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FEI Co. (NASDAQ:FEIC)

Q4 2007 Earnings Call

February 4, 2008 5:00 pm ET

Executives

Fletcher Chamberlin - Treasurer and Investor Relations Director

Don R. Kania - President and Chief Executive Officer

Raymond A. Link - Executive Vice President and Chief Financial Officer

Analysts

Satya Kumar - Credit Suisse

Bill Ong - American Technology Research

Steve O'Rourke - Deutsche Bank Securities

JoAnne Feeney - FTN Midwest Research

[inaudible] - Broad Point Capital

Matt Petkun - D.A. Davidson & Co.

Analyst for David Duley - Merriman Curhan Ford & Co.

Tom Diffely - Merrill Lynch

Mark Miller - Brean Murray Carret

[Phil DeSalamo - Capital Mansion]

Operator

Good afternoon, ladies and gentlemen. Thank you so much for standing by. Welcome to the FEI Q4 earnings conference call. During today’s presentation all parties will be in a listen only mode. Following the presentation the conference will be open for questions. (Operator Instructions) As a reminder this conference is being recorded today on Monday, the fourth of February, 2008. We’ll now turn the conference over to Mr. Fletcher Chamberlin. Please go ahead.

Fletcher Chamberlin

Thank you, operator. Good afternoon, ladies and gentlemen. As the operator said, I’m Fletcher Chamberlin, FEI’s Treasurer and Investor Relations Director. With me today at our headquarters in Oregon are Don Kania, our President and CEO and Ray Link, Executive Vice President and CFO. Before we begin our presentation we have the regular housekeeping matters to address.

This call contains forward-looking statements to the extent that we discuss expectations of our future corporate performance and guidance, customer orders, or revenue growth, performance by product and market, market developments and opportunities, the competitive landscape, product and technological developments, product introductions and shipment schedules, effects of future movements and exchange rates, changes in our effective tax rate, or other future plans and events, those 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 risk factors are cited in today’s press release and FEI’s most recent 10-K, 10-Q, and A-K documents and other filings with the SEC. Investors are urged to read these documents. Copies are available free of charge at the SEC’s website at www.SEC.gov or on our website or from FEI’s 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 and will be archived in the Investor Relations section of our corporate website at www.FEI.com.

I’ll now turn the call over to Don for his comments.

Don R. Kania

Thank you, Fletcher, and good afternoon, everyone. Welcome to our fourth quarter 2007 earnings call. Today I’ll summarize the fourth quarter and then review the results from the year and give you our outlook and priorities for 2008.

Looking at the fourth quarter, our net sales were the highest for any quarter in our history. They were up 9% from last year and 5% from the third quarter. Bookings of $156.3 million were the second highest total in our history and were up 2% from the third quarter. The book to bill ratio was 1.02 to 1 for the quarter and we have a backlog of $309 million.

Our gross margin at 40.7% was disappointing and was affected by product mix and to a lesser extent by the continued weakness of the US dollar. Net income in the fourth quarter was aided by a tax benefit that added $0.15 per share to the $0.40 result. Excluding the tax benefit, earnings per share were at the midpoint of our guidance.

Ray will go into more detail in a moment but first I want to review our 2007 performance and comment on 2008. Revenue for 2007 was a record up 24% from 2006. Our compound revenue growth rate for the last 5 years is 12% which is in line with our view of the market growth rate. Income from continuing operations and diluted EPS for the year were approximately triple the levels of 2006. Cash flow from operations was $51 million and total cash increased by $85 million from the end of 2006.

Despite the weakness of the dollar which declined 11% during the year relative to the Euro and the second half weakness of the semiconductor equipment portion of our business, the company has moved to a higher level of performance. In addition to revenue growth we had several key strategic objectives for the year. One was to establish and maintain technical leadership in our three core technologies. Titan established and maintained that position in TEM and we will continue to expand the product line with market-specific variations during the year. Meanwhile the introduction of the Helios DualBeam reaffirmed our leadership in that segment and propelled us to record small dual beam bookings for the fourth quarter and the year.

In 2007 we directed our investment to our SEM product line. As a result we expect by the second half of 2008 to have established the technology leadership in all our product lines. In addition the introduction of the Phenom imaging tool established a new market opportunity at a lower price point. With Titan, Helios, [A New Sem] and the Phenom, the company is well positioned for market leadership. We also made good progress on a second key objective, the expansion of our Asian business. Asian bookings, including Japan, were up 15% for the year and grew to 26% of the total from 23%. With the higher growth rate in our business outside of Japan, it is believed the Asian portion of our business will continue to be our fastest growing.

