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Electro Scientific Industries, Inc. (NASDAQ:ESIO)

F2Q08 (Qtr End 9/29/07)Earnings Call

October 24, 20075:00 pm ET

Executives

Chris Butterfield - Director of Investor Relations

Nick Konidaris - Chief Executive Officer

Kerry Mustoe - Corporate Controller and Chief AccountingOfficer

Analysts

Dave Duley - Merriman

Jim Ricchiuti - Needham& Company

Matt Petkun - DA Davidson & Company

Jeffrey Lin - Global Crown Capital

David Nierenberg - Nierenberg Investment Management

Robert Toomey - EK Riley Investments

Mark Miller - Brean Murray, Carret

Tom Diffely - Merrill Lynch

Mikey Brown - ICM

Operator

Good evening. My name is Kara, and I will be your conferenceoperator today. At this time, I would like to welcome everyone to the FiscalYear 2008 Quarter Two Earnings Call.

All lines have been placed on mute to prevent any backgroundnoise. After the speakers' remarks, there will be a question-and-answer session(Operator Instructions)

Thank you. Chris Butterfield, you may begin your conference.

Chris Butterfield

Thank you, Kara, and good afternoon, everyone. My name isChris Butterfield, Director of Investor Relations for ESI. With me today areNick Konidaris, our CEO; and Kerry Mustoe, our Corporate Controller and ChiefAccounting Officer.

This conference call will cover our fiscal year 2008 secondquarter and year-to-date results. Before we go into the details of the call, Iwould like to give you the required safe harbor language.

Some of what we will say will include forward-looking statementsconcerning customer orders, shipments, revenue, gross margins, expenses,non-operating income and taxes. These statements are subject to the safe harborprovisions of the Private Securities Litigation Reform Act of 1995.

These statements include a number of risks and uncertaintiesthat are discussed in more detail in today's press release and our filings withthe SEC. Actual results may differ materially from those forward-lookingstatements. This call also contains time-sensitive information that we believeto be accurate today, October 24, 2007, and which could change in the future. This call is theproperty of ESI.

Finally, we apologize for the delay in issuing our earningrelease. There were technical issues on the receiving end related to the filetransfer.

Now, I'll turn the call over to ESI CEO, Nick Konidaris.

Nick Konidaris

Thank you, Chris, and good afternoon, everyone. The secondquarter fiscal '08 represented another successful period for ESI. Including theresults from our New Wave Research division, ESI recorded the highest booking,shipment and revenue levels in several years.

For the second quarter, which now consists of thethree-month period of July through September, shipments of $87 millionrepresented a 24% increase from our last full fiscal quarter, the fourthquarter of fiscal '07.

The second quarter represented the highest level ofshipments since fiscal '01. Revenue for Q2 was $82 million, an increase of 15%from the fourth quarter, and also represented the strongest quarterly results sincefiscal '01. Of $74 million, orders for Q2 represented the third consecutivequarter of bookings in excess of $70 million and the highest level for ESI in 12quarters.

The strong results from Q2 were driven by a healthy demandfor our products, particularly in the passive component and interconnect groups,driven by multiple orders for our new 3550 high-capacitance tester and largeorders for our 33 series and 6650 test systems.

We recorded the highest quarterly order levels in the PassiveComponent segment since fiscal '01. The Interconnect and Micro-Machining Group setthe consecutive record breaking quarter in terms of orders due to strong demandin micro-machining applications.

For semiconductor products, we experienced expansion of ourUV applications in Q2, driven by our new 9850 dual-beam UV systems. Inaddition, multiple shipments of single-beam UV tools occurred during thequarter in Asia and Europe. Also,we saw strong demand for our dual-beam 9850 IR system during the quarter fromcustomers in Asia. Finally, orders for analog and mixed-signaltuning systems were up compared to Q4, following a large order from a majorNorth American semiconductor manufacturer.

Year-to-date at $104 million shipments and net sales of $99million, results for the four-month period of June through September were atthe high end of our expectations. Year-to-date margins on operating expenseswere also consistent with our guidance.

During the second quarter, we concluded the purchase of NewWave Research and commenced integration activities. Although our financialresults include only a portion of New Wave's activities in Q2, they contributedto the strong success of the quarter. The integration process is proceedingwell, and we expect to complete it on schedule.

As we announced previously, John Metcalf recently retiredfrom ESI, and the search for a new CFO is currently underway. We have appointedKerry Mustoe, our Corporate Controller and Chief Accounting Officer, to serveas CFO during the interim.

That concludes my opening remarks. I will now turn the callover to Kerry to discuss our financial results in detail.

Kerry Mustoe

Thank you, Nick, and good afternoon. Due to the recentlyannounced change in our fiscal year, the following information includes resultsfrom our second quarter of fiscal 2008, the period July through September, aswell as year-to-date information, which includes the month of June.

Where appropriate, we will make comparisons against thefourth quarter of fiscal 2007, which was our last full three-month fiscalperiod prior to Q2. Unless otherwise indicated, the following results includeour New Wave Research division.

In Q2, orders remained strong at $74 million or 3% higherthan Q4. This marks our third consecutive quarter with orders over $70 million andthe highest level since our fourth quarter of 2004.

Compared to the fourth quarter, strong order activity inboth the components in interconnect segment offset a decline in semiconductorproducts. The drop in semiconductor orders for the second quarter was due tothe timing of specific large orders received in June.

On a geographic basis, approximately 59% of orders were fromAsia, down from 69% reported in the fourth quarter. Thedecrease in Asia was offset by strong orders in the US.On a year-to-date basis, we recorded $99 million in orders with approximatelytwo-thirds of the activity coming from Asia.

