II-VI Incorporated F2Q08 (Qtr End 12/31/07) Earnings Call Transcripts

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 |  About: II-VI Incorporated (IIVI)
by: SA Transcripts

II-VI Incorporated (NASDAQ:IIVI)

F2Q08 (Qtr End 12/31/07) EarningsCall

January 22, 2008 9:00 am ET

Executives

Craig Creaturo - Chief FinancialOfficer and Treasurer

Francis Kramer - President andChief Executive Officer

Analysts

Avinash Kant - Broadpoint Capital

Pierre Maccagno - Needham & Company

Ian Fleischer - FBR CapitalMarket

Dave Kang - Roth Capital Partners

Chris McDonald - Kennedy Capital

Jim Hollister - Private Investor

Operator

Good morning my name Shekinah andI will be your conference operator today. At this time, I would like to welcomeeveryone to the II-VI Incorporated Second Quarter and Fiscal Year 2008 EarningsConference Call. (Operator Instructions)

Thank you. At this time, I wouldnow like to turn the conference over to Mr. Craig Creaturo, Chief FinancialOfficer and Treasurer. Please go ahead sir.

Craig Creaturo - Chief Financial Officer and Treasurer

Thank you, Shekinah, and goodmorning to everyone. I am Craig Creaturo, Chief Financial Officer and Treasurerof II-VI Incorporated. Welcome to the second quarter fiscal year 2008 II-VIIncorporated investor teleconference. As a reminder, this teleconference isbeing recorded on Tuesday, January 22, 2008.

The forward-looking statements wemay make during this teleconference speak as of today, and we do not undertakeany obligation to update these statements to reflect events or circumstancesoccurring after today.

Francis Kramer - President and Chief Executive Officer

Thank you, Craig, for theintroduction. I am Francis Kramer, President and CEO of II-VI Incorporated.Today, I will address a half dozen highlights that shaped our second quarterresults.

First, in our compoundsemiconductor group, the Wide Bandgap Materials group continues to make recordshipments of semi-insulating silicon carbide substrates to the RF applicationsmarket in North America. Potential customersin Asia are running multiple lots of oursubstrates through their manufacturing line with the expectation of successfulwafer qualification during their current calendar year.

We continue to transition morecapability to our new production facility in Starkville, Mississippi.Newly built premises in our recently expanded crystal growth facility in New Jersey have alreadystarted producing all crystals for commercial sales.

On the technical front, we aremaking progress in a large diameter crystal growth and wafer fabricationtechnology. And we continue to make deliveries of 100 millimeter semi-insulatingwafers to our government partners for evaluation. We are on track to release involume 100 millimeter wafers to the industry this calendar year.

Second. The second quarter waspositive from Marlow Industries. During the quarter, bookings in the defense,space and photonics market and the industrial markets increased significantly,while bookings for the telecom market was only slightly higher and the medicalmarket was lower compared to the first quarter. Revenues increasedsignificantly in the defense, space and photonics, telecom and medical markets,and showed a significant decrease in the industrial markets when compared to Q1as was expected.

Progress is being made by theproduct development and account management team. And as a result, we expect tosee an increase in industrial revenues in the second half of this year. Duringthe quarter, Marlow received a follow-on order from Sandia National Labs for thermoelectricpower generation generators based on Marlow's advanced technology. Also, ourlargest medical customer's next-generation product introduction, whichcontinued to experience delays in the second quarter, is now expected to startproduction in our Vietnamfacility during the third quarter.

Next, in our military and materialssegment, the Exotic Electro-Optics subsidiary completed negotiations during thequarter on a multiyear pricing agreement with this customer to produce sapphirewindow shrouds for the Advanced Targeting Pod, which is flown on the F15 andF16 fighter aircraft. The five-year pricing agreement implies to new ordersreceived through December 31, 2011, and solidifies Exotic's position as thesole source supplier of this high-performance product.

Consecutive with the execution ofthis agreement, Exotic Electro-Optics received a $5.9 million order forAdvanced Targeting Pods, which represents the balance of funding from initiallong-lead funding received in the first quarter. We recorded $2.3 million ofthis order in the second quarter due to our practice of not booking orders thatextend greater than 12 months. With the Exotic business unit during thequarter, profits exceeded forecast due to improved manufacturing yields, lowerscrap expenses and improved margins in our sapphire business unit.

The Pacific Rare Specialty Metalsand Chemicals, PRM subsidiary, portion of our military and materials segment,had measured success restarting the raw material supply lines during thequarter by securing our third major supply contract. The first significantswing in raw material shipment against that contract was sent to PRM during thequarter. A sizable order was secured for tellurium products, which added over$4 million to our bookings for the quarter.