Our new NanoPort customer applications and demonstrations center in Shanghai opened in January as part of our investment in the region. A third strategic goal has been improving in our gross margin. While we improved from 41% to 41.8% for the year, we did not make as much progress as we had planned. Several factors affected our gross margins including our market mix as the semiconductor market declined as a percentage of our total in the second half of the year and the continuous strengthening of the euro against the dollar and decline in our service margins.

I’ll talk more in a minute about how we are adjusting our plans. Let me first take a moment to talk about the current market situation and our view for 2008. While remaining optimistic about the long term growth rates for each of our markets, we are in an uncertain, perhaps deteriorating, macroeconomic environment, particularly in the United States. In aggregate, the overall picture is less robust than it was just a quarter ago but we expect that our global reach and multi market strategy make FEI less sensitive to an economic downturn. As most of you know, the outlook for the semiconductor equipment market is murky. Our NanoElectronics bookings in the fourth quarter were up 37% from weak performance in the third quarter. We anticipated that the third quarter would be the low point for NanoElectronics bookings and this has proved to be accurate.

While visibility is limited, we currently believe the first quarter NanoElectronics bookings will be down 10% plus or minus 10% compared with the fourth quarter. Although we will see fluctuations quarter to quarter, we currently expect that our full year bookings will be better than the industry as a whole. Several factors underpin our position. The demand for our products increases with the continued move by the industry to fire line with new materials and new structures, expanding the demand for TEM and the dual beams that prepare TEM samples. The industry emphasizes technology investment in cyclically slower periods and at the same time we have seen a two year technology driven cycle from our major customers ramping investment in even years. Anecdotally, some of our customers have indicated that even in this restrained capital spending environment, they will continue to invest in technology in 2008. We will expand our serve market NanoElectronic segment this year with new product introductions. As a result, we expect an uneven year on a quarterly basis but expect the technology investment during the year to allow us to perform better than average and to be well positioned for success when better times return.

NanoResearch and industry remained our last segment, our largest segment with over 40% of fourth quarter’s bookings. The 2008 outlook for the segment is positive because of the broad base of applications and global reach. The fourth quarter total was down somewhat from the record results in the third quarter but it was still the third highest quarterly bookings total in our history. It is useful to note that bookings were up 65% of the second half as compared to the first half of 2007. For the year NanoResearch and Industry bookings were up almost 10%.

Two key drivers of our business are global funding for NanoTechnology research and our strong product portfolio and expanding channel. We do not see that these drivers will be significantly affected by broader economic trends. Less than 15% of this business is based on industrial funding. In developed countries that might be affected by an economic slow down. Looking at it from another perspective, our bookings from NanoResearch and NanoBiology customers outside the US, Europe, and Japan doubled in 2007 over 2006. We expect continued growth from this base.

While we expect quarter to quarter fluctuations in the order rate, we continue to see a solid pipeline of bookings in NanoResearch as universities, institutions, governments, corporations fund NanoTechnology research around the globe. A significant fraction of this investment is viewed as part of the infrastructure required for economic competitiveness and growth. For example, Russia has announced a multi-year $5 billion investment in NanoTechnology and this year India will quintuple it’s investment. NanoBiology bookings in the fourth quarter of $24 million were a quarterly record and we’re more than twice the level of the third quarter. We continue to expect booking in this segment to be uneven but we expect significant long term growth.

This morning we took an important step when we announced the Krios, our new high performance Titan TEM aimed at the biology market. The Krios includes a high degree of automation for handling multiple samples along with Titan’s ultra high resolution 3D imaging capability. It’s aimed at cellular and structural biologists who need to visualize intricate individual molecules and cellular structures. We have shipped two systems already and we are pleased with the pipeline for the product. We expect the Krios to be a major growth driver in 2008 and it becomes an early entrez for us into a multi-billion dollar market for research into therapeutics and diagnostics.

In summary for 2008, we believe our growth opportunity will be driven by continued global investment in NanoTechnology, our technology leadership and new product introductions, expanding geographic penetration, especially in Asia, and growth through emerging markets in life sciences, the Phenom, and industrial applications. Strategically we will continue to invest in our growth engines of technology, marketing, and channel. We believe we will take a leadership position with the new SEM product and continue our TEM and dual beam leadership with Titan and Helios platforms.