Q2 shipments of $87 million were up $17 million compared tothe fourth quarter, the highest quarterly level of shipment since fiscal 2001.The increase was largely due to the shipments of interconnect systems, whichgrew 141% from the fourth quarter, as well as from passive tools, which grew70% from Q4. Geographically, Asia represented 79% of thequarter's total shipments.

Year-to-date shipments were $104 million with 81% of totalvolume in Asia. Q2 ending backlog was $56 million,including $5 million many backlog from New Wave. Approximately 85% of Q2'sending backlog is expected to ship in the third quarter.

Revenue for the second quarter was $82 million, up 15% fromQ4. The increase in revenue was the result of our strong product shipments inthe quarter. Passive component revenue was up substantially from Q4, driven byelectrical and visual test equipment. Our interconnect segment reportedrecord-breaking revenue levels, driven by strong demand for flex, IC packagingand micro-machining applications.

The semiconductor segment, although down from the fourthquarter, was the second highest level in five quarters, driven by strongshipments of memory repair and mixed-signal tuning systems. The revenue mix forthe second quarter was: semiconductor, 46%, down from 70% in the fourthquarter; passive component, 29%, up 18% from the fourth quarter; andinterconnect at 25%, up 12% from the fourth quarter.

Geographically, Asia represented 77%of the quarter's total revenue. Revenue was $99 million for the four-monthperiod, June through September. Revenue for Asia was 80%of that total for both the second quarter and year-to-date periods. Deferredrevenue was $19 million, up $7 million compared to Q4.

The increase in deferred revenue resulted from shipments,which included customer acceptance criteria along with $2 million from our NewWave division. Approximately $12 million of second quarter ESI and New Wave shipmentswere deferred and $5 million of prior period shipments were included in thesecond quarter's revenue.

Gross margin for the second quarter was 45%, including theimpact of $1.1 million in purchase accounting charges to cost of goods sold.Excluding the impact of purchase accounting, gross margins for the secondquarter was 46%, consistent with the fourth quarter of '07.

Despite the higher revenue levels for Q2, shift and productmix towards interconnect and passive systems had a negative overall impact toour margin rates for the period.

Operating expenses were $29 million, including the impact of$3.2 million in purchase accounting charges. Approximately $2.8 million of thepurchase accounting charges consisted of the write-off of in-process researchand development. Excluding the impact of purchase accounting, operatingexpenses for the quarter were $26 million compared to $23 million in the fourthquarter of fiscal '07. The increase in expense levels from the fourth quarterwas primarily due to the addition of New Wave.

Operating income for the fourth quarter was $7.5 million,including the impact of $4.3 million of purchase accounting charges. Operatingincome for the quarter, excluding the impact of purchase accounting, was $11.8million compared to $10.5 million for the fourth quarter of '07. Year-to-dateoperating income was $9 million or $13 million, excluding the impact ofpurchase accounting.

Second quarter interest, and other income, was $2.1 millionand was down compared to the fourth quarter. The decline was primarily due tolower average cash balances resulting from the purchase of New Wave and theimpact of our stock repurchase program. Year-to-date, we recorded $2.9 millionof net interest and other income.

Income tax expense for the second quarter was $4.1 million,an effective tax rate of 42%. Year-to-date tax expense was $4.9 million or aneffective annual rate of 41%. The $4.3 million in total purchase accountingadjustments are not deductible for tax. As these adjustments do reduce pretaxincome, they effectively increase our tax rates by 13 and 11 percentage pointsfor the three and four month periods respectively.

Second quarter net income was $5.5 million or $0.19 perdiluted share. Without the impact of purchase accounting, net income was $9.8million or $0.34 per diluted share compared with fourth quarter income of $7.9million or $0.27 per diluted share. The impact of purchase accounting thusreduced second quarter's reported net income by $4.3 million or $0.15 perdiluted share.

Year-to-date net income was $7 million or $0.24 per dilutedshare. Excluding the impact of purchase accounting, year-to-date net income was$11 million or $0.39 per diluted share.

Before I turn to the balance sheet, I would like to providethe results for New Wave Research and its impact to the second quarter.

For the period July 20th through September 29th, New WaveResearch reported orders and shipments of approximately $6 million each andrevenue of $5 million. New Wave shipments and revenue were below expectationsfor the periods, primarily due to the timing of the final close date of theacquisition.

Including their pre-acquisition results, New Wave's run ratefrom July 1st through September 29th was approximately $8 million for bothorders and revenue. Gross margins for New Wave were approximately 48% andoperating expenses were $3 million for the period following the acquisition.

Turning to our balance sheet, cash and investments were $179million, down $49 million from the fourth quarter of fiscal '07. The decreasewas primarily the result of $36 million in net cash investments for theacquisition of New Wave Research and $25 million in stock repurchases for thefour-month period. Cash provided from operations was $8 million for the secondquarter and $12 million year-to-date.

Within our investment portfolio, we reclassified $20 millionrelated to auction rate securities from short-term to long-term assets based ontheir underlying maturity date. We will retain this classification until suchtime as more frequent trading is resumed or they are liquidated throughrefinancing.

From mid-April through the end of the second quarter, werepurchased approximately 36 million in ESI stock and another 2 million in October.Having strategically invested over $75 million in total for both New WaveResearch and ESI stock in the last six months, we decided to spend therepurchase program earlier this month. However, we will continue to assess thebenefits of this program in light of our overall investment portfolio and otherstrategic opportunities.

Accounts receivable were $56 million, including $5 millionfrom New Wave, down slightly compared to the end of the fourth quarter. DSO forthe quarter was 63, an improvement of 8 days from the fourth quarter.Inventories of $92 million increased $11 million from the fourth quarter.

