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Executives

Chris Butterfield - Director of Investor Relations

Nick Konidaris - Chief Executive Officer

Kerry Mustoe - Corporate Controller and Chief Accounting Officer

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

Electro Scientific Industries, Inc. (ESIO) F2Q08 (Qtr End 9/29/07) Earnings Call October 24, 1969 11:00 PM ET

Operator

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

All lines have been placed on mute to prevent any background noise. 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 is Chris Butterfield, Director of Investor Relations for ESI. With me today are Nick Konidaris, our CEO; and Kerry Mustoe, our Corporate Controller and Chief Accounting Officer.

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

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

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

Finally, we apologize for the delay in issuing our earning release. There were technical issues on the receiving end related to the file transfer.

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

Nick Konidaris

Thank you, Chris, and good afternoon, everyone. The second quarter fiscal '08 represented another successful period for ESI. Including the results 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 the three-month period of July through September, shipments of $87 million represented a 24% increase from our last full fiscal quarter, the fourth quarter of fiscal '07.

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

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

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

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

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

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

As we announced previously, John Metcalf recently retired from ESI, and the search for a new CFO is currently underway. We have appointed Kerry Mustoe, our Corporate Controller and Chief Accounting Officer, to serve as CFO during the interim.

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

Kerry Mustoe

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

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

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

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

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

Q2 shipments of $87 million were up $17 million compared to the fourth quarter, the highest quarterly level of shipment since fiscal 2001. The increase was largely due to the shipments of interconnect systems, which grew 141% from the fourth quarter, as well as from passive tools, which grew 70% from Q4. Geographically, Asia represented 79% of the quarter's total shipments.

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

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

The semiconductor segment, although down from the fourth quarter, was the second highest level in five quarters, driven by strong shipments of memory repair and mixed-signal tuning systems. The revenue mix for the second quarter was: semiconductor, 46%, down from 70% in the fourth quarter; passive component, 29%, up 18% from the fourth quarter; and interconnect 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-month period, June through September. Revenue for Asia was 80% of that total for both the second quarter and year-to-date periods. Deferred revenue 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 New Wave division. Approximately $12 million of second quarter ESI and New Wave shipments were deferred and $5 million of prior period shipments were included in the second quarter's revenue.

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

Despite the higher revenue levels for Q2, shift and product mix towards interconnect and passive systems had a negative overall impact to our 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 the purchase accounting charges consisted of the write-off of in-process research and development. Excluding the impact of purchase accounting, operating expenses for the quarter were $26 million compared to $23 million in the fourth quarter of fiscal '07. The increase in expense levels from the fourth quarter was 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. Operating income for the quarter, excluding the impact of purchase accounting, was $11.8 million compared to $10.5 million for the fourth quarter of '07. Year-to-date operating income was $9 million or $13 million, excluding the impact of purchase accounting.

Second quarter interest, and other income, was $2.1 million and was down compared to the fourth quarter. The decline was primarily due to lower average cash balances resulting from the purchase of New Wave and the impact of our stock repurchase program. Year-to-date, we recorded $2.9 million of 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 an effective annual rate of 41%. The $4.3 million in total purchase accounting adjustments are not deductible for tax. As these adjustments do reduce pretax income, they effectively increase our tax rates by 13 and 11 percentage points for the three and four month periods respectively.

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

Year-to-date net income was $7 million or $0.24 per diluted share. 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 provide the results for New Wave Research and its impact to the second quarter.

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

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

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

Within our investment portfolio, we reclassified $20 million related to auction rate securities from short-term to long-term assets based on their underlying maturity date. We will retain this classification until such time as more frequent trading is resumed or they are liquidated through refinancing.

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

Accounts receivable were $56 million, including $5 million from New Wave, down slightly compared to the end of the fourth quarter. DSO for the 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's inventory. The remaining increase was due to the ramp in activity surrounding demand for passive components and interconnect products.