We will continue to invest in improving our distribution channels, especially in Asia and for the Phenom products. W will also continue to drive margin improvements through operating and supply chain improvements. We are accelerating our internal programs to balance our dollar Euro exposure, reduce our product costs by redeploying our supply chain, and better utilization of our low-cost manufacturing site in the Czech Republic.

In parallel, we will rationalize our product lines, significantly reducing the number of product platforms. We will also intensify our focus on improving service margins which have been stickier than anticipated. A weak dollar and unfavorable market mix create head winds but we still plan to make progress on margin improvement as we go through 2008.

With that I’m going to turn the call over to Ray.

Raymond A. Link

Thanks, Don. Net sales for the quarter of $152.5 million were up 9% from last year’s fourth quarter and up 5% from the third quarter. They were near the high end of our guidance range. Compared to the third quarter, NanoBiology revenue was up 33%. NanoResearch and Industry was up 31% and Service and Components was up 3% while NanoElectronics declined 31% as forecast. Compared to last year’s fourth quarter, we saw growth in all of our end market segments except NanoElectronics. The gross profit margin decreased from 42% in the third quarter to 40.7% in the fourth quarter primarily due to lower sales from our higher margin NanoElectronics business as we had forecast. The weaker dollar began to impact our gross margins in the fourth quarter when compared with the third quarter and even with a robust hedging program we’ll see further negative impact in 2008. The continued weakening of the dollar over the past two years has had a negative impact on margins. Our hedging program can mitigate short term movements but not multi year trends. The stronger Euro also creates a disadvantage compared to our Japanese competitors, making it difficult to maintain margins in some of our markets. As we look forward we continue to maintain our goal of improving gross margins but we also recognize we are facing cross currents in moving towards that goal. Higher revenue [assailed] more new products and improved operations all contribute to improving gross margins and in each of those we should see a positive impact over the next few quarters. At the same time as Don outlined, the mix of business with the wrong percentage of NanoElectronics revenue plus the weakness of the dollar will put pressure in the opposite direction. For Q1 we expect our gross margin will be around 40%.

Moving down the income statement to some of R&D and SG&A expenses was $52.1 million, up 10% from Q3. The strength of the Euro affects this total and we’ve made selective investments in marketing, R&D, and our sales organizations to support our growth. As expected, we saw higher commissions, increased profit sharing accruals, and other expenses in the quarter.

Looking forward, we expect total operating expense to decrease in the first quarter to approximately $50 million due in part to lower commissions and profit sharing accruals. We are focused on expense control in the current environment. Amortization of purchase technology was $450,000 in the fourth quarter and we expect that level to continue barring any future acquisitions. Below the operating income line other income was $3.8 million. This is primarily net interest income and balance sheet related foreign exchange gains and losses. The declining interest earnings from our short term investments we expect [inaudible] and see less than $3 million in the first quarter. We recorded a tax benefit in the quarter of $4 million, primarily due to the completion of various international tax audits. The lower tax rates for the fourth quarter contributed $0.15 to earnings per share compared with the normal rate of approximately 20.4% which is what the rate would have been without the benefit. The tax rate for 2008 is dependent upon our mix of US and international income and is expected to be approximately 25%. All this leads to income from continued operations of $17.2 million or $0.40 per share for the fourth quarter.

Before diluted share count was 46.5 million in the quarter. That includes shares attributable to our zero coupon and 2 7/8 % convertible notes. Please recall that in computing the earnings per share we add back $1.2 million of interest and related costs for two of our convertible note issues and then apply the diluted share count to the adjusted net income.

Turning to the balance sheet, we saw continued improvements in our total cash position during the quarter. Gross cash and investments included restricted cash and long term investments was $491.2 million at the end of the quarter, up $35.2 million from the third quarter and up $84.9 million for the full year. Cash flow from operations was $32.8 million for the fourth quarter and $51.5 million for the year. Net income, deferred taxes, and add back for depreciation amortization were the biggest contributors to the cash balance in the quarter along with a significant decrease in our receivables. Inventory increased only slightly during the quarter. Capital spend in the quarter was $7.3 million compared to depreciation expense of $3.8 million.