Approximately half of the increase was due to New Wave'sinventory. The remaining increase was due to the ramp in activity surroundingdemand for passive components and interconnect products.

Now, I will turn the call back to Nick for a business unitupdate and discussion of our outlook.

Nick Konidaris

I will start by discussing our semiconductor business.Orders for our semiconductor products were $26 million in the second quarter,down compared to the $40 million we recorded in Q4 '07. The year-to-date orderswere $42 million for this segment and were driven by strong demand for both ourdual-beam IR and UV systems and large orders for analog and mixed-signal devicetuning systems.

Although demand for our new products was strong in the firstfour months of the year, the memory industry is experiencing a period of fallingmemory prices. In an effort to reduce production cost, memory manufacturers areaccelerating their position to 70 and 80-nanometer technology nodes, whichshould increase adoption of our UV applications going forward.

The adoption of Microsoft's Windows Vista operating systemamong corporate users is expected to drive over time a significant increase inmemory demand. We expect ongoing demand for our newest IR and UV products willremain healthy in the near term.

In July, we announced our new 9850 dual-beam UV system atSemicon West. For the first time, we're offering a system that combines theproductivity gains of our patented dual-beam optical assembly with the ultrasmall spot size of our proprietary UV process.

The 9850 dual-beam UV is the fastest and most capable memoryrepair system ever produced by ESI. It is designed specifically to meet theneeds of our customers to process technology nodes of the 70 and 80-nanometerlevels and beyond. At the end of Q2, we had already received orders for thisexciting new system, and we've begun to ship them in October. I am particularlypleased to announce one of the first 9850 UV shipments also represented our500th shipment in the 9800 series.

Demand for our IR tools continued to be strong in the secondquarter and included two new customers for ESI. We received multiple ordersfrom Asia for our dual-beam 9850 IR system, including anorder from a first time customer in Korea.Demand for single-beam IR systems remained healthy for the quarter and alsoincluded an order from a new customer in Asia.

In LED scribing, we recently received multiple orders forour new AccuScribe 2112 system from New Wave. With a 20% throughput advantage overthe previous generation, laser scribe, the 2112 is an important addition to ourproduct portfolio and represents the growth potential inherent in the acquisitionof New Wave.

Turning to analog and mixed-signal device tuning systems,multiple orders in Q2 resulted in a 65% increase compared to Q4, driven by thestrength of our patented 1.3 micron process for tuning thin film on siliconresistance will continue to expand our presence in this market with majorcompetitive wins.

Now, I would like to turn to our passive component business.Orders for the second quarter were $24 million for the segment, 36% higher thanour results from the fourth quarter. Driven by strong demand for bothelectrical and visual test equipment, we reported the highest quarterly bookinglevels since fiscal '01. For the fourth-month period of June through September,we recorded orders of $26 million in this segment.

The passive component market continues to enjoy stablepricing and strong demand. The market is positively impacted by increasingdemand for leading edge consumer products such as handheld devices, multi-corePC processors, flat panel displays and high-definition televisions. Theadvanced features that are incorporated in these products drive demand forMLCCs that in turn drive demand four our test and inspection equipment.

Turning to our products, we experienced strong demand forboth electrical and visual test equipment during the quarter. Adoption of ournewest high-capacitance tester, the 3550, proceeded well during the period withmultiple orders from customers in Japanand Taiwan. Sinceits successful introduction in June, demand for this product has been accelerating,and we expect to continue to penetrate key captive and commercial manufacturersin this segment.

In the critical Japanese market, our products gained sharein Q2. In addition to orders for our 3550, we also received a largemulti-system order for our 6650 visual test system from a major manufacturer inJapan.

Our focus on sales and support in the largest MLCCmanufacturing region in the world has resulted in a steady [process] of keycompetitive wins for our products. Finally, worldwide demand for our 5300 and5400 series of electrical test systems remained strong for the period with areceipt of large orders in both Asia and North America.

Now, I would like to turn to our interconnect andmicro-machining business. Over the past several quarters, we have beenexpanding our focus to include micro-machining applications beyond our flex andIC packaging markets. Although we remain committed to the existing flex andpackaging markets, we see significant growth opportunities in micro-machining, particularlyfollowing the New Wave acquisition.

In recognition of this trend, we have remained an electricalinterconnect group to the Interconnect Micro-Machining Group or IMG.

Second quarter IMG orders were $24 million, 64% higher than$15 million recorded in the fourth quarter. This represents the secondconsecutive quarter of record-breaking orders for this segment. For thefour-month period, June through September, orders were $50 million.

During the quarter, we experienced healthy demand for ourproducts related to flex applications worldwide. In addition, we received alarge order for systems and upgrades from a major IC packager in Taiwan.Finally, growth in micro-machining applications contributed to a record quarterfor orders, shipments and revenue in the segment.

Now, I would like to turn to our guidance. The followingnumbers represent the consolidated expectations for ESI in the third quarter offiscal '08. We will not provide separate guidance for our New Wave Research division.

For Q3, we expect shipments revenues to be approximately $73million to $83 million. The gross margin percentage is expected to beapproximately 44% due to changes in product mix in the third quarter and theimpact of purchase accounting adjustments. Purchase accounting amortization isexpected to impact third quarter margins by 500,000. Excluding the impact ofpurchase accounting, margins are estimated at approximately 45%.

Operating expenses are expected to range from $26 million to$28 million for the quarter, including $1 million of integration costs and $500,000in purchase accounting amortization. We estimate net interest and other incomewill be approximately $1.7 million. The effective tax rate is anticipated to beapproximately 37% or 32% excluding the impact of purchase accounting.