The pricing on this order islinked to published market prices plus a premium for our processing fees. Webelieve this pricing structure will help reduce our financial exposure relatedto market price fluctuations. And market price for tellurium products increasednearly 12% in the quarter.

At this time, the raw materialcontracts in place support our fiscal year 2008 revenue projection of over $20million. PRM has met our earnings projections for the first half of the yearand is expected to continue on this trend for the entire year. Beyond theexternal revenue projections, PRM is starting to supply both selenium andtellurium products to other II-VI businesses. You will start to see somesizeable benefits for the insourcing of these raw materials in later quarters.

At our near-IR subsidiary, VLOC,the highlights include the continued meeting and exceeding the requiredschedule for deliveries of UV filter assemblies to our primary customer.On-time deliveries and quality has been 100% on this critical system that playsa key part in protecting helicopters deployed in Iraq and throughout the world.

VLOC experienced increasedbookings in each of the non-UV filter product lines driven by strong militaryand medical laser market orders. Increased medical bookings led to record 0.5million parts being manufactured this quarter in our Vietnam facility. YAG operationsimproved again during the quarter, while progress continued transferringadditional YAG fabrication configurations to Asia.

In the IR optics division,bookings in the second quarter exceeded those in the same period of last yearby 25%, breaking our previous quarterly bookings record by nearly 10%. Firsthalf totals for the current fiscal year surpassed last fiscal year by 16%.Orders levels for the quarter were boosted by large military component orders,which spilled over from the previous quarter.

In Japan, heightened demand for lasersystems increased our booking by 24% and 13%, respectively, compared to thesame quarter and first half of last fiscal year. Replacement optics orderlevels help make the second quarter the highest-ever for II-VI in Japan.Strength also in bookings from our Chinaoffice, which was up 29% over the first half of last year, confirmed reportsfrom OEMs in both Europe and Japanthat laser system sales growth rates remain very high in Asia.

Despite worries about a slowing US economy and its effect on the world, the USaftermarket bookings remain strong. Indeed, US job shop spending increased in2007 and is expected to remain high in 2008. According to the 2008 GardnerResearch's 40th Annual Capital Spending Survey, aerospace and medicalindustries cap their spending and work was largely outsourced to metalfabrication job shops.

As expected for the quarter, wehad to forgo material sales opportunities due to zinc selenide and zinc sulfidegrowth capacity limitations, resulting in an approximate 20% decline over thefirst six months of last fiscal year on these materials. However, withadditional capacity now available, this will allows us to reverse these resultslater in the fiscal year to take advantage of the many opportunities that stillawaits suppliers of component blanks for several government security andsurveillance programs.

Zinc selenide growth yieldsimproved during the quarter, as did the quantity of material produced. Thefirst furnace output from our newly added capacity was qualified successfullyin December. Concerns over the USeconomy have left many industry forecasted conflicted over CO2 laser systemgrowth in 2008. Many economic indicators are raised as concerns. A downturn inthe economy would affect II-VI first with a decline in our US aftermarket sales, which-to-datewe have not observed.

According to the recent January2008 market survey and forecast by Laser Focus World, the laser market grew 24%in 2007 versus a 7% forecast. On the nondiode side, laser side materialsprocessing was the key driver growing 31% in 2007. For 2008 Laser Focus Worldexpects the rate of growth for nondiode laser sales at about 10%. At II-VI weare prepared for a range of growth rates from that forecasted for last year towhat actually happened last year.

We are currently positioned witha strong backlog of products for all business units, which gives a solidfooting as we head into the second half of fiscal year 2008. We expect ourfinancial performance and cash generation to continue as we build our existingbusinesses and look for new opportunities that will grow the company for thebenefit of the shareholders.

Craig, this concludes my preparedcomments.

Craig Creaturo - Chief Financial Officer and Treasurer

Thank you, Fran. There areseveral items that I would like to draw your attention to from the justcompleted quarter.

First, we described in the pressrelease the gain that was recorded from our sale of our investment in 5NPlus.The pre-tax book gain on the sale was $26.5 million and the after-tax book gainwas $15.9 million. Once the book tax differences are taken into consideration, thepre-tax gain that we will pay income taxes on was approximately $28.5 million. II-VIreceived a consideration from the sale in Canadian dollars, and by December 31,2007 had converted substantially all of these funds to US dollars.