In January of this year we retired our 5.5% convertible notes which had $45.9 million outstanding. The share [inaudible] of these notes were not included in our share count. We have also reclassified the 150 million zero coupon convertible notes to current liabilities because they can be put back us on June 15th of this year. Because our stock price is currently below the conversion price of the notes, we expect the notes to be put back to us on that date. If the notes are paid off our share count would reduce by approximately 5.5 million shares, in effect paying the notes will act as a share buy back as far as our diluted EPS is concerned.

Regarding the details of our guidance, we expect revenue to the in the range of $145 million to $152 million. Our GAAP earnings per share for the first quarter assuming a 25% tax rate are expected to be in the range of $0.18 to $0.25. Bookings are expected to be above $145 million. The lower earnings forecast compared to Q4 reflects a number of factors including product mix, reduced cost absorption due to lower overall volume, a weaker dollar, lower net interest income due to market rates, and a slightly higher tax rate. These factors would be offset somewhat by reducing operating expenses planned in Q1.

With that I’ll turn it back to Don for some closing comments.

Don R. Kania

Thanks, Rick. As we look at the uncertain near term and environment, we’ve remained very optimistic about FEI’s prospects in the long term primarily because of four factors. One, we serve growing global markets where in part our products are seen as critical elements of infrastructure for economic growth. Two, we serve these markets with leadership technology incorporated into best in class products sold through an ever more capable global channel. Three, we expect to see benefits from our focus on product line rationalization, operations, and supply chain management to improve our gross margins and we have the strategies supported by a strong capital structure to continue our investment to realize long term growth for FEI.

Operator, I think we’re now ready for questions.

Question and Answer Session

Operator

(Operator Instructions) Our first question comes from Satya Kumar with Credit Suisse. Please go ahead.

Satya Kumar - Credit Suisse

Hi, thanks for taking my question. Can you talk a little bit about the [module] implications for the new products that you have come out with in biology and the new products you talked about introducing later in the year for electronics, and can you give us some specifics on the new products for NanoE?

Don R. Kania

Okay, margin implications, all of the new products, not all of which I’ll discuss in detail because they’re early in the process, are well above averages for products for the company and so as we’ve had a record in the past of doing new products, higher margins, and those are targeted with the products. So the Krios which we have announced fits into that box. Within NanoE there’s three products which we won’t talk about in any detail here and I think you’ll hear about it in subsequent quarters, two of which are already in beta with customers and it’s just premature for us to talk about that in public but we feel very good about the initial reception of those products and I think it positions us well for as I said grabbing some additional serve market in the NanoElectronics segment.

Satya Kumar - Credit Suisse

That’s helpful, thanks, Don and Rick, can you help quantify how much of an impact you have had over your gross operating margins over the last 12 months and supposing the Euro stayed flat from here on, which quarter will you no longer have the negative drag from the Euro?

Raymond A. Link

I’m taking the second part of the question first. If the Euro stays flat relative to Q4 what happens is that over time our hedging contracts, the gains that we enjoyed particularly in the second half of 2007 start to go away because they get replenished at the current rate so flat Euro at around 148 ultimately does have a drag on our gross profit margin. We’ll see a little bit of that in Q1 as a result of that. To answer the first part in terms of what the impact was over the Euro, the Euro did depreciate 11%. We largely had that hedged. We saw a little bit of a negative impact in the fourth quarter, probably to the tune of about 0.25% on margin, but for the other quarters we were somewhat in balance with our currency. When we look at it over a two year period though, we see that the Euro has appreciated about 22% since January of 2006 and that clearly has had a negative impact on our margins when you measure it over that two year period.

Satya Kumar - Credit Suisse

Can you give some color on June gross margins? Is there something that’s going on with the mechanics of the hedge that perhaps there was a bigger impact in June for gross margins or the product mix and all that will offset that?

Raymond A. Link

It was really, you’re talking about the first quarter or the second --

Satya Kumar - Credit Suisse

The second quarter. You seem to have not really had a big impact on gross margins in ’07 because of the hedges and is there some roll off and in Q1 you’re having some of that, will that be a bigger impact in Q2 or not really?