To summarize, Q2 was a very strong quarter with a thirdconsecutive period of orders in excess of $70 million. Quarterly shipments werethe highest recorded since fiscal '01 and revenue was the highest since '04.

We received multiple orders for our new 9850 UV dual-beamsystem, and overall demand in the semiconductor segment remained healthy overthe four-month period. Our passive component segment enjoyed the strongestorder level since fiscal '01, and our interconnect segment reported recordorder shipments and revenue. In addition, our New Wave acquisition added to ouroverall success.

Although our business is cyclical in nature, our long-termfocus and investment in the development of our new products and applicationshas resulted in a more diversified business structure for ESI.

We expect demand for our new products in the semiconductorsegment, particularly from our dual-beam IR and UV tools will remain healthy inthe near term. We expect demand for products in both our passive component andinterconnect and micro-machining groups to say remain strong. In addition, newproduct offerings such as the AccuScribe 2112 from our New Wave division are expectedto further expand our growth potential going forward.

Overall, we are optimistic that the business outlook for ESIin the third quarter and the remainder of fiscal '08 will continue to bestrong.

This concludes our prepared remarks. We're ready for yourquestions. Kara.

Question-and-AnswerSession

Operator

(Operator Instructions)

Your first question is from Dave Duley with Merriman.

Dave Duley - Merriman

Good afternoon. Congratulations on a nice quarter.

Nick Konidaris

Thanks, Dave.

Dave Duley - Merriman

I know it's kind of confusing to compare incongruentperiods, but we appreciate all the information in the press release. It makesit much better and easier to understand.

I have a couple of questions. One, housekeeping, the newwave revenue that you referred to in the quarter, that went into the revenuebucket that you renamed, correct? All the revenue went there?

Nick Konidaris

No. Approximately, two-thirds of that went into the bucket, IMG,and one-third went into the semiconductor bucket.

Dave Duley - Merriman

Okay. Along those lines, when we look at the segment breakoutand you look at the information you provided for the four-month period endingSeptember, just wanted you speak about two different things. First of all is,when you look at the semiconductor detail there, the numbers are downsequentially. Could you talk a little bit about what's going on there?

And then to the flip side, you have this huge increase inthe numbers, I think, in the passive component group. Could you talk a littlebit about the key drivers and trends there? I know you highlighted some of this.But why don't we flush it out a little bit more, both of those particularrevenue segments?

Nick Konidaris

Okay. The one point that I would like to make is that weoperate at the record level we established in Q4, all in the last six to sevenmonths, and we're guiding at that level. The semiconductor has gone down,primarily because, as you know, there was an imbalance between supply anddemand in the first half of the year, but we expect that over time, with thedrivers being Vista and the migration into the7280-nanometer technology node to correct itself.

In the area of components, the demand is strong because ofconsumers buy increasingly products that have more integrated electronics thatrequire more of those passive components, and there is a demand increase in componentsin the neighborhood of about 30% year-over-year.

In the IMG, in addition to flex and IC packaging, we seeadditional opportunities in micro-machining. So overall, what is happening is thatall of our three businesses are really contributing. There may be somecontinual in-balancing between the three businesses, but all of them arecontributing to the record numbers that we presented in the last seven months,two three-month quarters and one month, and in the confidence that you have in theguidance that we're providing.

Dave Duley - Merriman

Okay. And inside the passive group or the capacitor group,what do you think the contribution was from the new higher throughput tester? Iam kind of trying to figure out in that particular revenue bucket what's comingfrom --?

Nick Konidaris

At this point in time, about 25% of our business is from the3500. Sorry, to quantify the business in orders.

Dave Duley - Merriman

25% of the passive orders were for the new product?

Nick Konidaris

For the new product: These orders are going to becomeshipment revenue this coming quarter.

Dave Duley - Merriman

Okay. And, I guess, two final things from me is: can youtalk about what you think the right level of inventory is? I seem to rememberinventory bumping up last quarter and because you were going to ramp upshipments and now it's bumped up again. It looks to me like there is $10million or $15 million of inventory here that we would like to see turn intocash over time. I am just wondering: what your opinion is about that?

And then final housekeeping question is; why did you spendthe buyback?

Nick Konidaris

Okay. Let's talk about the inventory. We agree on theinventory. We'd like to see higher turns from the inventory. From time to time,however, we take calculated risks to take advantage of opportunities in themarketplace, which is dynamic as you know.

On the buyback, basically the image that I want to leaveeveryone is that over the last six months, we spent $75 million. We had anaggressive use of our cash. And we felt that the appropriate thing to do,because we're kind of a thinking company, is to take a pause and catch ourbreath. But we plan to continually, aggressively use our cash and takeadvantage of strategic opportunities that are in front of us.

Dave Duley - Merriman

Like we fulfilled the first buyback and we have to allocatea new one or just, kind of, wondering: why today or over the last month we'renot buying stock? What was the catalyst behind that?

Nick Konidaris

Well, the catalyst is that basically it was the acquisitionof NWR. If you put everything in perspective, we had usual cash in theneighborhood of $75 million. And on the buyback, suspension is what applies,but we bought back about $37 million of stock. So, we're very pleased to thatwe did that. We're very pleased with our cash usage. And as I said, we'recatching our breath, and we'll resume, but we need to do that by looking at theopportunities that are in front of us.

Dave Duley - Merriman

Thanks.

Nick Konidaris

Thank you.

Operator

Your next question comes from Jim Ricchiuti with Needham& Company.

Jim Ricchiuti - Needham & Company

Thank you. Good afternoon.

Nick Konidaris

Hello, Jim.

