kind of numbers is achievable, given the market environment and theproduct technologies and what not?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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'dlook at. Could that mean that you might move away from some of the things likelapping and dicing and maybe PVD or things like that that might not be quite asdifferentiated or something like that? Could those be areas that you could evendivest of over time?

John Peeler - Chief Executive Officer

Well, we are focusing our productlines within data storage. We're focusing on the alumina applications. We'refocusing on PVD research, and we'll continue to do lapping and dicing. So, weare focusing. We're being more careful with customer commitments, and we'reworking to do a smaller number of things really well rather than do a whole lotof 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 thegallium nitride type of products and the new E series, I believe it is, for theolder red, yellow, orange type of LEDs, how similar are those systems? Are youable to drive as they both start to ramp up? Are they going to give someleverage to you in terms of commonality of systems and manufacturingcommonality and what not to be able to drive the profitability in thatbusiness?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

Brett Hodess - Merrill Lynch

Thank you.

Operator

Our next question will come fromDavid 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 thatimpacted the gross margin percentage this quarter as it went down 600 basispoints? And then to get it back to 40%, what are the two or three mostimportant things for us to monitor to make sure that you can achieve thatprogress you're talking about?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

Okay, Dave. Obviously, we indicatedboth on this call and in prior guidance that we had some lower margin new betatools 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 wasprobably three points on the decline. There were also things like delayedacceptances of bifurcated products and that was a number that was probably $2.5million, in terms of gross margin.

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

So, I think we've seen certainlywithin the data storage world the management of CapEx, and that has impactedsort of the timing of acceptance of new products, as I indicated earlier, thescheduling of products in the second half of the year, and also just the signoff of products that we have currently in the mix.

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

David Duley - Merriman Curhan Ford

And so the things that will, likeyou'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 andSecretary

Right.

David Duley - Merriman Curhan Ford

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

That's a big impact, and we'vealso 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 thirdquarter. So that and some better margins in the backlog that we see now, thoseare, I'd say, the three things that we would point to.

David Duley - Merriman Curhan Ford

Okay. I guess I do have one otherquestion. You talked about the restructuring and emphasizing certain thingsless and reinvesting more money in certain areas that you think are worthwhileand you went through and talked about the areas that you're going to continueto invest in.

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

John Peeler - Chief Executive Officer

First of all, we have combinedseveral different engineering groups in the data storage process equipmentgroup. We believe there are some significant efficiencies to be gained bycombining those engineering groups. We have focused on the PVD researchapplications 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 whenit doesn't relate to areas of strength in our core competency, in our marketshare position. So, we are specifically targeting areas where we have a strongcore competency and not chasing market share in areas that have very, very lowgross margins.

David Duley - Merriman Curhan Ford

Okay, great.

Operator

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

Mark Miller - Brean Murray, Carret

Good afternoon. I see you justreported a record quarter. I think units were up 17%. Western Digital isexpected to have a similar result, plus they are expanding their wafer fab. Howdo 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 technologychanges, some process changes. Is that what's causing some of the weaknesswe're seeing short term?

John Peeler - Chief Executive Officer

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

We believe that some of our keycustomers are focusing their investment on improving their technology andmoving their capability up over a little bit of the longer term and are holdingback on some near-term capacity expansion due to that.

So, we have not seen as muchnear-term growth activity as we would have expected from the news. We dobelieve the growth is there, and we are getting orders for six and nine monthsout.

Mark Miller - Brean Murray, Carret

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

Mark Miller - Brean Murray, Carret

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

John Peeler - Chief Executive Officer

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

Mark Miller - Brean Murray, Carret

Thank you.

Operator

Next we'll hear from MarkFitzgerald from Banc of America Securities.

Mark Fitzgerald - Banc of America Securities

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

We have full expectations thatthe 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'redealing with trying to restructure and trying to get costs in line for theshort term here. And that's really what, I guess, the difference is.

Mark Fitzgerald - Banc of America Securities

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

Mark Fitzgerald - Banc of America Securities

But, I mean is it fair to saynothing has changed in terms of pricing environment or something that'sdeteriorated gross margins?

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

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

Mark Fitzgerald - Banc of America Securities

Okay. Thank you.

John Peeler - Chief Executive Officer

Still, Mark, the data storagemarket is substantially smaller for our business area than it was a year ago or18 months ago. And the semiconductor markets for our auto AFM business is in avery different state, and we are awaiting our new product year to really hitthe revenue ramp-up. It is doing well, but those two factors drive a largechange in the business versus where it was 18 months ago.

Mark Fitzgerald - Banc of America Securities

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

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 fromD.A. Davidson & Company.

Matt Petkun - D.A. Davidson & Company

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

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

Again, we had some bifurcationacceptance issues in that particular group of products. We also had, as Iindicated in general comments, some end of quarter activities in restructuringsome products, material variances in labor and overhead variances in trying toget maximum sales up for the quarter. So, there were some inefficiencies thatwe 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 andSecretary

That's correct.

Matt Petkun - D.A. Davidson & Company

In that business.

Jack Rein - Executive Vice President, Chief Financial Officer andSecretary

Overall, we said 40%, yes.

Matt Petkun - D.A. Davidson & Company

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

John Peeler - Chief Executive Officer

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

Matt Petkun - D.A. Davidson & Company

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

John Peeler - Chief Executive Officer

They're using alternatetechnologies 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 WeiselPartners 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 youmade 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 thenew auto AFM. I want to understand how extendible or how much, rather,additional improvement you can get in throughput beyond the 3x you'redelivering with this iteration? Does this platform rather have a life beyondthis iteration is the question?

John Peeler - Chief Executive Officer

Well, the, the second halfrevenue improvement is really auto AFM ramp-up and buys for the data storagebusiness to support new technologies. So, on one hand, we have orders forproducts in the second half. And on the other hand, we have a new platformthat's in beta now, seems to be getting good reviews and has real concreteperformance and productivity improvements.

So, we believe that that willramp in the second half. So those are the two things that are driving our viewthere. We put a lot of work into this platform, from both the software and ahardware point of view. It is an entirely next generation product, and weexpect it to have a long lifetime. That's probably about as far as I canreasonably 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 offat this point. I want to thank you all for joining us today. Jack, Debra and Iare planning to attend several investor conferences in the coming months, and Ilook forward to meeting many of you at that time.

Operator, that concludes ourcall.

Operator

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

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