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FEI Company (NASDAQ:FEIC)

Q1 2012 Earnings Conference Call

May 1, 2012 17:00 ET

Executives

Fletcher Chamberlin – Treasurer and Communications Director

Don Kania – President and Chief Executive Officer

Ray Link – Executive Vice President and Chief Financial Officer

Analysts

Bill Ong – B. Riley & Company

Zach Larkin – Stephens Incorporated

Joe Maxa – Dougherty & Company

Jim Ricchuiti – Needham & Company

Derik de Bruin – Bank of America

Tycho Peterson – JPMorgan

David Duley – Steelhead Securities

Mark Miller – Noble Financial Capital Markets

Patrick Ho – Stifel Nicolaus

Tom Diffely – D.A. Davidson & Company

Operator

Good day, ladies and gentlemen and thank you for standing by. Welcome to the FEI First Quarter Earnings Conference Call. During today’s presentation, all participants will be in a listen-only-mode. Following the presentation, the conference will be opened for questions. (Operator Instructions) This conference call is being recorded today Tuesday, May 1, 2012.

And I’d now like to turn the conference over to Mr. Fletcher Chamberlin. Please go ahead sir.

Fletcher Chamberlin – Treasurer and Communications Director

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

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

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

These and other risk factors are cited in today’s press release on slide two of the slides posted on this call and in FEI’s most recent 10-K, 10-Q and 8-K documents and other filings with the SEC. Investors are urged to read these documents. Copies of the SEC filings are available free of charge on the commission’s website at sec.gov or on our website or from our Investor Relations department at 503-726-7710. The company assumes no duty to update forward-looking statements set out in those documents or made on this call. This call is the property of FEI Company. It will be archived in the Investor Relations section of our corporate website at www.fei.com.

Now, I’ll turn the call over to Ray for a review of the results and then Don will give you the view of our markets, the outlook and the business environment.

Ray Link – Executive Vice President and Chief Financial Officer

Thank you, Fletcher, and good afternoon, everyone. We had a solid quarter and the numbers are straightforward. The highlights on slide three are revenue and bookings were the highest for any quarter in our history. Bookings were above our guidance and the book-to-bill was above 1 to 1. GAAP earnings were right in the middle of guidance and our balance sheet remained strong even as we put cash to work in the past quarter. We have now recorded 24 consecutive quarters or 6 full years of GAAP profit, demonstrating consistency over the long-term in varying economic environments.

Bookings for the quarter were $221.8 million, up 16% from Q1 of 2011 and up 9% from Q4’s net order total. Our recent acquisitions contributed less than 3% of bookings. Don will discuss the makeup of orders in our markets in a moment. Changes in currency rates had a small impact in our orders in totals and backlog this quarter. At the end of the latest quarter, the euro was $1.33 compared to $1.29 at the end of Q4. The backlog at the end of the quarter was $434.9 million and represents about 6 months of revenue at our current run rate.

Moving to slide four, first quarter revenue was up 10.5% from a year ago and 2% from the fourth quarter. Compared with a year ago, less than 2% of our revenue growth came from acquisitions offset in part by less than a 1% reduction due to changes in foreign exchange rates. Revenue growth was driven by Electronics segment, which was up 27% from last year’s first quarter and 42% from the fourth quarter of 2011 and made up 36% of the total.

The Electronics segment also had a strong bookings and a book-to-bill ratio of 1.12 for the quarter. Materials Science segment revenue of $73.2 million was up 4% from the first quarter of 2011 and down 20% on a normal seasonal basis from a record level fourth quarter of 2011. Within this segment, natural resources revenue was up 30% compared with last year’s first quarter and material science research revenue was flat.

Life Sciences' Q1 revenue was down 24% from last year’s first quarter and 16% from the fourth quarter as expected. As we have said, we expect quarterly variations in this business based in part on a number of Titan Krios system shift in any given quarter. We continued to invest in this business as we look to integrate the high-end digital light microscope business of TILL Photonics, which we acquired in November 2011 and accelerated the completion of correlated workforce solution combining light and electron microscopy. Service and Component revenue was up 18% for the first quarter compared with last year and 8% with fourth quarter that continues to grow with our installed base. Service gross margins were 33.4% compared with 32.9% in last year’s first quarter.

Turning to slide five, our revenues continue to be well balanced geographically with continued strong growth in Asia. North American revenue was up 9% from last year and 17% from the fourth quarter and made up 32% of the total. Europe and the Middle East was up 9% from last year and down 9% from the fourth quarter and made up 29% of the total. Japan and Asia together were up 14% from last year’s first quarter and up 1% from the fourth quarter and made up 39% of the total.