Jim Ricchiuti - Needham & Company

Nick, hello. I wonder: if you would comment on orders trendsin the current quarter? And here is what I am going with: Given the change inthe fiscal year, I am just wondering: if you have any insight as to whetherthere is going to be some seasonality in the business from a bookingsstandpoint for this quarter ended December?

Nick Konidaris

Good question. I think people talk about seasonality. But firstof all, we don't provide guidance in orders. But whatever seasonality is, wethink that our shipments revenues are going to be in the $73 million to $83 millionrange.

Jim Ricchiuti - Needham & Company

Okay. Just on the passive side of the business, Nick, realgood demand for your equipment. Is your sense that that's sustainable? Do yousee some lumpiness in that area of the business? What are you hearing from yourpassive component customers?

Nick Konidaris

That right now, they want systems yesterday practically. It'snot going to last forever, but it's going to last this quarter and through thebeginning of '08 at least. We don't have visibility beyond that.

Jim Ricchiuti - Needham & Company

Okay. Kerry, I wonder if you would comment on this one. I amjust trying to get to the gross margin for the four-month period ex purchaseaccounting. You gave it to us for the three-month period. I was just curious:what was it for the four-month period?

Kerry Mustoe

The purchase accounting adjustment, it's the same, becausewe didn't have any related to June first of all. So you add back the sameamount.

Jim Ricchiuti - Needham & Company

Got it.

Kerry Mustoe

Okay.

Jim Ricchiuti - Needham & Company

And then, I guess, I was struggling a little bit getting toyour $0.39 number for the quarter for the four-month period. Is that what itwas backing out everything for the four-month?

Kerry Mustoe

Yes, we backed out a total of about $1.1 million in cost ofgoods sold adjustment and another $3.2 million in SG&A adjustment for atotal of about $4.3 million. That would take our income up to $11.2 million,which is $0.39.

Jim Ricchiuti - Needham & Company

Okay. And then the tax rate on that was?

Kerry Mustoe

The tax rate gets lowered by 11 points down to about 30%.

Jim Ricchiuti - Needham & Company

Got it. Okay. That's fine. Thank you. Just switching gearsfor a second to New Wave: can you talk a little bit about the applications thatyou're seeing for the equipment? Is it more in the high-brightness LED space,Nick? Are you seeing any activity, for instance, on the LCD side?

Nick Konidaris

Yes. There is activity in the high-priced, low LED, and theactivity there is scribing supply of wafers. There is also activity inrepairing flat panels. The products that New Wave has is called QuikLaze. That'sthe main product.

This is not a complete system. This is just the engine,which is basically the laser with the optical parts that is being bought bypeople who integrate it into a complete system to do repair. Customers like Contrel,[AMBS], Hitachi or [Samwha].

That business is in the same neighborhood AccuScribe is. AndI think that as the marketplace improves in '08, we're taking appropriate stepsright now to take advantage of that growth in the market.

Jim Ricchiuti - Needham & Company

Okay. And you alluded to some new products from New Wave.Can you elaborate at all as to whether this is going to take you into adifferent segment of the market? Or: perhaps give you a full system solutionfor other segments?

Nick Konidaris

Yes. The elaboration was on the AccuScribe. This is a newproduct in the category of LED scribing. This is a more productive product thanthe predecessor product. And LED we think this is a fast-growing market andthat will allow us to maintain the strong position in the market that roughlyis in the neighborhood of about 60% market share and take advantage of thegrowth in blue LED.

Jim Ricchiuti - Needham & Company

Okay. Great! Thank you.

Nick Konidaris

Thank you.

Operator

Your next question comes from the line of Matt Petkun withDA Davidson & Company.

Matt Petkun - DADavidson & Company

Hi. Good afternoon.

Nick Konidaris

Hello.

Matt Petkun - DA Davidson & Company

A busy summer for you guys, especially, on the shipment andacquisition front. My first question was just a housekeeping question. Kerry, Imissed the backlog number at the end of that period.

Kerry Mustoe

That was $56 million.

Matt Petkun - DADavidson & Company

$56 million. And then, Nick, you gave out a bookings numberfor the passive components group of about $24 million in the September period.What was it for the interconnect micro-machining business?

Nick Konidaris

Hold on for a second.

Kerry Mustoe

It was also about $24 million.

Nick Konidaris

Yes, I think $24 million.

Matt Petkun - DADavidson & Company

Okay. And for just the June period, you said it was $2million in the passive component. What was it in the June period for the interconnectmicro-machining?

Nick Konidaris

$6million.

Matt Petkun - DA Davidson & Company

$6 million? Okay.

Nick Konidaris

Year-to-date, $30 million.

Matt Petkun - DADavidson & Company

What's that?

Nick Konidaris

$30 million year-to-date, total.

Matt Petkun - DADavidson & Company

Right. Nick, my next question would be: I understand that thereis lot going on with the acquisition of New Wave in the micro-machining area,but I believe that you guys have had some orders in the micro-machining realmwith some of your organic tools that you've been working on at ESI. Could youtell us a little bit more what's going on there in terms of some other productsoutside of just what New Wave Research brings in the micro-machining market?

Nick Konidaris

We do a lot of things internally, and we're pursuing severalmicro-machining applications on materials different than the ones that we havebeen operating in the future and industry is different the ones that we havebeen operating in the past. But I will not go any further than that.

Matt Petkun - DADavidson & Company

Well, the growth has been pretty solid in that part of thebusiness. I would like to get excited about it, but it's hard for me to beexcited about something I don't know much about. You can't tell us anythingmore than it's just different substrates?

Nick Konidaris

That's what I can tell you.

Matt Petkun - DADavidson & Company

Is it for the electronics end market?

Nick Konidaris

I think I told you everything that I could.