Raymond A. Link

It’s really on a go for it basis. Maybe I’m still struggling with what you’re getting at on the question. The major impact in ’07 on margins was shifted mix where now e-revenue dropped off fairly considerably from $61 million in Q2 to $48 million in Q3 to about $33 million in Q4 and that business largely has roughly an 8 to 10 percentage point favorable margin compared to our other end markets so that was the biggest really drag on margins and as I said earlier, the dollar was largely in check with our hedging programs for the most part of the year and we’re starting to see a little bit of a gap as we move into 2008.

Satya Kumar - Credit Suisse

Can we do a follow up later? One last question. I’m trying to understand how the semi equipment portion of the business is going to behave in ’08. If you can help quantify that, supposing the broader semi cap market is down say 15% or so, what type of performance can we expect from FEI given that your customers are missing more in R&D instead of different types of the cycle?

Don R. Kania

I would say what we’ve been saying. It’s difficult to be quantitative, obviously, but we’ll do better. We’ll do better within whatever average you want to pick because of the reasons I outlined earlier. I also think we’re going to see and my sense is talking with customers that we might see some restraint in the first half of the year or at least in the first quarter of the year, you sense more tentativeness right now which would push the investment which will occur within the year a little bit alter into the year, probably into the second quarter and third quarter of the year. So I would say our view is because of the way we’re positioned, we’re mostly a technology buy, we’ll do better than average, so if you say it’s down 15% we’ll do better than that, and I think overall we have to watch. The quarters are going to be uneven because I think the environment’s moving around relatively rapidly and if you look at the capital equipment announcements by many of the companies to date, I think just as many are flat to slightly up to down and I think that’s just a reflection of uncertainty in the go forward environment with the issues in memory of sort of mixed in as well, so some of the lack of profitability in the memory business.

Raymond A. Link

This creates a lot of uncertainty right now but ultimately people have to buy technology, they have to invest, and customers have indicated to us that they will invest.

Satya Kumar - Credit Suisse

Okay, thanks much.

Operator

Next is Bill Ong with American Technology Research. Please go ahead with your question.

Bill Ong - American Technology Research

Yes, hi, good afternoon, gentlemen, and congratulations, it was good 2007. Can you provide some insight as far as the change in the business? Let’s say one to two months ago between your initial forecast and what you expected in the March quarter versus what you gave guidance and what I’m trying to get at is I know that the semi side business weakened but were you able to hold steady to your forecast on the research and industry?

Raymond A. Link

Yes, I think the obvious things to point to in changes from our view to say last call and today is the semi remains uncertain but I think if you listen to our descriptions and look at the number, the second half in research has been very, very robust for us and that should put Biology in there as well. So we feel positive about that 40 plus, 50% fraction of our business going into ’08 and semi is a bit of the uncertainty. I would say probably the other piece of the puzzle is the dollar, the continued erosion to dollar fourth quarter was not kind to the dollar relative to the Euro and I think those two pieces were probably the biggest changers from our view three months ago to our view right now.

Bill Ong - American Technology Research

Okay, can you also talk about seasonality? You do have a healthy backlog. Do you expect seasonally for June to be up from March quarter levels and then pull back in September because of the summer holidays and then pick up in December? Maybe just qualitatively just giving what you know right now?

Raymond A. Link

I would say that we have no reason to believe at this point that our traditional seasonality will change but we are entering a new market period so I think we should withhold judgment and we’ll tell you more about the second quarter after we finish the first.

Bill Ong - American Technology Research

Okay, that’s it. Thanks so much.

Operator

The next question is coming from the line of Steven O’Rourke with Deutsche Bank. Please go ahead.

Steve O'Rourke - Deutsche Bank Securities

Thank you, good evening. Last call you talked about some low double digit revenue growth for 2008 year-over-year. With this incremental uncertainty building in and NanoElectronics, does that still hold?

Raymond A. Link

I would say we would not commit to that number right now. I think we need to get through the first part of the year with some visibility because if the semi segment is as bad as some predict that would be a drag on the performance that we had anticipated when we put those numbers out there.

Steve O'Rourke - Deutsche Bank Securities

Okay and are the lower revenue and order guidance numbers in 1Q ‘08, is that due entirely to NanoElectronics?

Raymond A. Link

Yes, pretty much.

Steve O'Rourke - Deutsche Bank Securities

Okay and you also made a comment in your prepared remarks about service gross margin in 2007. Could you elaborate a bit on that?