Now, looking at slide six, gross margin in the quarter was 45.1% up from 44.4% in the fourth quarter. Higher volume, the return of the Electronics business to 36% of our total and continued gains from our expanded manufacturing in the Czech Republic helped gross margins in the latest quarter. Gross margin in the second quarter 2012 is continued expected to continue to improve and we believe we are on track to reach our goal of a 47.5% gross margin in the fourth quarter of 2012.

Turning to slide seven and moving down the income statement, total operating expenses were $64 million that includes $2.3 million due to our Till Photonics that aspects acquisition. It compares with $62 million in the fourth quarter of 2011, excluding the specific items we noted in our fourth quarter results. Operating expenses included $22.7 million or 10.4% of sales for research and development as we continue to invest for growth in 2013 and beyond. Operating income in the quarter was $34.1 million, up 7% from last year’s first quarter and up 5% from the fourth quarter’s non-GAAP results. Non-operating expenses $2 million in the first quarter compared with $2.5 million expense in the fourth quarter and $200,000 expense in last year’s first quarter.

Unusual volatility and currency rates early in the quarter caused larger than normal balance sheet translation losses. We expect non-operating expense to be under $1.5 million in the second quarter. Our tax rate for the quarter was 19.8% and we expect it to be approximately 22% in future quarters. Net income was $25.7 million or $0.63 per diluted share. That’s in the middle of our guidance range equal to our non-GAAP number for the fourth quarter and up 17% from last year’s first quarter. The weighted average shares for diluted EPS in Q1 was $41.5 million, compared with $41.3 million in Q4 and $42.1 million shares in the last year’s first quarter. We bought 18,900 shares in the open market in the first quarter at an average price of $43.29.

As you can see on slide eight, our balance sheet remains very strong and we have deployed our cash to improve shareholder returns. Total cash and investments at the end of the quarter included a restricted cash and long-term investments was $396.4 million compared with $456.1 million at the end of the fourth quarter. That’s after spending $30.2 million to purchase ASPEX Corporation, making $23 million of profit-sharing and management incentive payments that were accrued during 2011 and capital expenditures of $6.2 million. Net cash after subtracting debt was $307.4 million or $8.10 per share. Cash flow used in operating activities was $32.2 million in the first quarter. EBITDA was $39.2 million, up from $28.9 million in the fourth quarter and $37.5 million in the last year’s first quarter. Days sales outstanding increased from the record low in the fourth quarter and inventory turnover remained essentially flat.

With that, I’ll turn the call over to Don for comments about our business and our outlook.

Don Kania – President and Chief Executive Officer

Thank you, Ray, and good afternoon, everyone. We’ve started 2012 at all-time record orders, all-time record revenue and solid execution after our record-setting 2011. Revenue and earnings were up over last year and in line with our guidance. The book to bill ratio was greater than one to one. Our gross margin improved and R&D spending was up as planned. We continue to execute the strategies in each of our businesses, which will grow our served available market and expand our geographic reach. This quarter, we saw particular strength in electronics and natural resources and ongoing returns for our investments in Asia and emerging economies.

Turning now to slide nine, we will review the bookings for the first quarter. The largest segment this quarter was electronics with $87 million in orders, a record for this segment. It was up 20% from a strong fourth quarter and up 35% from last year’s first quarter with record orders from Asia. Orders totaled over $275 million for the last 12 months.

In the quarter, key semiconductor customers led by memory expanded their investments in new nodes containing finer features, new materials and more complex structures. In particular, the move to expanded production in sub 32 nanometer nodes drives an expansion of demand for higher resolution TEMs and accompanying DualBeams. This trend and our new products are able to meet the challenges of shrinking nodes and as resulted in an increase in our share of total spending in the last few years. We expect this trend to continue as we expand our footprint in yield, metrology and inspection.

Looking forward, we anticipate bookings for Electronics to remain strong in the second quarter, although off from the record first quarter and to do well throughout the year as memory, logic and foundry customers attack the challenges of 2x and 1x nodes. The second largest segment in the first quarter was Material Science with $65.1 million in bookings. That’s up 18% from last year’s first quarter and down 9% from a seasonally strong fourth quarter. Business continued to be strong in Asia, while Europe and the U.S. were down compared with both the fourth quarter and last year’s first quarter.

In particular, the U.S. remains weak as we have noted in the past several quarters. In India, strength resulted from the purchase of high-end tools for its most prestigious institutions. In Japan, we had another key multi-tool win at a world-class research institution. Within Material Science segment, bookings for our natural resources business were more than double last year’s first quarter. The bulk of the business continues to come from mining companies with some contribution from oil and gas laboratory applications.