Matt Petkun - DADavidson & Company

Okay. Well, it sounds interesting. We look forward to moreinformation there. I think that's all my questions are for now. Thanks so much.

Operator

Your next question comes from Jeffrey Lin with Global CrownCapital.

Jeffrey Lin - GlobalCrown Capital

Good afternoon and congratulations on the quarter.

Nick Konidaris

Thank you.

Jeffrey Lin - GlobalCrown Capital

Just one quick question: What kind of visibility did youhave in the mixed-signal market, and could you discuss what's going on therebriefly?

Nick Konidaris

Yes. Mixed-signal market is composed of big players here in US,customers like Texas Instruments as an example. And we do have a very competitiveproduct, one that I believe offers better throughput because of the proprietarylaser wavelength that is using the 1.3 micron, and we constantly have beenwinning competitive design wins and winning market share in this segment.

Jeffrey Lin - GlobalCrown Capital

How much visibility do you have in this area?

Nick Konidaris

Well, it's in the neighborhood of a quarter ahead, maybe oneto two quarters ahead. But basically, this area is one that is within thesemiconductor segment is less cyclical, generally speaking.

Jeffrey Lin - GlobalCrown Capital

All right. Thank you.

Nick Konidaris

Thank you.

Operator

(Operator Instructions)

Your next question comes from David Nierenberg with NierenbergInvestment Management.

David Nierenberg -Nierenberg Investment Management

Nick, it's wonderful to see the trajectory that you'regetting from the new products that you've been investing in for such a longtime. Congratulations.

Nick Konidaris

Thank you, David.

David Nierenberg -Nierenberg Investment Management

I would disappoint you, and the other shareholders, however,if I failed to note my dissenting opinion about the cessation of the sharerepurchase program. If I can just pull out several things that I've heardtoday, your existing cash and investment portfolio is $179 million.

In response to Dave Duley's question about inventory, Ididn't hear you disagree that there might be a potential over time to pickanother $10 million to $15 million out of that. And I want to remind everyonethat when your next 10-Q comes out, we'll see that you have $6 million cash in Taiwanin a litigation escrow account. The combination of those things brings cashvery close to $200 million.

And I will also note that in the four months of the fiscalyear-to-date, you've generated $12 million of cash according to your pressrelease. If you annualize that cash flow, that operating cash flow, that itselfpays for the acquisition of New Wave Research. So, I don't understand: why yoususpended the repurchase?

Nick Konidaris

Dave, thank you for your comments. We're listening to yourcomments carefully. I have to assure you about that. We started with anobjective of repurchase of $50 million. Today, we have spent between therepurchase and the acquisition $75 million. And all I have said is that: “weare pausing to catch our breath”.

Things are too fast, and we want to think exactly what we'redoing, because, as I said, we want to assess what is the best use of our cash.We're not going to sit on that cash and disappoint you. We want to use it.

David Nierenberg -Nierenberg Investment Management

I have another disappointment with your cash. I believe KerryMustoe said, if I heard her right, that you have reclassified $20 million ofwhat used to be short-term cash into long-term cash. And, if I understand theGAAP accounting of that, that may have been driven by the fact that that moneymay have been invested in short-term instruments: where you have tomark-to-market if it's listed as a short-term asset?

Can Kerry please tell us: how much of a markdown we wouldhave taken had we continued to keep that $20 million in short-term?

Kerry Mustoe

David, first of all, you're correct. We didn't markdown anyof our investments, and we would not have been required to markdown those investmentsdespite their classification. These are auction rate securities and given thefact that those auctions aren't currently trading on a short-term basis, wethought it was more appropriate classification.

However, there has been no change in the value of theunderlying securities, no change in credit quality, hence no markdowns. Infact, when you look at all of our investments currently, we actually aresitting on unrealized gains, a small amount of gains as opposed to net losses.

David Nierenberg -Nierenberg Investment Management

On the $20 million?

Kerry Mustoe

On the $20 million and on the total investments.

David Nierenberg -Nierenberg Investment Management

You have an unrealized gain on the $20 million?

Kerry Mustoe

Actually, we have zero loss or gain on the $20 million, andwe have unrealized gains on the remainder.

David Nierenberg -Nierenberg Investment Management

So, you have no losses on your investment portfolio?

Kerry Mustoe

That's correct.

David Nierenberg -Nierenberg Investment Management

Very good. I retract my question on that.

Kerry Mustoe

Thank you.

David Nierenberg -Nierenberg Investment Management

I guess the only other thing I don't understand from thecomments today is there was a comment that said that in the period of time thatwe have owned New Wave Research that revenues were less than our expectations.

And if I got it right, it sounded like they were less thanexpectations because of the timing of the purchase of the company. Could youamplify on that, please?

Nick Konidaris

Yes. We're splitting hairs here. Accurately, you're correct.But we bought the company on July 20th. So, the revenues of $5 million are fromJuly 20th through the end of September. The company from July 1st through theend of September had revenues of $8 million.

So, if we bought the company from July 1st, it would be inline with our expectations. Because we bought them on July 20th, and there was alittle bit more brisk revenue in the first three weeks of July as opposed tothe remaining of the period in an average per week, that's the meaning of belowexpectations.

David Nierenberg -Nierenberg Investment Management

Got it. Thank you.

Nick Konidaris

Thank you.

Operator

(Operator Instructions)

Your next question comes from Robert Toomey with EK RileyInvestments.

Robert Toomey - EKRiley Investments

Hi, good afternoon.

Nick Konidaris

Hello, Rob.

Robert Toomey - EKRiley Investments

Hello. Can you hear me okay? Hello.

Nick Konidaris

Yes.