During the quarter, we recognizedour final equity earnings in 5NPlus as a component of other income ofapproximately $350,000. Because of this disposal, the major item that appearsin the investments line item of the December 31st, 2007 balance sheet is the carryingvalue of the company's minority investment in Fuxin Electronic, which we madein March 2007.

Second, we were able to use thefunds from 5NPlus investment sale along with strong cash generated fromoperations during the quarter to significantly reduce our debt. As of December31, 2007 the only component of debt that we have is a Yen denominated loan thatacts as a natural balance sheet hedge for our operations in Japan. It is currently our plan tomaintain this Yen debt instrument in addition to having access to our $60 millionline of credit facility.

Third, during the third quarterwe will be making a tax payment due from the sale of 5NPlus of approximately$10.6 million. We also used cash earlier this month in January to fund theinitial payments required for the HIGHYAG transaction. Besides these two usesof cash, we plan on making some further capital investments and completing ouropen stock repurchase program over the next few quarters.

Fourth. Even when the impact ofthe 5NPlus investment sale was removed, the just completed quarter was a recordquarter for EBITDA at $19.3 million, topping the mark we set two quarters agoand resulting in a quarterly EBITDA margin of 26%. Our trailing 12 monthsEBITDA of $72.6 million excluding the impact of the 5NPlus investment sale atDecember 31, 2007 increased by $9 million or 14% from one year ago.

Fifth. While our gross margin forthe quarter at 42.9% was lower than the second quarter of last fiscal year, itdid improve nicely from the 40.1% gross margin level from the first quarter,and exceeded our fiscal year 2007 gross margin level. Our military andmaterials and compound semiconductor businesses both posted solid gross margingains during the quarter.

The infrared optics business alsomade some gross margin improvements during the quarter, and furtherimprovements are expected for the remainder of the fiscal year as our materialgrowth yields improve and we utilize the capacity expansion of the zinc-basedmaterials portion of this business.

Sixth. The effective tax rate forthe quarter was 35.5%, which was significantly higher than the 27% rate for thefirst quarter. The rate increase is primarily due to the gain on the sale ofthe 5NPlus investment. Excluding the 5NPlus gain, the rate would have been approximately28% for the quarter.

The projected full year rate forfiscal 2008 is approximately 29.5% including the 5NPlus gain, and approximately25.5% when it is excluded. This represents an increase from the 24% rate oflast fiscal year, and reflects a higher level of US sourced income as well asan expected tax rate increase in China.

We are awaiting final Chinese taxauthority guidance that made less in the impact of this new rate increase onour operations in China.And if any tax rate reduction were to occur, then we will adjust the tax ratein the future period.

Seventh and finally, it's importantto highlight the fact that our year-to-date bookings are up 18% compared to thesame period last year. Our backlog during the quarter increased byapproximately $5.5 million and now stands at $122 million. The components ofthe December 31, 2007 backlog were infrared optics at $34 million, near-infraredoptics at $26 million, military and materials at $41 million and compound semiconductorgroup at $21 million.

This record level of backloggives us good visibility and confidence that the third quarter revenues will bea record for the company, surpassing the record revenues we achieved in thejust completed quarter. All of the II-VI business segments showed higherrevenues in the just completed quarter when compared to the first quarter ofthe fiscal year.

Fran, this concludes my preparedremarks. Before we begin the question-and-answer session, I would like tomention that these comments and answers to certain questions containforward-looking statements, which are based on current expectations. Actualresults could differ materially.

For information about factorsthat could cause the actual results to differ materially, please refer to the "RiskFactors" section of our Form 10-K for the fiscal year ended June 30, 2007.

Shekinah, we're now ready tobegin the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes fromthe line of Avinash Kant with Broadpoint Capital.

Avinash Kant

Good morning, Fran and Craig.

Craig Creaturo

Good morning.

Francis Kramer

Good morning.

Avinash Kant

One or two questions actually.First, talking about the materials used, especially on the zinc selenide andthe zinc sulfide side, you did say that you've improved by the end of Decemberquarter. Does that mean you will start to see material sales at the level thatyou had before, the yields have started going down from the March quarteronwards.

Francis Kramer

In the third quarter, we willpick-up our sales and materials, but I think it will take us fourth quarter toget back to the rate of sales that we had about a year ago. The yieldimprovement we started to hint toward the last quarter, we maybe, had improvedfrom our low point to get back to where we want to be, probably covered about15% of that distance in the first quarter.

Here in the second quarter, wepicked up another 25% of the distance. So, we are about 40% of the way back,another 60% to come, most of which I think will happen here in the thirdquarter.

