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Executives

Craig Creaturo - Chief Financial Officer and Treasurer

Francis Kramer - President and Chief Executive Officer

Analysts

Avinash Kant - Broadpoint Capital

Pierre Maccagno - Needham & Company

Ian Fleischer - FBR Capital Market

Dave Kang - Roth Capital Partners

Chris McDonald - Kennedy Capital

Jim Hollister - Private Investor

II-VI Incorporated (IIVI) F2Q08 (Qtr End 12/31/07) Earnings Call January 22, 2008 9:00 AM ET

Operator

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

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

Craig Creaturo - Chief Financial Officer and Treasurer

Thank you, Shekinah, and good morning to everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI Incorporated. Welcome to the second quarter fiscal year 2008 II-VI Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, January 22, 2008.

The forward-looking statements we may make during this teleconference speak as of today, and we do not undertake any obligation to update these statements to reflect events or circumstances occurring after today.

Francis Kramer - President and Chief Executive Officer

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

First, in our compound semiconductor group, the Wide Bandgap Materials group continues to make record shipments of semi-insulating silicon carbide substrates to the RF applications market in North America. Potential customers in Asia are running multiple lots of our substrates through their manufacturing line with the expectation of successful wafer qualification during their current calendar year.

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

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

Second. The second quarter was positive 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 medical market was lower compared to the first quarter. Revenues increased significantly in the defense, space and photonics, telecom and medical markets, and showed a significant decrease in the industrial markets when compared to Q1 as was expected.

Progress is being made by the product development and account management team. And as a result, we expect to see an increase in industrial revenues in the second half of this year. During the quarter, Marlow received a follow-on order from Sandia National Labs for thermoelectric power generation generators based on Marlow's advanced technology. Also, our largest medical customer's next-generation product introduction, which continued to experience delays in the second quarter, is now expected to start production in our Vietnam facility during the third quarter.

Next, in our military and materials segment, the Exotic Electro-Optics subsidiary completed negotiations during the quarter on a multiyear pricing agreement with this customer to produce sapphire window shrouds for the Advanced Targeting Pod, which is flown on the F15 and F16 fighter aircraft. The five-year pricing agreement implies to new orders received through December 31, 2011, and solidifies Exotic's position as the sole source supplier of this high-performance product.

Consecutive with the execution of this agreement, Exotic Electro-Optics received a $5.9 million order for Advanced Targeting Pods, which represents the balance of funding from initial long-lead funding received in the first quarter. We recorded $2.3 million of this order in the second quarter due to our practice of not booking orders that extend greater than 12 months. With the Exotic business unit during the quarter, profits exceeded forecast due to improved manufacturing yields, lower scrap expenses and improved margins in our sapphire business unit.

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

The pricing on this order is linked to published market prices plus a premium for our processing fees. We believe this pricing structure will help reduce our financial exposure related to market price fluctuations. And market price for tellurium products increased nearly 12% in the quarter.

At this time, the raw material contracts in place support our fiscal year 2008 revenue projection of over $20 million. PRM has met our earnings projections for the first half of the year and is expected to continue on this trend for the entire year. Beyond the external revenue projections, PRM is starting to supply both selenium and tellurium products to other II-VI businesses. You will start to see some sizeable 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 required schedule for deliveries of UV filter assemblies to our primary customer. On-time deliveries and quality has been 100% on this critical system that plays a key part in protecting helicopters deployed in Iraq and throughout the world.

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

In the IR optics division, bookings in the second quarter exceeded those in the same period of last year by 25%, breaking our previous quarterly bookings record by nearly 10%. First half 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 laser systems increased our booking by 24% and 13%, respectively, compared to the same quarter and first half of last fiscal year. Replacement optics order levels help make the second quarter the highest-ever for II-VI in Japan. Strength also in bookings from our China office, which was up 29% over the first half of last year, confirmed reports from OEMs in both Europe and Japan that laser system sales growth rates remain very high in Asia.

Despite worries about a slowing US economy and its effect on the world, the US aftermarket bookings remain strong. Indeed, US job shop spending increased in 2007 and is expected to remain high in 2008. According to the 2008 Gardner Research's 40th Annual Capital Spending Survey, aerospace and medical industries cap their spending and work was largely outsourced to metal fabrication job shops.

As expected for the quarter, we had to forgo material sales opportunities due to zinc selenide and zinc sulfide growth capacity limitations, resulting in an approximate 20% decline over the first six months of last fiscal year on these materials. However, with additional capacity now available, this will allows us to reverse these results later in the fiscal year to take advantage of the many opportunities that still awaits suppliers of component blanks for several government security and surveillance programs.