Robert Toomey - EKRiley Investments

In your guidance, Nick, or your outlook comment, I think youmentioned a 45% gross margin.

Nick Konidaris

Correct.

Robert Toomey - EKRiley Investments

And I would just like to maybe revisit that issue. It was myexpectation that we should start to see gross margin moving up into the high40s. And I just want to understand: why that may not be happening at this time?

Nick Konidaris

Yes. Your expectation is correct. That's what we've beenconsistently saying, and that's the expectation that we have work to do here toaccomplish that. But basically, this is due to a mix shift away fromsemiconductor to IMG and components.

Robert Toomey - EKRiley Investments

And in your comments, I couldn't follow totally the commentsrelated to the mix shift in semi. Are you saying that memory repair as apercentage of the mix has declined somewhat?

Nick Konidaris

That's exactly right.

Robert Toomey - EKRiley Investments

But you did say that you expect memory repair and spendingon the part of, particularly some of the Asian companies, to remain strong. SoI am a little bit confused about: what's going to be driving the semiconductorportion of that business right now? And: how do you think mix will affect grossmargin over the next quarter or two?

Nick Konidaris

Yes, the memory part is a healthy business. That's how wecharacterize that. And this is driven primarily by transition to the 70 and 80-nanometernodes. That requires a lot of in addition to capacity technology base and isdriven by Vista. These are the two drivers.

In the short term, as I said, and you have seen that in theQ2 already, there is going to be a little bit of a mix in favor of IMG and PCG.Memory is lumpy, but continues to be healthy.

Robert Toomey - EKRiley Investments

Okay. So I just want to make sure I understand with respectto your overall outlook, you feel that the business looking out here into thisquarter and the following quarter, say over the next quarter or two: there hasbeen really no change or degradation? Would you say: in the strength of thebusiness? Or, in your outlook, would you say is: as good or stronger?

Nick Konidaris

That's what I would say.

Robert Toomey - EKRiley Investments

Okay. Thank you very much.

Nick Konidaris

Thank you, Robert.

Operator

Your next question comes from Mark Miller with Brean Murray,Carret.

Mark Miller - BreanMurray, Carret

Thank you. I just had a question.

Nick Konidaris

Hello,Mark.

Mark Miller - Brean Murray, Carret

Hello. We'vebeen hearing from some of the foundries, and I am just wondering what degree ofexposure there, Taiwansemiconductor and UMC plans to reduce capital spending next year. How will thatimpact you and what's the degree of exposure there?

Nick Konidaris

Well, in the semiconductor, we're dealing primarily with fabmemory manufacturers. A lot of them are IDMs or they have partnerships that arededicating a very large part of their capacity to satisfy the principlepartner.

So TSMC is not a picture there. But I was listening recentlythat, this is public information to a major memory manufacturing CEO speaking,and he said, and I think many people say that the memory segment grows fasterthan semiconductor and it's going to continue doing so through 2009.

The prices are not what they wanted, what the industrywanted them to be in the first half, but the memory business for the next two yearsis strong. And I think it's the most active part in the semiconductor industryoverall.

Mark Miller - BreanMurray, Carret

Okay. The second question is: certainly the PC area isenjoying strong demand right now. And there is some discussion about doubleordering, but that's kind of telling me that even with the price -- I am justcurious about: how long the DRAM pricing situation you guys feel will remainaggressive?

Just on the strong demand we're seeing, if there is acapacity digestion issue, it seems like that with the strong demand continuingthat that might not be as long as some people feel. What's your take on that?

Nick Konidaris

I think that in the first couple of years, the industry experienceda large scale price correction in the first half of '07. However, I think thatdemand is trending better, primarily because of Vista,corporate adoption. I mean these are the two main drivers from the marketplace.

Mark Miller - BreanMurray, Carret

All right. Thank you.

Nick Konidaris

Thanks, Mark.

Operator

Your next question comes from Tom Diffely with MerrillLynch.

Tom Diffely - MerrillLynch

Yes, good afternoon. I was hoping you could talk a littlebit more about your leverage to the NAND portion of the memory market. And, inparticular: if you have an incremental wafer start in DRAM versus anincremental wafer start in NAND, what's the percentage change in the potentialbusiness for your company?

Nick Konidaris

It's difficult to give you an overall rule of thumb, becausethat is changing and is highly situational. What I would say, however, is thatmemory manufacturers who are both DRAM and NAND manufacturers, they do use oursystems. And an incremental wafer today, regardless if it is DRAM or NAND, inaverage commands the same incremental need for repair system.

Tom Diffely - MerrillLynch

So if one of your customers creates a 30,000 wafer per monthDRAM fab, it's the same demand for you if it was a 30,000 wafer start NAND fab.

Nick Konidaris

It used to be that the NAND was less, but for reasons thatare the agglomeration of many situations we hear from customers that sometimesthe need for repair for NAND is higher than for DRAM.

Tom Diffely - MerrillLynch

Okay.

Nick Konidaris

But that's not a general rule of thumb.

Tom Diffely - MerrillLynch

Okay. And: is there any move of the traditional players whodid not use your technology like Toshiba, SanDisk, Micron to move towards thememory repair? Or: are they going to continue using software as far as you cantell?

Nick Konidaris

I cannot detect any shift. They will continue doing whatthey do.

Tom Diffely - MerrillLynch

Okay. And, so really, it's just the guys who do both NANDand DRAM that are going to use your tools for NAND?

Nick Konidaris

That's correct.

Tom Diffely - MerrillLynch

Okay. All right. Thank you.

Nick Konidaris

Thank you.

Operator

Your next question comes from David Nierenberg withNierenberg Investment Management.