Avinash Kant

So, somewhere close to 60% levelby the end of third quarter and then the rest by the end of fourth quarter, isthat a reasonable assumption?

Francis Kramer

No, when I was commenting on thisyield getting the yields of our process back to the steady state that we'd liketo, we are 40% of the way now there at the end of the second quarter. I really thinkat the end of the third quarter, we'll be more like 90%, 95% back. And so, ourlevel of sales -- while we are making that improvement, we will pickup oursales back towards the old level in the third quarter, maybe pick up half totwo-thirds of that level. And then in the fourth quarter, our sales and ouryields I think will be back.

Avinash Kant

And if you could give us someidea about your international exposure for the quarter and also how much ofrevenues are exposed to the industrial application?

Craig Creaturo

Overall, for the company,Avinash, the international sales for the quarter was right on 45%, and themajority of those international sales are going for industrial applications,specifically more operations in Japan.Fran has mentioned and highlighted that we are seeing very strong businessthere, and that is primarily going for industrial laser applications to OEMsand aftermarket users in Japan.So, that's a big driver of our international operations.

Francis Kramer

From the industrial point ofview, each one of our divisions has some industrial component with theexception of our one group, Exotic Electro-Optics. But when you weigh thatnumber, I would say 50% is industrially driven, of which the bulk of thathedged to the IR optics division.

Avinash Kant

Right. And what's the trendthere, given what's being talked about the economy in general? Have you seenany kind of slowdown or any weakness over there?

Francis Kramer

No, as I made comment in myprepared remarks, we have not seen a falloff in our aftermarket order rate,which is the best indication of how people are running their lasers. Certainly,there is the dialog that things are slowing around. We've not felt it, and wesure do not find it in our aftermarket in Japan this quarter.

Europe aftermarket is harder forus to see, because we sell mostly to the aftermarket over there through theOEMs, are kind of little bit of concern by the European OEMs and theirproduction rate here in the third and fourth quarter, but that's not theaftermarket.

So, I have to say we've not feltit, the consumer driven slowing down and therefore the slowing down of howpeople run their lasers. We have not felt it in the aftermarket at this point.

Avinash Kant

And one final question in the samevein, basically intensive visibility, Fran, typically how far out do you seeand how much clarity do you get from your customers about the future business?

Francis Kramer

Well, the aftermarket is notvisible. We really run that business more on the statistics, and it's runningsolid right now. I would say from the way its running, we could project 90 daysout that we're going to get our order rate for the aftermarket around theworld. Going further than that is very hard for us to do.

The OEMs on the other hand weprobably have 90 to 180 days. So Craig made the comment that our backlog isreally solid for the third quarter and we will have record revenues in thethird quarter. That solid we are working into the fourth quarter right now onwhat we expect, so 90 to 130-40 days is we're pretty solid.

Avinash Kant

That's pretty good. Thank you somuch.

Francis Kramer

You are welcome.

Operator

Thank you, your next questioncomes from the line of Pierre Maccagno with Needham.

Pierre Maccagno

Congratulations on the quarterFrancis and Craig.

Francis Kramer

Thanks Pierre.

Pierre Maccagno

Can you tell us again how muchbusiness, zinc selenide business did you forego during the quarter and do youbelieve you might have lost share there or is it something you can recover?

Francis Kramer

Yeah, I made the comment in myprepared remarks that we were 20% off quarter over last year's similar quarter,because we didn't have the capacity to quote. So we really don't break out whatour total material sales are, so I am only able to give you a relative, we weredown 20%. But it's really a profitable product, so when we resume our shipmentsin that area, third quarter and for sure in the fourth quarter, it does have anice gross margin help.

Pierre Maccagno

You will continue growingcapacity for several more quarters or are you mostly done?

Francis Kramer

Oh no, we don't agree to it. Weare going to grow more, certainly this return to the yields that we have had inthe past. That will help us here in the third quarter and we're bringing on thecapacity expansion that we outlined in prior calls. We have the facility we'reputting in and quite a bit of capacity. We started to see the first of thatcapacity late in the quarter in December qualifying the material out of thesenew furnaces, take some time very important to have everything and safe andproperly operating, and we are on our way there, we'll get more of that newcapacity in the third and fourth quarter.

Pierre Maccagno

So basically have you tweaked theprocess now or are you getting more capacity of your existing furnaces?

Francis Kramer

That would be one portion ofwhere we are getting the capacity from, we have a gradual deterioration in ouryields, year, year-and-a-half ago, we have been working on getting that back inorder, and we've picked up getting back to the yield level we want on our olderfurnaces. 40% of the way there in the first and second quarter combined, Ithink we'll get the rest of the way back to where we've been here in the thirdquarter.