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

According to the recent January 2008 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 materials processing was the key driver growing 31% in 2007. For 2008 Laser Focus World expects the rate of growth for nondiode laser sales at about 10%. At II-VI we are prepared for a range of growth rates from that forecasted for last year to what actually happened last year.

We are currently positioned with a strong backlog of products for all business units, which gives a solid footing as we head into the second half of fiscal year 2008. We expect our financial performance and cash generation to continue as we build our existing businesses and look for new opportunities that will grow the company for the benefit of the shareholders.

Craig, this concludes my prepared comments.

Craig Creaturo - Chief Financial Officer and Treasurer

Thank you, Fran. There are several items that I would like to draw your attention to from the just completed quarter.

First, we described in the press release 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 gain was $15.9 million. Once the book tax differences are taken into consideration, the pre-tax gain that we will pay income taxes on was approximately $28.5 million. II-VI received 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 recognized our final equity earnings in 5NPlus as a component of other income of approximately $350,000. Because of this disposal, the major item that appears in the investments line item of the December 31st, 2007 balance sheet is the carrying value of the company's minority investment in Fuxin Electronic, which we made in March 2007.

Second, we were able to use the funds from 5NPlus investment sale along with strong cash generated from operations during the quarter to significantly reduce our debt. As of December 31, 2007 the only component of debt that we have is a Yen denominated loan that acts as a natural balance sheet hedge for our operations in Japan. It is currently our plan to maintain this Yen debt instrument in addition to having access to our $60 million line of credit facility.

Third, during the third quarter we 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 the initial payments required for the HIGHYAG transaction. Besides these two uses of cash, we plan on making some further capital investments and completing our open stock repurchase program over the next few quarters.

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

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

The infrared optics business also made some gross margin improvements during the quarter, and further improvements are expected for the remainder of the fiscal year as our material growth yields improve and we utilize the capacity expansion of the zinc-based materials portion of this business.

Sixth. The effective tax rate for the quarter was 35.5%, which was significantly higher than the 27% rate for the first quarter. The rate increase is primarily due to the gain on the sale of the 5NPlus investment. Excluding the 5NPlus gain, the rate would have been approximately 28% for the quarter.

The projected full year rate for fiscal 2008 is approximately 29.5% including the 5NPlus gain, and approximately 25.5% when it is excluded. This represents an increase from the 24% rate of last fiscal year, and reflects a higher level of US sourced income as well as an expected tax rate increase in China.

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

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

This record level of backlog gives us good visibility and confidence that the third quarter revenues will be a record for the company, surpassing the record revenues we achieved in the just completed quarter. All of the II-VI business segments showed higher revenues in the just completed quarter when compared to the first quarter of the fiscal year.

Fran, this concludes my prepared remarks. Before we begin the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements, which are based on current expectations. Actual results could differ materially.

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

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

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the 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 and the zinc sulfide side, you did say that you've improved by the end of December quarter. Does that mean you will start to see material sales at the level that you had before, the yields have started going down from the March quarter onwards.

Francis Kramer

In the third quarter, we will pick-up our sales and materials, but I think it will take us fourth quarter to get back to the rate of sales that we had about a year ago. The yield improvement we started to hint toward the last quarter, we maybe, had improved from our low point to get back to where we want to be, probably covered about 15% of that distance in the first quarter.

Here in the second quarter, we picked 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 third quarter.

Avinash Kant

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

Francis Kramer

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

Avinash Kant

And if you could give us some idea about your international exposure for the quarter and also how much of revenues are exposed to the industrial application?

Craig Creaturo

Overall, for the company, Avinash, the international sales for the quarter was right on 45%, and the majority 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 business there, and that is primarily going for industrial laser applications to OEMs and aftermarket users in Japan. So, that's a big driver of our international operations.

Francis Kramer

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

Avinash Kant

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

Francis Kramer

No, as I made comment in my prepared 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 we sure do not find it in our aftermarket in Japan this quarter.

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

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

Avinash Kant

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

Francis Kramer

Well, the aftermarket is not visible. We really run that business more on the statistics, and it's running solid right now. I would say from the way its running, we could project 90 days out that we're going to get our order rate for the aftermarket around the world. Going further than that is very hard for us to do.

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

Avinash Kant

That's pretty good. Thank you so much.

Francis Kramer

You are welcome.

Operator

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

Pierre Maccagno

Congratulations on the quarter Francis and Craig.

Francis Kramer

Thanks Pierre.