Progress has been good for our well side product, where we’re in a qualification phase now, marketing the specific used cases that we developed in our testing programs to customers in conventional and unconventional oil and gas exploration and production. We expect to have our first paid installations of the well side product later this year. Life Sciences bookings are $15.1 million in the quarter were down from last year and the fourth quarter. We have seen some delays in the large orders and expect stronger orders in the second quarter. Our pipeline remains strong, in particular for the cryo’s with unexpected strength in Eastern Europe and Asia.

The pipeline contains an expanding number of prospects that intend to use cryo electron microscopy along with their installed base of XRD and NMR systems, mimicking our cooperative agreement with the National Institute of Health. Meanwhile, the integration of TILL Photonics light microscopy business is focused on the creation of an FEI only correlative microscopy solution. Our investments in TILL, the National Institutes of Health and the OHSU Knight Cancer Center, cooperative programs of progressing as we build our Life Sciences business for long-term. As we develop work flows across our business unit and especially in life sciences and natural resources, the challenge of managing large data sets of multiple 2D and 3D images are growing insignificant.

Suffer programs such as our map solutions for combining multiple images will play a larger role. Also, our tomography segmentation and single particle analysis products for 3D imaging and analysis are central to our life sciences work flows. We will maintain our technology leadership in electron microscopy and expand further with solutions based on software and data management. First quarter bookings for servicing components went all-time record and up 36% from the fourth quarter at a normal seasonal basis as a number of annual contracts are renewed in the first quarter. Service bookings are up 14% compared with last year’s first quarter.

The double-digit growth reflects in part, the ramp of our shipments that began in the fourth quarter of 2010 as those products are now coming off warranty. We expect a normal seasonal sequential decrease in service bookings in the second quarter. But year-over-year growth should continue. Looking at geographic bookings on slide 10, we had another very strong quarter in Asia including Japan, with strength in Electronics and Material Science. Asian bookings including Japan were up 35% from last year and just above the record levels of the fourth quarter of last year. They made up 47% of the total. Bookings were particularly strong in India and Korea. Geographic diversity remains strong with orders totaling $2 million or more from 15 different countries in the quarter.

Slide 12 is a summary of our guidance for the second quarter of 2012. We expect revenue to be in the range of $215 million to $225 million. Bookings are expected to be at least $205 million, which if achieved will be a record for our second quarter. Earnings per share are expected to be in the range of $0.64 to $0.70. We are on track to reach our goal of gross margins of 47.5% in the fourth quarter of 2012. In addition to increasing our proportion of higher margin products, we expect lower cost from increased volume from the Czech Republic, continuing sourcing improvements and the end of the manufacturing services agreement in Hillsboro. After the transformative growth of 2011 and a solid first quarter, we continue to expect FEI to grow organically in 2012.

Electronics will continue to increase its share of customer spend, Material Science will be okay with potential weakness in the US and parts of Europe, offset by continued global investments in technology. Natural Resources will continue its penetration in the labs of mining and oil and gas companies and is expected to see its first orders in revenue from the well side solution. We project Life Sciences will accelerate as we begin to reap the benefits of our recent investments. Service is expected to continue its long-term high single digit growth. Our current estimate for revenue growth for the full-year compared with the record levels achieved in 2011 is in the 6% to 9% range.

Assuming foreign exchange rates stay where they are now, the FX rate change will nearly offset the revenue growth from acquisitions. We are on the path to continue growth, improve margins and generate cash. For the cash on our balance sheet, we will continue to target M&A and be opportunistic buyers of our stock. I’m proud of the entire FEI team that has delivered these results.

We are again planning a New York Investor meeting on June 7 from 9:30 through lunch when we will have an opportunity to meet more members of the management team and learn more about our progress on expanding our served available market for long-term growth, our plans for margin expansion and uses for our cash. If you’d like to attend and have not already applied to our invitation, please contact Fletcher.

With that operator, we are ready for questions.

Question-and-Answer Session

Operator

Thank you, sir. And ladies and gentlemen, we will begin the question-and-answer session at this time. (Operator Instructions) Our first question comes from the line of Bill Ong with B. Riley & Company. Please go ahead.

Bill Ong – B. Riley & Company

Yes. Good afternoon, gentlemen. Nice job on your continued execution.

Don Kania

Thanks, Bill.

Bill Ong – B. Riley & Company

Just a few questions, what’s the booking seasonality of FEI, just given that the business mix have changed in the last couple of years. As you look at June quarter, in 2005-2008, it’s generally been down sequentially. In last two years, it’s been up. So maybe some color on how the bookings, how they should be, given that your business is a little bit different now than in its past?