So that's a big help on ourcapacity, and the second big help is the new furnaces we're bringing online.We've been a year building them, and now it's starting to produce product.

Pierre Maccagno

Can you remind us, what is theCapEx for the year?

Craig Creaturo

Pierre, we're anticipating somewhere between$18 million and $20 million through the six months that we just ended back inDecember. Capital spending has run about right in the middle of that range,just right over $9 million.

Pierre Maccagno

Okay. And finally, how do youexpect the depreciation of the dollar to affect the business?

Craig Creaturo

For 2006, it's an interestingquestion for us, Pierre. In some ways that does help us, for instance in ourinternational sales operations, specifically in Japan, to a lesser extent inGermany, that depreciation in the US dollar, actually that's helped us a littlebit, but on a flipside, we do have the manufacturing operations in our Asianoperations, which are mostly tied and closely related to the dollar. So ouroperations in Singapore, China, Vietnam,and even in the Philippinesthat goes the other way for us.

So roughly speaking I mean, Ithink its kind of a mix bag for us we're fortunate that we're fairly balancedthere is not a hard and fast rule for II-VI and if the dollar appreciate itsbad or good, it's a little bit of both for us and, because some of thefunctional currency in our Asian manufacturing, as a functional currency is theUS dollar.

When we do have some deteriorationin the US dollar, some of that offset does come back to us through foreigncurrency gains. So, it's a little bit of a mix bag overall. I think thehighlights at least in the last couple of quarters have been the strengtheningin the Yen for us has been good because Japan is one of the key top two orthree markets that we service into. Fran, if you want add to...

Francis Kramer

Yes, I don't know, when I wouldmake this comment, we might have to defend it at a later stage but a 10%weakening in the US dollar against Singapore dollar and so on. I thinkit hurts us half to one gross margin point and that's been going down over thelast two years maybe as much as 20% now.

Craig Creaturo

That's right.

Pierre Maccagno

Okay. Great, thanks.

Operator

Thank you. Your next questioncomes from the line of Ian Fleischer with FBR Capital Market.

Ian Fleischer

Hi, good morning.

Francis Kramer

Hi, Ian.

Ian Fleischer

Could you comment on, you laidout your guidance for the rest of the year. What are the swing factors that getyou to or the most significant swing factors that get you to the high end ofthe guidance versus the low end?

Craig Creaturo

I think, Ian, Fran has kind oftouched on a couple of them. One is, getting back into the and seeing the continuedimprovement of the zinc selenide yields and how that sets us up for not onlygetting back into further material sales but also allows us to participate inthe overall optics growth. I think that's one key factor. Second factor will bekind of the continued improvement segment earnings wise or bottom-line wisefrom our military materials group. They have just done a tremendous job overlast several quarters and we are really anticipating the day we will continuealong that track. I think a third factor would be PRM and in continuing to rampthat business up. As Fran mentioned in his comments, really right now thebenefits for PRM have been pretty much external to the company.

Now in the back half of the year,as far as sourcing tellurium and selenium from PRM for couple of ourbusinesses. We are going to get some cost savings and gross margin improvementbecause of that. So, I would say those were the key factors and then the onlyother item that I would put in there would be integrating HIGHYAG into thebusiness mix. We did include that in the forecast. We are expecting therevenues of HIGHYAG for the second half of fiscal year '08 to be roughly $4million to $5 million or so with a little bit of improvement, with little bitof help on the bottomline.

So that is a factor that thatwe'll roll on and get them engrained and get them in the II-VI familybusinesses here and have them start reporting earnings as soon as this quarterthat we're about ready to enter in March.

Francis Kramer

Ian, I would add an importantthing also to hit that high end of the earnings guidance we have is, we need tobe near the high end of our revenues and bookings. And right now, we have astrong backlog for the third quarter, but to make the high end number we needgood bookings that would come in late February and March. So, that last $2million or $3 million of shipments we are projecting. We are projecting thebookings and everything looks like that will happen, but in the late thirdquarter if something would change it might take a little bit of the top end ofour earnings. We need those bookings and revenues to do it.

Ian Fleischer

Okay. And with respect to yourcapacity, your additions to capacity when do you expect that fully up?

Craig Creaturo

End of this fiscal year. We'vegot the two features that the recovery on yields another part of our currentfurnace production is we are expanding the amount of output we try to get ineach furnace, that development continues and will probably go past the fiscalyear. But the second feature of adding these new furnaces in our other facilitythat will happen and we think we will get all online by end of June.