Don R. Kania

Sure. The service gross margins didn’t make the progress that we wanted to make in that area. We are introducing an efficiency enhancement in this remote diagnostics program called Rapid and that is being adopted but in addition what we’ve found is we’ve had to do some restructuring in the field to garner the efficiencies that we need to implement to see continued margin improvement, so it’s taking us longer than we anticipated to see margin improvement.

Steve O'Rourke - Deutsche Bank Securities

Fair enough and one last question just on general markets, on the Research and Biology side of the house, do you have a feel for what the year-over-year growth in your available market opportunity is in 2008?

In the Research area we would say in the range of 8% to 12% and let’s figure out how the year progresses and that’s been historical and I would say in the Biology segment we quote 15% plus. Difficult for us to put a top on that but all indications are, especially as we introduce new products, the opportunity grows for us.

Steve O'Rourke - Deutsche Bank Securities

And do you have a feel for the NanoElectronics year-over-year?

Don R. Kania

No. You know there are people, I read all the stuff you guys read and talk to a lot of the people you talk to and I think that sentiment is so dynamic, I think we should just watch closely because the long view is so murky, it’s a quarter by quarter affair until things clear.

Steve O'Rourke - Deutsche Bank Securities

Fair enough. Thank you very much.

Operator

Thank you. JoAnne Feeney with FTM Midwest. Please go ahead with your question.

JoAnne Feeney - FTN Midwest Research

Good afternoon guys. Thanks for taking my call. Question really about the structural changes driving gross margin. So clearly we have headwinds here from macroeconomic weakness, especially with the semi conductor world. First of all, are you seeing any concrete signs outside of NanoElectronics of weakening conditions in your order flow or change in visibility from what’s typical at this time of year?

Don R. Kania

I would say no. I would say as we tried to describe in our comments, we’re quite positive on Research and I would say with the new products we’re very positive on Biology for the year. I will continue to emphasize, and I look at our own behavior and listen to Ray’s comments. Everybody’s going to get conservative in the short term because of uncertainty, but I feel very confident when we look at these markets, the drivers for these markets, the year are going to be very good for those two pieces of our business.

JoAnne Feeney - FTN Midwest Research

And so if we try to think about what might drive your gross margin up, you had at one point a target of about 45%. Perhaps you could give us a little bit of insight at to what percentage new tools might start to take over your total revenue flow is one driver for that gross margin change?

Don R. Kania

I’m not sure we can wrap a number around that easily right now, JoAnne. So if you look at last year, I would be winging it. I think you’ve got - why don’t we get back to you on that. I don’t want to make something up here. But I would say we’re more likely to see additional drive besides the new products from some of the operational improvements that I just described by year end. So I think we can pick up some points there. We can pick up hopefully some points with product mix overall, both the NanoE and new products and the outlier for us is where’s the currency go and we are not currency traders. We try to do our best to hedge against it but that is the crosswind that’s slowing us down a bit.

JoAnne Feeney - FTN Midwest Research

So could you potentially describe the scenario that would have to play out in order for you to reach say $170 million in revenues and 45% gross margins by year end?

Don R. Kania

$170 million in revenue, we’ve got back to historical mixes on NanoE versus the rest of our business and the Euro doesn’t wildly misbehave, that’s quite doable.

JoAnne Feeney - FTN Midwest Research

So there are structural changes on the way that could drive gross margin up from 40% to 45% by the fourth quarter?

Don R. Kania

With that kind of revenue increase, yes, and the right mix. Those are the things that have been working against us, if you look at the maps for last year. If you remember Ray’s numbers we went from $62 million was it NanoE in Q1 to $33 million. We have that IS margin part of our business from the year end and still on the year did pretty well with some improvements in margin overall.

Raymond A. Link

I think it’s important to point out that our other market segments, the margins particularly in NanoBio did improve year-over-year, they ramped up a little bit in Nano R&I. Service was essentially unchanged and even within NanoE the margin increased but the change second half versus first half was so dramatic in revenue that it really made it difficult for us to achieve our objectives. If we had just had that same relative mix of business Q2 rolling through the year we would have had, we’d be sitting here with substantially higher margins. $30 million of revenue got substituted, it was at roughly 51%, 52% with revenue at roughly 43% and that’s a huge impact and then you overlay the dollar that depreciated at 11% while admittedly we were relatively well hedged, that’s going to start making it difficult.

JoAnne Feeney - FTN Midwest Research

And then it sounds like you have identified the source of the service gross margins stickiness. Can you give us a sense of the time frame over which it would take you to raise gross margins up to where you thought you could take them sort of a low 30’s I think?