Pierre Maccagno

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

Francis Kramer

Yeah, I made the comment in my prepared 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 what our total material sales are, so I am only able to give you a relative, we were down 20%. But it's really a profitable product, so when we resume our shipments in that area, third quarter and for sure in the fourth quarter, it does have a nice gross margin help.

Pierre Maccagno

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

Francis Kramer

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

Pierre Maccagno

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

Francis Kramer

That would be one portion of where we are getting the capacity from, we have a gradual deterioration in our yields, year, year-and-a-half ago, we have been working on getting that back in order, and we've picked up getting back to the yield level we want on our older furnaces. 40% of the way there in the first and second quarter combined, I think we'll get the rest of the way back to where we've been here in the third quarter.

So that's a big help on our capacity, 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 the CapEx 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 in December. Capital spending has run about right in the middle of that range, just right over $9 million.

Pierre Maccagno

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

Craig Creaturo

For 2006, it's an interesting question for us, Pierre. In some ways that does help us, for instance in our international sales operations, specifically in Japan, to a lesser extent in Germany, that depreciation in the US dollar, actually that's helped us a little bit, but on a flipside, we do have the manufacturing operations in our Asian operations, which are mostly tied and closely related to the dollar. So our operations in Singapore, China, Vietnam, and even in the Philippines that goes the other way for us.

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

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

Francis Kramer

Yes, I don't know, when I would make 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 think it hurts us half to one gross margin point and that's been going down over the last two years maybe as much as 20% now.

Craig Creaturo

That's right.

Pierre Maccagno

Okay. Great, thanks.

Operator

Thank you. Your next question comes 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 laid out your guidance for the rest of the year. What are the swing factors that get you to or the most significant swing factors that get you to the high end of the guidance versus the low end?

Craig Creaturo

I think, Ian, Fran has kind of touched on a couple of them. One is, getting back into the and seeing the continued improvement of the zinc selenide yields and how that sets us up for not only getting back into further material sales but also allows us to participate in the overall optics growth. I think that's one key factor. Second factor will be kind of the continued improvement segment earnings wise or bottom-line wise from our military materials group. They have just done a tremendous job over last several quarters and we are really anticipating the day we will continue along that track. I think a third factor would be PRM and in continuing to ramp that business up. As Fran mentioned in his comments, really right now the benefits 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 our businesses. We are going to get some cost savings and gross margin improvement because of that. So, I would say those were the key factors and then the only other item that I would put in there would be integrating HIGHYAG into the business mix. We did include that in the forecast. We are expecting the revenues of HIGHYAG for the second half of fiscal year '08 to be roughly $4 million to $5 million or so with a little bit of improvement, with little bit of help on the bottomline.

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

Francis Kramer

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

Ian Fleischer

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

Craig Creaturo

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

Ian Fleischer

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

Craig Creaturo

I think we've kind of targeted Ian to get that - we are starting to see a little bit of that benefit, we are getting through some of the older contracts that we have I think and we will start 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 '08 we should start to really realize the full benefits of that lower costs selenium and tellurium. We have spent of a lot of work in the last six months probably for the first six months I should say of the PRM ownership, as far as qualification, as far as coordination et cetera and now we're really starting to – in calendar '08 we'll actually start to use them as a primary supplier for a couple of our businesses.

Ian Fleischer

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

Francis Kramer

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

And as that few of those turn down there into post of running their lasers, say, five days a week, 12 hours a day, and if they go to five days, eight hours, we feel it a little bit. But at that 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 of people using high-power CO2 lasers of about 50,000-55,000 units around the world. So, they are constantly trading out their optics to get better performance. 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 the line 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 straight to us the 65-70. The OEM business though that they buy from us is split. They are buying for their assembly line, and they are often the primary suppliers into the aftermarket.

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

Dave Kang

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

Craig Creaturo

I think we're seeing a little bit of 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 over longer period of time over the last, say, 10 quarters or so, we've been dancing around that 40%-42% range. Touching up to 45% is little bit of a higher mark for us, but I don't think we're anticipating any other drastic changes there.

Dave Kang

But assuming it does, I mean is that going change your business model as far as currency situation and all that?

Craig Creaturo

I don't think it will have a big impact, 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 rise because 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 wondering if you can comment a little bit more on the gross margins situation. Fran, you talked about 60% still to come. So what does that mean in terms of gross margin? Can we expect another point or so in terms of the gross margin improvement when you capture the 60%?