Now, I will turn the call back to Nick for a business unit update 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 orders were $42 million for this segment and were driven by strong demand for both our dual-beam IR and UV systems and large orders for analog and mixed-signal device tuning systems.

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

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

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

The 9850 dual-beam UV is the fastest and most capable memory repair system ever produced by ESI. It is designed specifically to meet the needs of our customers to process technology nodes of the 70 and 80-nanometer levels and beyond. At the end of Q2, we had already received orders for this exciting new system, and we've begun to ship them in October. I am particularly pleased to announce one of the first 9850 UV shipments also represented our 500th shipment in the 9800 series.

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

In LED scribing, we recently received multiple orders for our new AccuScribe 2112 system from New Wave. With a 20% throughput advantage over the previous generation, laser scribe, the 2112 is an important addition to our product portfolio and represents the growth potential inherent in the acquisition of 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 the strength of our patented 1.3 micron process for tuning thin film on silicon resistance will continue to expand our presence in this market with major competitive 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 than our results from the fourth quarter. Driven by strong demand for both electrical and visual test equipment, we reported the highest quarterly booking levels 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 stable pricing and strong demand. The market is positively impacted by increasing demand for leading edge consumer products such as handheld devices, multi-core PC processors, flat panel displays and high-definition televisions. The advanced features that are incorporated in these products drive demand for MLCCs that in turn drive demand four our test and inspection equipment.

Turning to our products, we experienced strong demand for both electrical and visual test equipment during the quarter. Adoption of our newest high-capacitance tester, the 3550, proceeded well during the period with multiple orders from customers in Japan and Taiwan. Since its successful introduction in June, demand for this product has been accelerating, and we expect to continue to penetrate key captive and commercial manufacturers in this segment.

In the critical Japanese market, our products gained share in Q2. In addition to orders for our 3550, we also received a large multi-system order for our 6650 visual test system from a major manufacturer in Japan.

Our focus on sales and support in the largest MLCC manufacturing region in the world has resulted in a steady [process] of key competitive wins for our products. Finally, worldwide demand for our 5300 and 5400 series of electrical test systems remained strong for the period with a receipt of large orders in both Asia and North America.

Now, I would like to turn to our interconnect and micro-machining business. Over the past several quarters, we have been expanding our focus to include micro-machining applications beyond our flex and IC packaging markets. Although we remain committed to the existing flex and packaging markets, we see significant growth opportunities in micro-machining, particularly following the New Wave acquisition.

In recognition of this trend, we have remained an electrical interconnect 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 second consecutive quarter of record-breaking orders for this segment. For the four-month period, June through September, orders were $50 million.

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

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

For Q3, we expect shipments revenues to be approximately $73 million to $83 million. The gross margin percentage is expected to be approximately 44% due to changes in product mix in the third quarter and the impact of purchase accounting adjustments. Purchase accounting amortization is expected to impact third quarter margins by 500,000. Excluding the impact of purchase 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 $500,000 in purchase accounting amortization. We estimate net interest and other income will be approximately $1.7 million. The effective tax rate is anticipated to be approximately 37% or 32% excluding the impact of purchase accounting.

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

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

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

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

Overall, we are optimistic that the business outlook for ESI in the third quarter and the remainder of fiscal '08 will continue to be strong.

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

Question-and-Answer Session

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 incongruent periods, but we appreciate all the information in the press release. It makes it much better and easier to understand.

I have a couple of questions. One, housekeeping, the new wave revenue that you referred to in the quarter, that went into the revenue bucket 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 breakout and you look at the information you provided for the four-month period ending September, just wanted you speak about two different things. First of all is, when you look at the semiconductor detail there, the numbers are down sequentially. Could you talk a little bit about what's going on there?

And then to the flip side, you have this huge increase in the numbers, I think, in the passive component group. Could you talk a little bit 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 particular revenue segments?