Don Kania

Well, I think one thing we didn’t highlight which is probably the most interesting thing is we achieved all time record orders in Q1. And traditionally, Q4 is the strongest quarter overall. And it wasn’t due to any one transaction it was the multiple transactions that cause that to happen. And so when we look at the seasonality of the year, given that we started on this record basis are guiding to a quarterly record into -- we feel pretty good about the first half and then I think generally as we look at the second half with our pipeline, I think we’ll probably see again, what we’ve seen in the past is the half-to-half increase from the order perspective. Three sometimes is a challenge, two is sometimes a challenge. And as you comment that seems to be moving around. It’s tough to make a detail call right now, but I think we feel pretty good about the year as we try to frame up for you.

Bill Ong – B. Riley & Company

That’s helpful. I appreciate that color. And then my last question is that given that the oil and gas market is still uncharted opportunity for electron microscope applications, perhaps you can now offer a competitive assessment or what’s the key to major adoption. So, maybe as a perspective, electron microscopes were first introduced in semiconductors as a mainstream in the early 90s and Life Sciences about few years ago. So, what’s the critical factor that caused that critical mass adoption? Is it software, resolution, service support and what’s that key hurdle to really get that wide adoption in natural resources? So, maybe you can contrast and say at the different end markets?

Ray Link

Yeah. So I think if we – I think the best way to look at this is I think from a technology perspective, that’s what we demonstrated last year when we chose three partners to deliver the product to a site in partnership with the services company to generate real data on real-wells under real conditions. What we’re doing now is taking a lot of the information that we’ve learned from those, now carrying that to the customer base both directly as FEI and in partnership with service providers. And what's the jargon in the industry is they are in the qualification phase. That is, people are saying, this makes sense for this kind of well. Let’s start to talk about how we can do, attach to make that happen. And so now we are in that discussion to form that – to actually get paid to go do this service as opposed to do it on a beta kind of arrangement.

So when I look at other – I think the prospective to take if each industry has an adoption cycle and we are going down that learning curve here. Electronics, pretty savvy, they love technology change. Mining has been slower and we’ve been in mining longer. But we don’t have a mine sit solution as mature as we have in oil and gas which we’ve been in a shorter period of time. And so I wouldn’t expect as we’ve described in oil and gas we’ll see qualification orders and revenues this year and a further quantification of the total available market to us as we enter ‘13, which has been our decent follow-up. Okay.

Unidentified Analyst

Ray, thank you so much. Nice work.

Ray Link

Thanks, Bill.

Operator

Thank you. And our next question comes from the line of Zach Larkin with Stephens Incorporated. Please go ahead.

Zach Larkin – Stephens Incorporated

Hey, good afternoon, gentlemen. Congrats on the quarter.

Don Kania

Thank you.

Zach Larkin – Stephens Incorporated

Hey, first, if I wondered if you could talk about with the strength in electronics, how much of that was driven or could you quantify a little bit, how much was driven off of data storage and memory versus other avenues?

Don Kania

Yeah. Data storage was particularly small in the quarter experimental around to find the find the exact numbers 10%...

Zach Larkin – Stephens Incorporated

Of electronics?

Don Kania

Yeah, of electronics. So, it wasn’t a big driver in the quarter. The big driver were Asian memory manufacturers were the biggest chunk, which is why when we look at the balance of the year, we look at those customers and customers in the foundry and the logic space and our intimacy with them indicates that we’ve got a shot to have a good year.

Zach Larkin – Stephens Incorporated

And then can you quantify Asian memory? How big was that in the quarter?

Don Kania

We’re not going to get that specific. We typically don’t do that and you guys can do the – you can do the correlation and figure out who it is. That’s also something we certainly can’t say explicitly, but I am not going to figure out.

Zach Larkin – Stephens Incorporated

And then also I wondered if, with the discussions on the correlative microscopy and things moving along, could you give us any sense of any milestones that were ahead either with Oregon or with the NIH and types of milestones you are looking for as we move through the year is evidenced that the progress is going on coming up with that final solution?

Don Kania

Yeah. Let’s start with the NIH. I think, actually the most interesting thing is that as I mentioned, when we look at the pipeline, we see customers now who seem what we have launched with the NIH and hey, maybe this is a great idea. We are seeing more of that in the pipeline. Even before, we have actually done much. But what we expect to do this year is to get some real data on real world problems at the NIH associated with cryo electron microscopy and NMR, XRD, other modalities of measuring, either in conjunction with each other or complementarity or solving some problems that those other modalities just can’t do. And I won’t go any -- I can’t go any further at this point. But we’ve gotten some additional outside interest in that set of problems as well.