Craig Creaturo

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

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

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

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

I hope that answers your questions, trying to give more specific numbers. But there definitely is improvement there, both on improved yield, selling out the capacity, getting back into the material-only business in the infrared optics business. Those are all things that are positive for the gross margin in that business.

Dave Kang

Okay. And lastly, actually a couple of more. Regarding the UV filter, you booked about $13.5 million last quarter. How much of that was shipped in the December quarter and when should we 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 think we're due to get an add on to that in the fourth quarter.

Craig Creaturo

And Dave, maybe to answer your question about longer-term, last year, our FY'07 revenues from the UV filter business 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 larger growth rate as we seen in the past, but definitely a nice solid and profitable business for us.

Dave Kang

And still for helicopters, no fixed-wing aircraft at this point, correct?

Francis Kramer

Yes, no.

Dave Kang

Any update on the fixed-wing opportunities or --?

Francis Kramer

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

There continues to be development activity on the commercial platform that's been funded for two different primes to work on that, but that's as far as it's gone commercially. And I know of no fixed-wing military plane that there is a plan to put it on. Maybe our guys who are closer might know. I know some of the slow, low-flying cargo planes have some, but it's not a major deployment.

Dave Kang

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

Craig Creaturo

Yes, we had no activity in that program, David, in the December ending quarter. We did have some activity in first quarter Q1 of FY'08. It is our intent. On the open repurchase program, we have 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 question comes 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 optics business, I mean -- excuse me, was there a run rate in the upper 20s to low 30s?

And I know you've had a meaningful increase in selenium costs between then and now. But I am just wondering if anything structurally has changed in that business that would prevent you from getting back to those kind of margin level?

Craig Creaturo

I think, Chris, it's a good question. We definitely are targeting to get back in those levels. Again, I think 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 of ramp that business up.

Part of the growth that we are expecting for Q3 and the rest of the fiscal year is coming from infrared optics businesses. 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 are expecting higher levels of revenue and doing that with the current operations that we have.

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

So, I think there is nothing that's fundamentally changed about the infrared optics business that wouldn't be able to put us back. Over the next several quarters, it will take a little while to get there, but we should be able to get back up into the high 20% and maybe up into the low 30s at some point.

Francis Kramer

Chris, the only thing I'd add to what Craig said is there might be two gross margin points that are tied to this foreign exchange, the weaker US dollar. Until that, we might not get two of them back. So, as Craig was saying, we are headed for 30. We are not headed for 32 because of that.

Craig Creaturo

That's right.

Francis Kramer

But if you look a year ago at this time where we're in the 28% operating segment margin for optics, when we just 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-up question from the line of Pierre Maccagno with Needham & Company

Pierre Maccagno

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

Francis Kramer

The portion of our business that's using distributors is fairly low. We've done some acquisitions over the last several years in Germany and Switzerland overall, and the distributors selling our products, if you look - lets just look at the infrared optics business, it's probably less than 5% is what I would assume would be through distributors. And then if you look at II-VI as a whole, some groups we do use distributors a little bit more frequently. I would say it's probably less than 10%.

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

So I don't think we have any burning needs right now. I think some of the things we have done over the last several years addressing Germany and Switzerland specifically had definitely got a couple of their key areas to be serviced by II-VI entities rather than distributor.

Pierre Maccagno

Thanks.

Operator

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

Jim Hollister

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

Francis Kramer

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

Jim Hollister

Very good, thank you very much.

Francis Kramer

Welcome.

Operator

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

Ian Fleischer

Yes just quickly, in your infrared optics business, can you touch on geographic areas of strength or weakness in the context of both and orders?

Francis Kramer

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

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

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

Ian Fleischer

Okay. And just to stay on the European 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-power OEM builders are. They are sending their machines into Eastern Europe, into the BRIC countries. And some of their strength in the last six months has probably been headed into China, India and so on.

I cannot tell there. They're only telling us that they're not going to go on up at much further rate at the moment, that's to start the slow of the growth rate that we're wondering about and more driven. And we cannot see into their order book, whether it's driven by the writing up in the BRIC countries or is it due to a let up, or just a slight not as rapid growth in main Europe right now. We do not know that. But they'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 further questions. Will there be any closing remarks?

Francis Kramer

Yes, Shekinah. If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the quarter ending March 31, 2008 is tentatively scheduled for before the market opens on Tuesday, April 22, with a conference call to follow that same day at 9:00 AM Eastern Time.

Thank you for participating in today's conference call.

Operator

Thank you. This now concludes today's II-VI Incorporated second quarter and fiscal year 2008 earnings conference call. You may now disconnect.

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