Nick Konidaris

Okay. The one point that I would like to make is that we operate at the record level we established in Q4, all in the last six to seven months, and we're guiding at that level. The semiconductor has gone down, primarily because, as you know, there was an imbalance between supply and demand in the first half of the year, but we expect that over time, with the drivers being Vista and the migration into the 7280-nanometer technology node to correct itself.

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

In the IMG, in addition to flex and IC packaging, we see additional opportunities in micro-machining. So overall, what is happening is that all of our three businesses are really contributing. There may be some continual in-balancing between the three businesses, but all of them are contributing 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 the guidance 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? I am kind of trying to figure out in that particular revenue bucket what's coming from --?

Nick Konidaris

At this point in time, about 25% of our business is from the 3500. 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 become shipment revenue this coming quarter.

Dave Duley - Merriman

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

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

Nick Konidaris

Okay. Let's talk about the inventory. We agree on the inventory. 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 the marketplace, which is dynamic as you know.

On the buyback, basically the image that I want to leave everyone is that over the last six months, we spent $75 million. We had an aggressive 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 our breath. But we plan to continually, aggressively use our cash and take advantage of strategic opportunities that are in front of us.

Dave Duley - Merriman

Like we fulfilled the first buyback and we have to allocate a new one or just, kind of, wondering: why today or over the last month we're not buying stock? What was the catalyst behind that?

Nick Konidaris

Well, the catalyst is that basically it was the acquisition of NWR. If you put everything in perspective, we had usual cash in the neighborhood 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 that we did that. We're very pleased with our cash usage. And as I said, we're catching our breath, and we'll resume, but we need to do that by looking at the opportunities 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 trends in the current quarter? And here is what I am going with: Given the change in the fiscal year, I am just wondering: if you have any insight as to whether there is going to be some seasonality in the business from a bookings standpoint for this quarter ended December?

Nick Konidaris

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

Jim Ricchiuti - Needham & Company

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

Nick Konidaris

That right now, they want systems yesterday practically. It's not going to last forever, but it's going to last this quarter and through the beginning 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 am just trying to get to the gross margin for the four-month period ex purchase accounting. 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, because we didn't have any related to June first of all. So you add back the same amount.

Jim Ricchiuti - Needham & Company

Got it.

Kerry Mustoe

Okay.

Jim Ricchiuti - Needham & Company

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

Kerry Mustoe

Yes, we backed out a total of about $1.1 million in cost of goods sold adjustment and another $3.2 million in SG&A adjustment for a total 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 gears for a second to New Wave: can you talk a little bit about the applications that you'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 the activity there is scribing supply of wafers. There is also activity in repairing flat panels. The products that New Wave has is called QuikLaze. That's the 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 by people 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. And I think that as the marketplace improves in '08, we're taking appropriate steps right 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 a different segment of the market? Or: perhaps give you a full system solution for other segments?

Nick Konidaris

Yes. The elaboration was on the AccuScribe. This is a new product in the category of LED scribing. This is a more productive product than the predecessor product. And LED we think this is a fast-growing market and that will allow us to maintain the strong position in the market that roughly is in the neighborhood of about 60% market share and take advantage of the growth 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 with DA Davidson & Company.

Matt Petkun - DA Davidson & Company

Hi. Good afternoon.

Nick Konidaris

Hello.

Matt Petkun - DA Davidson & Company

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

Kerry Mustoe

That was $56 million.

Matt Petkun - DA Davidson & Company

$56 million. And then, Nick, you gave out a bookings number for 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 - DA Davidson & Company

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

Nick Konidaris

$6 million.

Matt Petkun - DA Davidson & Company

$6 million? Okay.

Nick Konidaris

Year-to-date, $30 million.

Matt Petkun - DA Davidson & Company

What's that?

Nick Konidaris

$30 million year-to-date, total.

Matt Petkun - DA Davidson & Company

Right. Nick, my next question would be: I understand that there is 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 realm with some of your organic tools that you've been working on at ESI. Could you tell us a little bit more what's going on there in terms of some other products outside 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 several micro-machining applications on materials different than the ones that we have been operating in the future and industry is different the ones that we have been operating in the past. But I will not go any further than that.