So we feel good we’re on a track record. So what you should expect to see before the years out is hopefully some publications in the area that really start to become quite definitive if there is value added here. We’ll be a little bit slower at OHSU at the Knight Cancer Center because they’re building a building and we are installing some equipment in temporary spaces right now. But nonetheless, they are going to be the first recipient of, I won’t be specific about this, but some of our optical products and they will be working the bugs out of those basically beta testing those this year. And so as we get in to some product launches in this space, some of which will use tools technology, those will be the other benchmarks that you will see this year.

Zach Larkin – Stephens Incorporated

Alright. Thanks very much.

Operator

Thank you. And our next question comes from the line of Joe Maxa with Dougherty & Company. Please go ahead.

Joe Maxa – Dougherty & Company

Well, thank you very much. I was looking at the gross margins in the service business has been a little bit down sequentially, and that business is growing. So that’s where I’m kind of little disconnect to getting to the 47.5% of that business continues to grow there is a lot to overcome yet?

Ray Link

Joe, its Ray. You’re right. The margins in our service business were down a bit from Q4. We had exited the year quite strong at 35%. We had higher than normal spare parts cost in Q1. We expect that to turn around and have plans to have margin improvement in our service business. As we look forward throughout the course of the year, I think one thing you have to think about though is that incremental revenue, as we generally grow and one quarter doesn’t necessarily show the trend, but our normal pattern is if for example, if revenue were to go up $10 million this quarter for example if we hit the high end of our guidance, most of that incremental revenue generally round about 90% of it is products, not service. So when you think about that in margin of mix, incremental revenue generally does help because we yield a higher overall aggregate margin on our products than we do in our service.

Joe Maxa – Dougherty & Company

Okay. That’s helpful. The 6% to 9% growth you mentioned for this year, is that include any potential orders from Intel opening their facilities?

Ray Link

Well, we never comment specifically on customers, but I would have to say that in the logic space, we expect the Intel to be a purchaser. So at some point in the year, I’m sure Intel will place some money, is retail to place some orders.

Joe Maxa – Dougherty & Company

And last then, are you still looking for bulk $25 million from your acquisitions this year?

Ray Link

Yes.

Joe Maxa – Dougherty & Company

Okay. That’s it. Thank you.

Ray Link

Very good.

Operator

Thank you. And our next question comes from the line of Jim Ricchuiti with Needham & Company. Please go ahead.

Jim Ricchuiti – Needham & Company

Hi. Thanks. Good afternoon. Don, you, I think, alluded to some delays in the Life Sciences area. Can you elaborate on that, is that just a timing issue, is it some -- are you beginning to see some potential impact just from macroeconomic concerns in that area of the business?

Don Kania

Yeah. The two that were in front of us for the quarter, I can comment explicitly on that, they were internal politics related, not related to any macro whatsoever. So it becomes a timing issue. In one case, it’s being reviewed and it’s the dean change. So the new dean has their review, et cetera. So we’re looking at some of those kinds of occurrences in the area where you’re booking 20 plus million a quarter and you’ve got $7 million order rounding around that and that really becomes the issue.

Jim Ricchuiti – Needham & Company

Okay. And then in the – looking at the – yeah, maybe this is more of an economically sensitive area, the Material Sciences business in general, are you seeing any impact you alluded to, I think possible, little slower Europe and U. S. Is does that tie in with just some of the macro concerns or is it?

Don Kania

I think we are pretty, we continue to say I think the same story for the past few quarters, which is U. S. has been slow and anything that has sciences in it for FEI, so that’s materials and life sciences. Just, it’s been that way and we expect it to just at least for the near-term stay that way. And Europe, parts of Europe are quite strong. Germany, even France, the northern parts of Europe remained steadfast in their investment. And Eastern Europe, bright light, I was just in Poland a few weeks ago and tremendous opportunity continues there. They’re expanding their scientific infrastructure. They’re still interested in being part of the EU. And so they need to ramp up that infrastructure, so they can compete for those common EU dollars. That’s the formula that’s going forward.

The way I would think about it is we have high dollar items. Spinning back to the U.S. in particular, I used to be a researcher and what you worry about most when there’s budget uncertainty in front of you is your people. So people are going to be cautious until for the kind of high dollar ticker items we provide until there becomes more clarity on ‘13 budget. And so any upside – any improvement there as far as I’m concerned is upside for us. We’ve built a relatively conservative view of the U.S. into our forecast for the year. So if our glorious Congress can figure out what they’re going to do and the President signs it, then I think that clarity will probably guide to an improved environment for orders for FEI.

Jim Ricchuiti – Needham & Company

Okay. And one final question, just as we think about your plan to double your available market by 2014, to what extent are the pieces in place in both life sciences and natural resources or do you need – I guess what I’m getting to is how much further in terms of acquisition opportunities do you have to look to really get to that point?