Ian Fleischer

Okay and then on the PRM benefitswith respect to sourcing. When do you think you'll fully feel that benefit fromPRM?

Craig Creaturo

I think we've kind of targetedIan to get that - we are starting to see a little bit of that benefit, we aregetting through some of the older contracts that we have I think and we willstart to really see some more significant benefits this quarter in Q3,definitely in Q4 and I think as we lean in FY '09, I think for us calendar '08we should start to really realize the full benefits of that lower costs seleniumand tellurium. We have spent of a lot of work in the last six months probablyfor the first six months I should say of the PRM ownership, as far asqualification, as far as coordination et cetera and now we're really startingto – in calendar '08 we'll actually start to use them as a primary supplier fora couple of our businesses.

Ian Fleischer

And just finally on the demandside would you see a change in demand earlier in your OEM business or yourafter market business?

Francis Kramer

Well it happened earlier I thinkin the OEM business. The OEMs are out there trying to sell capital machines andthey will be able to see the auto turndown or any of those things that arecapital related the diversity that we have in the aftermarket is extraordinary.The amount of ways or applications that are out there across all differentfields is unbelievable.

And as that few of those turndown there into post of running their lasers, say, five days a week, 12 hours aday, and if they go to five days, eight hours, we feel it a little bit. But atthat same time, there is some new applications that go out there. And so,somebody else starts to buy for the aftermarket.

There is an installed base ofpeople using high-power CO2 lasers of about 50,000-55,000 units around theworld. So, they are constantly trading out their optics to get betterperformance. So, it's a diverse mix. So, we feel stillness in the OEMs.

Ian Fleischer

Great. Thanks very much.

Operator

(Operator Instructions)

Your next question comes from theline of Dave Kang with Roth Capital.

Dave Kang

Thank you. Good morning. Fran,can you remind us what the mix is between OEM versus aftermarket?

Francis Kramer

Yes. So, OEM orders to us,probably 35% to 40%, maybe 30% to 35%.

Dave Kang

Okay.

Francis Kramer

That means aftermarket straightto us the 65-70. The OEM business though that they buy from us is split. Theyare buying for their assembly line, and they are often the primary suppliersinto the aftermarket.

So, you would break that 30% oftheir business is 35 that they buy from -- that there are orders from them. Youare probably seeing not much more than 10 point out of the survey going totheir assembly line. So, you end up being about 90% aftermarket driven.

Dave Kang

Okay. And I noticed, though, yourinternational business went up by above 5 percentage points. I think lastquarter, it was about 40%. Now, it's 45%. Should we expect that mix to continueto increase going forward, especially with this US going to recession or possiblygoing to recession?

Craig Creaturo

I think we're seeing a little bitof shift there, Dave, I don't think we believe it's going to go to 50% or 55%.I think we're seeing some slight shifts there. If you look kind of back overlonger period of time over the last, say, 10 quarters or so, we've been dancingaround that 40%-42% range. Touching up to 45% is little bit of a higher markfor us, but I don't think we're anticipating any other drastic changes there.

Dave Kang

But assuming it does, I mean isthat going change your business model as far as currency situation and allthat?

Craig Creaturo

I don't think it will have a bigimpact, Dave. Again, the one that's going to have some impact would be in Japan.Again, we're getting a little bit of a pick up there as topline sales risebecause of the strength in the Japanese yen. But, overall, I don't think --that's not going to change our business model that much.

Dave Kang

Got it. And then, I was wonderingif you can comment a little bit more on the gross margins situation. Fran, youtalked about 60% still to come. So what does that mean in terms of grossmargin? Can we expect another point or so in terms of the gross marginimprovement when you capture the 60%?

Craig Creaturo

Yes. I think overall, Dave, weare expecting the margins to continue and improve. To give you a kind of aspecific number would be a little bit difficult. Fran's comments were morespecific to the infrared optics business.

We are seeing the segmentearnings in that business improve. Second quarter earnings were up as apercentage of revenue and total dollars wise versus the first quarter. Wedefinitely expect that to happen in the third and fourth quarters.

To give you a specific percentageis little bit difficult, but I mean we are very encouraged by the gross marginimprovement that we had, picking up almost 3 percentage points, 300 basispoints second quarter over first quarter.

We are trying to kind of get backin the kind of toward the mid-40s for gross margin. We have been kind ofhovering for the last three, four quarters down into the lower 40% range. Andif we target over the next two to four quarters to get back up into themid-40s, then that's overall our kind of longer-term plan.