Matt Petkun - DA Davidson & Company

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

Nick Konidaris

That's what I can tell you.

Matt Petkun - DA Davidson & Company

Is it for the electronics end market?

Nick Konidaris

I think I told you everything that I could.

Matt Petkun - DA Davidson & Company

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

Operator

Your next question comes from Jeffrey Lin with Global Crown Capital.

Jeffrey Lin - Global Crown Capital

Good afternoon and congratulations on the quarter.

Nick Konidaris

Thank you.

Jeffrey Lin - Global Crown Capital

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

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 competitive product, one that I believe offers better throughput because of the proprietary laser wavelength that is using the 1.3 micron, and we constantly have been winning competitive design wins and winning market share in this segment.

Jeffrey Lin - Global Crown Capital

How much visibility do you have in this area?

Nick Konidaris

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

Jeffrey Lin - Global Crown Capital

All right. Thank you.

Nick Konidaris

Thank you.

Operator

(Operator Instructions)

Your next question comes from David Nierenberg with Nierenberg Investment Management.

David Nierenberg - Nierenberg Investment Management

Nick, it's wonderful to see the trajectory that you're getting from the new products that you've been investing in for such a long time. 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 share repurchase program. If I can just pull out several things that I've heard today, your existing cash and investment portfolio is $179 million.

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

And I will also note that in the four months of the fiscal year-to-date, you've generated $12 million of cash according to your press release. If you annualize that cash flow, that operating cash flow, that itself pays for the acquisition of New Wave Research. So, I don't understand: why you suspended the repurchase?

Nick Konidaris

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

Things are too fast, and we want to think exactly what we're doing, 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 Kerry Mustoe said, if I heard her right, that you have reclassified $20 million of what used to be short-term cash into long-term cash. And, if I understand the GAAP accounting of that, that may have been driven by the fact that that money may have been invested in short-term instruments: where you have to mark-to-market if it's listed as a short-term asset?

Can Kerry please tell us: how much of a markdown we would have 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 any of our investments, and we would not have been required to markdown those investments despite their classification. These are auction rate securities and given the fact that those auctions aren't currently trading on a short-term basis, we thought it was more appropriate classification.

However, there has been no change in the value of the underlying securities, no change in credit quality, hence no markdowns. In fact, when you look at all of our investments currently, we actually are sitting 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, and we 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 the comments today is there was a comment that said that in the period of time that we have owned New Wave Research that revenues were less than our expectations.

And if I got it right, it sounded like they were less than expectations because of the timing of the purchase of the company. Could you amplify 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 from July 20th through the end of September. The company from July 1st through the end of September had revenues of $8 million.

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

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 Riley Investments.

Robert Toomey - EK Riley Investments

Hi, good afternoon.

Nick Konidaris

Hello, Rob.

Robert Toomey - EK Riley Investments

Hello. Can you hear me okay? Hello.

Nick Konidaris

Yes.

Robert Toomey - EK Riley Investments

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

Nick Konidaris

Correct.

Robert Toomey - EK Riley Investments

And I would just like to maybe revisit that issue. It was my expectation that we should start to see gross margin moving up into the high 40s. 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 been consistently saying, and that's the expectation that we have work to do here to accomplish that. But basically, this is due to a mix shift away from semiconductor to IMG and components.

Robert Toomey - EK Riley Investments

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

Nick Konidaris

That's exactly right.

Robert Toomey - EK Riley Investments

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

Nick Konidaris

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

In the short term, as I said, and you have seen that in the Q2 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 - EK Riley Investments

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

Nick Konidaris

That's what I would say.

Robert Toomey - EK Riley 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 - Brean Murray, Carret

Thank you. I just had a question.

Nick Konidaris

Hello, Mark.