Don Kania

The acquisition is not required. We think we have all the pieces of the puzzle to get to that stated goal. And I think the real key here, show up at our Investor Day and we’ll take a much deeper dive in to that. But no, we have the pieces in place. It’s more about creating the products and the market understanding. And also – we’re also in the process of hiring individuals that can support, those markets with the expertise that FEI doesn’t have for example. We’ve been doing a lot of hiring in the oil and gas area. Just hired an ex-Schlumberger executive there to make sure that we have the insight to an expertise in that industry. Those become the pacing items. That’s why it doesn’t happen magically overnight.

Needham & Company

Fair enough. Thank you.

Operator

Thank you. And our next question comes from the line of Derik de Bruin with Bank of America. Please go ahead.

Derik de Bruin – Bank of America

Hi. Good afternoon.

Don Kania

Hi, Derik.

Derik de Bruin – Bank of America

Hi. As a life sciences analyst, I just wanted to ask you a couple of questions on the revenue projections in life sciences market does sound like you did have a couple of big orders that got delayed. But I mean when you look at the seasonality in that business and I realized last year was a little bit different. Is it 1Q little softer, 2Q little stronger, 3Q or a little bit stronger or a little bit softer than 2Q and then 4Q a much bigger number, you expect that seem to have a projection this year, as well?

Don Kania

I think it’s more half-to-half stores by the better way to look at it, for us because we’re a bit granular. But usually the front half is weaker than the second half and there’s a lot of dynamics you could pretend to explain that. That’s just what typically happens. And so you see the budget flush for, two to three ratio depends a lot on timing, because the euros, I’ll like to go on vacation. And Q2 has been seasonally a little bit slow for us occasionally. So I don’t know – that’s a tough call to make between two and three. But once usually, you’re coming off for four, usually slow.

Derik de Bruin – Bank of America

Okay.

Don Kania

One slow, four very fast and two, three is a tough call. So I like to think half-to-half.

Derik de Bruin – Bank of America

Okay. That’s very helpful. Hey, it’s certainly based upon your last conference call and you kind of talked about this – discussions about the second half of the year. It does sound like I would say you’re incrementally a little bit more positive on your kind of outlook for the back half?

Don Kania

I think we’re just getting – you get closer to it, you can see things. I would say, in particular, our visibility electronics is much better than it has ever been probably, because as we become more important to that customer base, we’re getting more of an intimate relationship with them. And then the rest is our, I would say, it’s our typical pipeline, looking at our pipelines. So we feel – if you look at that, you look at the customer interactions and yeah, we expect to see that typical seasonal front half to the back half improvement.

Derik de Bruin – Bank of America

Great. I’ll get back in queue. Thank you.

Don Kania

Sure.

Operator

Thank you. And we have a question from the line of Tycho Peterson with JPMorgan. Please go ahead.

Tycho Peterson – JPMorgan

Hey, good afternoon. Don, in your commentary, you talked about strong growth in the service business as I think some of the placements from 2010 come off of warranty, maybe just talk a little bit about your outlook on service overall and I think you’ve talked about kind of high single digit-growth long term, so how do we kind of reconcile those components and what does the service growth rate look like going forward and what’s the opportunity to maybe capture share?

Don Kania

Well, I think share is pretty much dominated by us because it’s proprietary work that we do. There is not a lot of alternate parties that provide service to our products. So I think what we would argue generally is that we should see high – maybe slightly higher than we’ve seen in the past, single digit growth in the area, like to be surprised with the upside, but I don’t think we do that right now. We’ve got things rolling off warranty, we also have much more effective marketing programs than we’ve had in the past, in terms of getting customer conversion as opposed - to contracts versus timing materials, which is from a efficiency perspective, superior for us and superior value to the customer.

So those are the trends I’d look at. We’ll see a little bit more, but you got to remember the installed base is 8000 plus tools. We shipped 700 a year, so that’s 10% on top. But nonetheless, you see a little bit of a boost from that as things roll off, especially on the more complicated tools. And in addition, Electronics is really good because that’s the highest percentages of conversions to contracts in the Electronics segment because they’re manufacturing and they like to be sure that those tools are going to be up and serviced by FEI.

Tycho Peterson – JPMorgan

And then maybe as we – a follow-up, as we think about the tail business, can you just talk a little bit about what the underlying growth rate is there, any milestones we should be thinking about and overall, how big of an opportunity is optical microscopy for you guys?