I hope that answers yourquestions, trying to give more specific numbers. But there definitely isimprovement there, both on improved yield, selling out the capacity, gettingback into the material-only business in the infrared optics business. Those areall things that are positive for the gross margin in that business.

Dave Kang

Okay. And lastly, actually acouple of more. Regarding the UV filter, you booked about $13.5 million lastquarter. How much of that was shipped in the December quarter and when shouldwe expect another follow-on, probably another couple of more quarters or --?

Francis Kramer

Yes, maybe a quarter-and-a-half,and we probably to over that 13 -- maybe shipping 40%-50% of it. And I thinkwe're due to get an add on to that in the fourth quarter.

Craig Creaturo

And Dave, maybe to answer yourquestion about longer-term, last year, our FY'07 revenues from the UV filterbusiness was right around $20 million. We're expecting that to go up around 20%or so this year, so where the run rate that's kind of closer to $24 million,$25 million in sales for that business. So, it's not as high or not as largergrowth rate as we seen in the past, but definitely a nice solid and profitablebusiness for us.

Dave Kang

And still for helicopters, nofixed-wing aircraft at this point, correct?

Francis Kramer

Yes, no.

Dave Kang

Any update on the fixed-wingopportunities or --?

Francis Kramer

I think it's right now kind ofjust out on the debating platform. The change in politics is kind of cominginto the discussion. There could be a change in one of the wars in Iraqand good news that no fixed-wing commercial plane has been struck. So, I thinkit's in the debating mode.

There continues to be developmentactivity on the commercial platform that's been funded for two different primesto work on that, but that's as far as it's gone commercially. And I know of nofixed-wing military plane that there is a plan to put it on. Maybe our guys whoare closer might know. I know some of the slow, low-flying cargo planes havesome, but it's not a major deployment.

Dave Kang

Got it. And Craig, just a lastquestion. Can you talk about the repurchase program? How much was bought orbought back last quarter and what the plans are going forward?

Craig Creaturo

Yes, we had no activity in thatprogram, David, in the December ending quarter. We did have some activity infirst quarter Q1 of FY'08. It is our intent. On the open repurchase program, wehave about 165,000 shares that are still on the program that we have opened,and we do anticipate completing that over the next few quarters or so.

Dave Kang

Okay, thank you.

Operator

Thank you. Your next questioncomes from the line of Chris McDonald with Kennedy Capital.

Chris McDonald

Hi, Fran and Craig. Nice results.

Craig Creaturo

Hi, Chris.

Francis Kramer

Hi, Chris.

Chris McDonald

If I look back into the '05, '06,even early '07 timeframe that the margin performance in the Infrared opticsbusiness, I mean -- excuse me, was there a run rate in the upper 20s to low30s?

And I know you've had ameaningful increase in selenium costs between then and now. But I am justwondering if anything structurally has changed in that business that wouldprevent you from getting back to those kind of margin level?

Craig Creaturo

I think, Chris, it's a goodquestion. We definitely are targeting to get back in those levels. Again, Ithink this yield challenge that we have been dealing with for the last three,four quarters or so really has pushed us down to the lower 20% as we kind oframp that business up.

Part of the growth that we areexpecting for Q3 and the rest of the fiscal year is coming from infrared opticsbusinesses. As Fran and I touched on, we have a nice backlog. The products,we've taken a record level of bookings this quarter. We definitely areexpecting higher levels of revenue and doing that with the current operationsthat we have.

So, I think we have thecapability and capacity to do a lot more revenue, but not without adding a lotof cost structure in the infrared optics business. And then the other pointthen you touched on was as we transition the selenium purchases away from ourcurrent supplier and get more on supply from PRM, that will definitely help thegross margins as well.

So, I think there is nothingthat's fundamentally changed about the infrared optics business that wouldn'tbe able to put us back. Over the next several quarters, it will take a littlewhile to get there, but we should be able to get back up into the high 20% andmaybe up into the low 30s at some point.

Francis Kramer

Chris, the only thing I'd add towhat Craig said is there might be two gross margin points that are tied to thisforeign exchange, the weaker US dollar. Until that, we might not get two ofthem back. So, as Craig was saying, we are headed for 30. We are not headed for32 because of that.

Craig Creaturo

That's right.

Francis Kramer

But if you look a year ago atthis time where we're in the 28% operating segment margin for optics, when wejust did 23, I do think we'll get back to the 28-plus.

Chris McDonald

Okay, great. Thank you.