David Nierenberg -Nierenberg Investment Management

Nick, I'd like to come back to Bob Toomey's questions aboutthe economic model of the business, the 50-30-20 model. It looks to me that ifwe take out the non-recurring merger related below the line expenses thatyou've got the 30 about where you want it to be, but that the principle elementof the short fall is on gross margin.

But, it also is obvious this quarter that your semiconductorgroup as a percent of revenues is far below what it's normally been. Could youor Kerry please tell us: if instead of being, say -- I think you said about 46%of shipments for semiconductor, if semiconductor had been, say, 60% ofshipments in quarter, at this kind of run rate, your gross margin would haverisen from 46%, after adjustments, to approximately what?

Nick Konidaris

I don't want to avoid the question. We don't have an exactanswer. I would not like to take this phone to have conversations around thiskind of gross margin questions. But again, the semiconductor products enjoybetter margins than the other products, and we do work on all products to keepimproving the margins.

David Nierenberg -Nierenberg Investment Management

I am not trying to extract a proprietary insight about thememory yield improvement margin, but rather trying to make the point that youhad a very unusual mix this quarter. And if one were to normalize it, clearlythe gross margin would have been higher than 46.

Nick Konidaris

Yes, I agree. In fact, if you were to look at the June --hold on for a second. Yes, if you look at gross margin for Q1, you see there a numberthat it is in Q1, which was one month and had the different composition ofgross margin, was 47.6%.

David Nierenberg - Nierenberg InvestmentManagement

Yes. Okay. Thankyou.

Nick Konidaris

Okay.

Operator

Your next question comes from Mikey Brown with ICM.

Mikey Brown - ICM

Hi. Thanks. This is just knit picking on an otherwise greatquarter. But my question is if you look at the three-month period, you were doingabout $27 million a month, and in June, it was 17. Can you talk a little bitabout what's going on there?

Nick Konidaris

Yes, absolutely. I have said many times that I am look attwo quarters and try to average in two quarters. So, if you look at fourmonths, you find out that our sales have been $99 million. If you back out ofthose $99 million, $5 million for New Wave Research, you come with $94 millionfor ESI. If you divide that by 3, you come to about $23.5 million. So, it isabout a $70 million quarter for ESI.

The guidance that we're providing is basically between $73 millionto $83 million. If we take the mid-point, which is $78 million, you can seethat this is $8 million, which is a historical number for New Wave Research and$70 million for ESI, which is at the level we operated in year-to-date in '08.

So, my summary is that we operate at the record level of thelast four months. And by the way, if you do the calculation for the lastseveral months, meaning Q2, Q1 and Q4 previous, you're going to come to thesame conclusion, and both of these quarters are record quarters.

Mikey Brown - ICM

Okay. No, I don't have any problem with that. I guess myquestion is that of the four months, it looks like June was a lot weaker thanthe others. Are there people on vacation? Is there something going on?

Nick Konidaris

No, shipments were weaker, bookings were strong. I mean theproblem with this business is that it's lumpy. If you look at the business on aweekly basis, you'll come to no conclusion. You've got to look over a longerperiod of time.

Mikey Brown - ICM

Okay. So this is a just an artifact of the fact that for thefirst time, you had to report one month instead of three. Is that correct?

Nick Konidaris

That's exactly correct.

Mikey Brown - ICM

Okay. Thank you.

Nick Konidaris

So, I am looking at a business usually as a six monthsrolling average.

Mikey Brown - ICM

Okay.

Nick Konidaris

Okay?

Mikey Brown - ICM

Thank you.

Nick Konidaris

Thanks.

Operator

You have a follow-up question from the line of Dave Duleywith Merriman.

Dave Duley - Merriman

Yes. I was looking to my notes, and I didn't write thenumber down. You went through each segment and talked about the order number,and I missed the DRAM order number or the memory repair order number. Could youjust throw that out again?

Nick Konidaris

Yes, no problem. DRAM was $16 million for Q1, which is Juneand $26 million for Q2. So, total year-to-date four months was $42 million. Theseare the numbers.

Dave Duley - Merriman

Okay. So the one month, that's what I thought I heard. I wasa little confused. So, that little stub month had quite a nice order number onthe DRAM side?

Nick Konidaris

That's right.

Dave Duley - Merriman

Okay. Now when you gave your guidance of this $73 million to$83 million, and you kind of said it, but I just wanted you to repeat it so youdrive it home. What are the trends on the revenue? This is both revenue andshipment guidance. On a revenue basis, what should be the direction of thenumbers versus the period that we're comparing it to?

Nick Konidaris

I would say that we do operate today as a company at $300million per year on an annual basis, or we operate at 75 plus on a quarterlybasis.

Dave Duley - Merriman

Okay. And what I was getting at it the $75 million inguidance, which is the mid-point of your range. What is the trend in eachrevenue bucket, in the DRAM bucket, in the passive group and in the drillgroup? How should we think about revenue progressing between last quarter andthis quarter, the trends? Is DRAM going to be up, down; passive up, down; drillup, down? How should we look at that?

Nick Konidaris

Yes, I cannot provide that breakdown. I would say that DRAMis going to continue to be healthy and the two other segments are going to bestrong.

Dave Duley - Merriman

Okay. Thank you.

Nick Konidaris

Okay. Thanks.

Operator

It appears that there are no further questions. Do you haveany closing remarks?

Nick Konidaris

Yes. Thank you very much for joining us. You are welcome tocall Kerry, Chris or me if you have any further questions. This concludes ourcall. Thanks for your interest in ESI.

Operator

This concludes tonight's conference call. You may nowdisconnect.

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Source: Electro Scientific Industries F2Q08 (Qtr End 9/29/07) Earnings Call Transcript

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