Don Kania

Optical in a standalone is not our goal here. I want to be clear. Though we will get some, we will get sales from that, our primary goal is producing that FEI only correlative solution, which we believe both from a optical to TEM and an optical to DualBeam to this various routes to sophisticated coupling of the two classes of imaging, that’s where the real win for FEIs . And so in terms of milestone, look for our product introductions, new products, that will be the first sign of that we’re getting traction in moving forward. And then we can talk to you about the order flow after that. I think in terms of characterizing the served market, I’ll - roughly I think we are thinking $150 million of served markets falling in to our last year of late. We will be more specific in June, we’re kind of pulling all those numbers together, but think about it and I’ll tell you 100 million to 200 million. We already have visibility too by the way to think about it with optical in our core right now.

Tycho Peterson – JPMorgan

Great, thank you very much.

Operator

Thank you. And our next question comes from the line of David Duley with Steelhead Securities. Please go ahead.

David Duley – Steelhead Securities

Yeah. A couple of questions from me, I was interested in the Electronics business, you mentioned you’re seeing strength from the memory guys. When do you expect the foundry folks to show up at the table or already there that just the memory guys are a little bit stronger. If you could just give us a little bit more granularity about what’s going on?

Don Kania

Dave, what I would say is sometimes before the end of the year.

David Duley – Steelhead Securities

Okay.

Don Kania

Yeah, it’s hard to be specific about cores of a specific subset. I would say that we’ve been pretty intimate about all the foundry – the major foundry players. And we have a very strong sense that those that need to develop process improvements see more value in FEI than they did a year ago. And so I think we’ll see some good investments from the two major players in this segment before the year is out.

David Duley – Steelhead Securities

Is the amount of dollars that you are capturing from the memory guys increasing with the move below 32 nanometer?

Don Kania

Yes.

David Duley – Steelhead Securities

Do you expect the same kind of bulge from the foundry or are you already there from the foundry and it’s just a matter of having them move forward with 28 nanometer process?

Don Kania

Yeah. The foundry side, that’s varied a lot with customers. Certainly, customers have always been – or have come from a focus of process development and have been very good FEI customers. Others who are now ramping up in the world of process development, trying to be leaders in that area, we see significant expansion potential in their spend.

David Duley – Steelhead Securities

Okay. And should we come to expect the gross margin in electronics area to kind of be at this level that it was at the most recent quarter?

Don Kania

No, I don’t think there is any radical changes from that in the short term.

David Duley – Steelhead Securities

Okay. And then with electronics gross margin, I did notice that revenue was up pretty nicely, but the margin was flat. So I imagine there’s a change in mix there, is it just.

Don Kania

Yeah. As always, mix is the answer.

David Duley – Steelhead Securities

Okay. That’s it for me. Thank you.

Don Kania

Thank you, sir.

Operator

Thank you. And our next question comes from the line of Mark Miller with Noble Financial Capital Markets. Please go ahead.

Mark Miller – Noble Financial Capital Markets

Congratulations everyone on another great quarter. Looking ahead, like you said you’re benefiting from electronics. Can another driver be starting next year -- do you think that’s going to increase the need for your equipment?

Don Kania

I think – you may realize the offer this product called the Vion product, which is our high-speed milling tool that’s in with a variety of customers looking at some of those issues and also some packaging related issues. I think it’s a TBD still at this point. But I think it’s an area that we’re probing into.

Mark Miller – Noble Financial Capital Markets

Europe held up pretty well for you. You’ve mentioned it before, did you -- have you seen any roll off so far this quarter?

Don Kania

This quarter with our general back end loading in most of our transactional activities that FEI has no data even to think about.

Mark Miller – Noble Financial Capital Markets

Okay, thank you.

Operator

Thank you. And we have a question from the line of Patrick Ho with Stifel Nicolaus. Please go ahead.

Patrick Ho – Stifel Nicolaus

Thank you very much. Don, maybe if you can give a little more color or just add a little bit of detail in terms of some of the comments you just made about the electronics business and the semiconductor. What are some of the process techniques that say, the foundries are doing -- that are doing now, that’s increasing, I guess the capital spend for your tools?

Don Kania

Yeah. And I think that, I alluded to the few words in the prepared text. We talked about yield, we talked about methodology. And effectively we talked about inspection. And what we’re seeing is a trend for the customer base. So that’s all customers to pull us more intimately in to areas that are more closely tied to revenue generation by the semiconductor manufacturers. Not going in line, the usual caveats on all that. But becoming more central to that, but that requirement and that’s all you get the 2X and certainly 1X nodes, you need to buy more FEI stuff at least that’s our interpretation of the customer input to be in the game.