Mark Miller - Brean Murray, Carret

Hello. We've been hearing from some of the foundries, and I am just wondering what degree of exposure there, Taiwan semiconductor and UMC plans to reduce capital spending next year. How will that impact you and what's the degree of exposure there?

Nick Konidaris

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

So TSMC is not a picture there. But I was listening recently that, 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 faster than semiconductor and it's going to continue doing so through 2009.

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

Mark Miller - Brean Murray, Carret

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

Just on the strong demand we're seeing, if there is a capacity digestion issue, it seems like that with the strong demand continuing that 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 experienced a large scale price correction in the first half of '07. However, I think that demand is trending better, primarily because of Vista, corporate adoption. I mean these are the two main drivers from the marketplace.

Mark Miller - Brean Murray, Carret

All right. Thank you.

Nick Konidaris

Thanks, Mark.

Operator

Your next question comes from Tom Diffely with Merrill Lynch.

Tom Diffely - Merrill Lynch

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

Nick Konidaris

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

Tom Diffely - Merrill Lynch

So if one of your customers creates a 30,000 wafer per month DRAM 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 that are the agglomeration of many situations we hear from customers that sometimes the need for repair for NAND is higher than for DRAM.

Tom Diffely - Merrill Lynch

Okay.

Nick Konidaris

But that's not a general rule of thumb.

Tom Diffely - Merrill Lynch

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

Nick Konidaris

I cannot detect any shift. They will continue doing what they do.

Tom Diffely - Merrill Lynch

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

Nick Konidaris

That's correct.

Tom Diffely - Merrill Lynch

Okay. All right. Thank you.

Nick Konidaris

Thank you.

Operator

Your next question comes from David Nierenberg with Nierenberg Investment Management.

David Nierenberg - Nierenberg Investment Management

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

But, it also is obvious this quarter that your semiconductor group as a percent of revenues is far below what it's normally been. Could you or 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% of shipments in quarter, at this kind of run rate, your gross margin would have risen from 46%, after adjustments, to approximately what?

Nick Konidaris

I don't want to avoid the question. We don't have an exact answer. I would not like to take this phone to have conversations around this kind of gross margin questions. But again, the semiconductor products enjoy better margins than the other products, and we do work on all products to keep improving the margins.

David Nierenberg - Nierenberg Investment Management

I am not trying to extract a proprietary insight about the memory yield improvement margin, but rather trying to make the point that you had a very unusual mix this quarter. And if one were to normalize it, clearly the 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 number that it is in Q1, which was one month and had the different composition of gross margin, was 47.6%.

David Nierenberg - Nierenberg Investment Management

Yes. Okay. Thank you.

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 great quarter. But my question is if you look at the three-month period, you were doing about $27 million a month, and in June, it was 17. Can you talk a little bit about what's going on there?

Nick Konidaris

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

The guidance that we're providing is basically between $73 million to $83 million. If we take the mid-point, which is $78 million, you can see that 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 the last four months. And by the way, if you do the calculation for the last several months, meaning Q2, Q1 and Q4 previous, you're going to come to the same conclusion, and both of these quarters are record quarters.

Mikey Brown - ICM

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

Nick Konidaris

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

Mikey Brown - ICM

Okay. So this is a just an artifact of the fact that for the first 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 months rolling 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 Duley with Merriman.

Dave Duley - Merriman

Yes. I was looking to my notes, and I didn't write the number 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 you just throw that out again?

Nick Konidaris

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

Dave Duley - Merriman

Okay. So the one month, that's what I thought I heard. I was a little confused. So, that little stub month had quite a nice order number on the 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 you drive it home. What are the trends on the revenue? This is both revenue and shipment guidance. On a revenue basis, what should be the direction of the numbers versus the period that we're comparing it to?

Nick Konidaris

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

Dave Duley - Merriman

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

Nick Konidaris

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

Dave Duley - Merriman

Okay. Thank you.

Nick Konidaris

Okay. Thanks.

Operator

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

Nick Konidaris

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

Operator

This concludes tonight's conference call. You may now disconnect.

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