Operator

Thank you. We have a follow-upquestion from the line of Pierre Maccagno with Needham & Company

Pierre Maccagno

Yes. Can you remind us whatpercent of your business do you outsource now to external distributors? And anyfurther plans for more acquisitions in that area?

Francis Kramer

The portion of our businessthat's using distributors is fairly low. We've done some acquisitions over thelast several years in Germany and Switzerland overall, and the distributorsselling our products, if you look - lets just look at the infrared opticsbusiness, it's probably less than 5% is what I would assume would be throughdistributors. And then if you look at II-VI as a whole, some groups we do usedistributors a little bit more frequently. I would say it's probably less than10%.

So by and large, we are using ourown subsidiaries in sales and marketing locations to do those transactions. Wedon't really have that many, I think everybody has targeted the in source and Ithink one of the things we've done recently is setup our own sales andmarketing organization and trading company in China. And that obviously isanticipation of future growth in that area, but that was a start from scratchthat was not an acquisition of the distributor per se, that was actually juststarting a brand new facility.

So I don't think we have anyburning needs right now. I think some of the things we have done over the lastseveral years addressing Germany and Switzerland specifically had definitelygot a couple of their key areas to be serviced by II-VI entities rather thandistributor.

Pierre Maccagno

Thanks.

Operator

Thank you. We do have questionfrom the Jim Hollister a private investor.

Jim Hollister

Good morning, gentlemen. Onequick one have you seen any benefits from your Philippine operation yet?

Francis Kramer

Yes, in the comments I made Jimthroughout the dialogue that PRM, which is our Philippine subsidiary made oursales projections in our earnings expectations for the first half. So, that'svery, very good, we expect them to finish the year around north of $20 millionin sales and to be certainly accretive to us during the year. And the comment Imade which is really an important one is that, we have gotten some raw materialsupply contracts. We think that our pace on how we can grow that business willbe geared to the pace that which we can get these raw material supplyarrangement setup.

Jim Hollister

Very good, thank you very much.

Francis Kramer

Welcome.

Operator

We have a follow-up question fromIan Fleischer with FBR Capital Market.

Ian Fleischer

Yes just quickly, in yourinfrared optics business, can you touch on geographic areas of strength orweakness in the context of both and orders?

Francis Kramer

Lets go orders first,really-really strong in Japan,really strong in China, agood strength in Europe and good strength in the US, when I say that I am referringto the OEMs and the after market on all four of those continents or thosegeographic areas. So, not one that I can point a weakness to when I know we're alllooking for that because of what's going on in the economy. But at this momentwe have not had it, it could happen any moment or it might go on and happen.

We're tuned up to the one that'stalking maybe a [lead] up would be the OEMs in Europe.They are saying their order rate, they built a lot of factory, high-powerlasers that are running worldwide right around 5,500 units per year. That'swhat the capacity and that's what everybody has been tuning up for, headed upto 6,000 from 5,500. And I think that the Europeans on their part of it aresaying, we're not going to go on up from 5,500 to 6,000 for our portion. We'reseeing this starting to level off. So that's the segment where we get a littlebit of whiteness.

On the shipment side for ourrevenues, it's equal across to all three, four major areas. We're shipping toevery place pretty much equally according to our order book.

Ian Fleischer

Okay. And just to stay on theEuropean orders, is there a difference between Western and Eastern Europe?

Francis Kramer

Yeah. I am really referring to Western Europe. That's where one of the big high-powerOEM builders are. They are sending their machines into Eastern Europe, into the BRIC countries. And some of their strength in thelast six months has probably been headed into China,Indiaand so on.

I cannot tell there. They're onlytelling us that they're not going to go on up at much further rate at themoment, that's to start the slow of the growth rate that we're wondering aboutand more driven. And we cannot see into their order book, whether it's drivenby the writing up in the BRIC countries or is it due to a let up, or just aslight not as rapid growth in main Europe right now. We do not know that. Butthey're just signaling little bit slowing in the growth rate.

Ian Fleischer

Okay. Thanks very much.

Craig Creaturo

Welcome.

Operator

(Operator Instructions)

At this time there are no furtherquestions. Will there be any closing remarks?

Francis Kramer

Yes, Shekinah. If there are nomore questions, I would like to thank everyone for participating today. Ournext earnings release for the quarter ending March 31, 2008 is tentativelyscheduled for before the market opens on Tuesday, April 22, with a conferencecall to follow that same day at 9:00 AM Eastern Time.

Thank you for participating intoday's conference call.

Operator

Thank you. This now concludestoday's II-VI Incorporated second quarter and fiscal year 2008 earningsconference call. You may now disconnect.

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