And so the leading edge guys, both in memory and logic, we have tremendous intimacy with them, which is grown. We see what their pathways going forward are. A good fraction of the foundry business, we have that same level of intimacy and it’s expanding with others. So we feel pretty good about all those trends, trend is our friend here. Things are getting harder. And we see that people are migrating to look to FEI for these more substantive answers than as we would have talked about a few years ago, just FEI, like failure analysis. So that’s a -- I would say in a macro sense, a very positive trend for the next few years.

Patrick Ho – Stifel Nicolaus

Great. In terms of your path to the 47.5 gross margin target that you outlined, you gave some of the variables in the past about moving to the Czech Republic, product mix and those type of variables. How much of an impact do you believe your shift back in house manufacturing to Hillsboro, how much -- I guess when and how much do you believe that will have an impact towards your targeted goal?

Ray Link

Patrick, it’s Ray. We’ve completed the transition over. So we’re now running the factory under an FEI management. So that’s been completed. It will take about two quarters to get the full benefit and that has to do with the fact that we have inventory that we acquired from UCT that already had to stack margin in that. Once that bleeds off, so that basically it gets us to Q4, where we should receive the full benefit of that. It’s less than 1% margin point, but it’s not an insignificant amount.

Patrick Ho – Stifel Nicolaus

Great, thank you.

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Tom Diffely with D.A. Davidson & Company. Please go ahead.

Tom Diffely – D.A. Davidson & Company

Yeah, afternoon. I guess first, I want to thank you guys for having a solid quarter, what’s been a pretty volatile earnings season here. It’s always good to see. So well first question on the taxes, you give us the 22% goal for this year. Can you view that as a long-term tax rate and just specifically, it sounds like that includes what’s equivalent to the R&D tax credit in Europe, but not in the U. S., is that correct?

Don Kania

Tom, I would call that our current long-term right to expand anything in taxes as long-term, but when you put together a model going out of couple of years, that’s a fair rate to use. There are so many different variables between when the U. S. is going to -- the R&D credit rolls on, rolls off, we’ve got situations in Europe, we’ve got some favorable tax structures in the Czech Republic and in Holland and those ones could be pretty well locked and loaded for the near-term. So, there is going to be some variability. We like to think 22% as a good guidance rate. Like everything, we try to do better than our guidance. But I think if you’re building a longer term model, that’s just a fair rate to use.

Tom Diffely – D.A. Davidson & Company

Okay. I mean then Don, just related to your correlated business, is there a kind of a standard suite of products that goes into that and is there any kind of specialty computing that you need as well?

Don Kania

Okay. So in the correlated area, I think there is some – I just want to be sure. There is software and there is actually quite sophisticated software that goes into that business like the maps. But in terms of computational intensity, it’s really our structural biology business that is the most computationally intensive. So that’s the thing we’re doing with NIH.

Tom Diffely – D.A. Davidson & Company

Okay.

Don Kania

So, we are actually, I’d just say, generally exploring one of the right options for customers in that space, which typically has an intensity to be local clusters, GPU class clusters and things like that. So these are very, very high-performance computing environments that people use to support the tools.

Tom Diffely – D.A. Davidson & Company

Okay. And then if you look at the oil and gas industry, it sounds like you have some nice business in the labs. Is that a precursor to the field or is that a different set altogether?

Don Kania

Generally, the laboratory support is going in the direction of unconventionals. That’s where people are buying equipment to understand the rocks associated with unconventional. I would say that’s going to build on, if you remember, two of our – one of our three beta size was in fact unconventional and it’s still ongoing in Poland. That seems to be a pretty rife area, because people know nothing. I mean, there is a lot of ignorance, which is reflected in the purchase of tools to try to understand more, more technical tools at our well site solution, but we think the well site solution has a nice used case or I’d just call it a potential used case in unconventional shale. So we’re going to let that play forward, so they are related and one may in fact enable the other. That is the research by these customers could potentially help our field applications become more important.

Tom Diffely – D.A. Davidson & Company

Okay. And then when you look at the kind of the thousands of sites out there, is there a certain subset that seems to be kind of your first approach or first attack?

Don Kania

Yeah. We’ve got a very specific list of used cases, but we’re not going to talk about those right now.

Tom Diffely – D.A. Davidson & Company

Okay. Alright.

Don Kania

You want to have a healthy competition.

Tom Diffely – D.A. Davidson & Company

Thanks.

Operator

And gentlemen, I’m showing no further questions in queue at this time. Please continue.

Fletcher Chamberlin – Treasurer and Communications Director

Thank you very much everyone. We appreciate it. This is Fletcher. If you’d like to come to the June 7th meeting, send me an email or you may call us 503-726-7710. We look forward to seeing a lot of you in June and if you want to come Oregon before that. So thanks very much for being in the call.

Operator

Ladies and gentlemen, that concludes our call for today. Thank you very much for your participation. You may now disconnect.

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