Don R. Kania

I would say if you look at more like the high 20’s, 30-ish, as we exit the year.

JoAnne Feeney - FTN Midwest Research

Okay, thank you very much.

Operator

Thank you. Our next question is coming from [inaudible] with Broad Point Capital. Please go ahead.

[inaudible] - Broad Point Capital

Good afternoon. A lot of my questions have been answered but I needed some clarification on a few of the things. I was not sure if you were able to break out the impact of currency and product mix in the current quarter margins.

Raymond A. Link

Essentially if we take the 42% that we earned in Q3, we lost approximately 1 full percentage point on mix, largely on the NanoElectronics going down, and then we have about another quarter point on currency. Those are the main issues. There’s a lot of other little nits and nats but those two account for roughly the entire change.

[inaudible] - Broad Point Capital

So the currency impact alone for the quarter was only a quarter point, right?

Raymond A. Link

For Q4, then it starts getting more difficult as we go into Q1.

[inaudible] - Broad Point Capital

And how is that?

Raymond A. Link

It’s very simple, we had larger hedging gains in Q4 because those contracts we put in place back in Q4 of ’06 and Q1 of’07 where the contracts that we have maturing in the first quarter of this year were ones we started to layer in as we advanced into 2007 so the strike prices are higher so the gains are less.

[inaudible] - Broad Point Capital

Okay, so when you talk about roughly 40% gross margins in the March quarter, you have a much higher impact from the currency, how much is that?

Raymond A. Link

Pretty much the whole difference.

[inaudible] - Broad Point Capital

Okay, so roughly compared to the third quarter that will be roughly one percentage point.

Raymond A. Link

0.7 of a point, yes.

[inaudible] - Broad Point Capital

Okay, and one more thing, I think in the past you’ve talked about low double digit kind of growth rate in the full year. Now are you still sticking with that or...?

Raymond A. Link

As I commented earlier, we’re backing off that number pending more visibility particularly in the NanoElectronics segment and the overall macro environment so we still think we feel very positive about Research, Biology, and some of our emerging opportunities and we remain uncertain about the electronics beat so that’s the musing on that double digit growth.

[inaudible] - Broad Point Capital

Okay and one final question, in terms of the Research division revenues, you did see some drop in your bookings of course those were on a very high level, how do you expect bookings to be going forward?

Raymond A. Link

Well I think overall as we try to describe, we feel positive about that segment for the year so we expect bookings to grow through, there. We don’t give specific guidance on market segments for the year but we expect growth there and I think I’ll just leave it at that.

[inaudible] - Broad Point Capital

And you’ve not seen any push outs or any cancellations or any delays in taking the delivery in that particular segment so far?

Raymond A. Link

No, in fact, and really in neither segment at this point, but the quarter’s young and especially in electronics, what I’m looking for is when the Asians return from their holiday to see what kind of indications we get. I think that’ll be a time when we get a little more clarity into the future for Q1-Q2.

[inaudible] - Broad Point Capital

Okay, thank you so much.

Operator

Our next question is coming from Matt Petkun with D. A. Davidson & Company. Please go ahead.

Matt Petkun - D.A. Davidson & Co.

Hi, good afternoon. First, Ray, what’s our expectation for other income, non-operating income next quarter?

Raymond A. Link

It’ll probably be slightly below the $3 million largely driven by the rapidly falling short term interest rates.

Matt Petkun - D.A. Davidson & Co.

Okay, and the hedge is not captured there?

Raymond A. Link

It’s a little complicated there. There’s two types of hedges. The hedges that we do for our revenue and expenses do not go into that line item. Hedges that flown to that line item are balance sheet hedges for receivables and payables. There is some relatively small amount of the loss that goes through there to offset the changes in the balance sheet but that’s generally about half a million dollars and that’s been relatively consistent. The main component of other income is interest income minus interest expense. While we paid off the note, the 5.5% on $46 million. Prior to a month ago we were pretty much making a tiny little bit of money out of that. As rates dropped dramatically, that’s when we decided to call that, so that’s really a net zero impact, so what we’re seeing is the remaining cash balances rates dropping from the 5.5% to below 4% right now.

Matt Petkun - D.A. Davidson & Co.

Okay and then in the past several quarters you guys have provided a little bit of a break out in terms of the bookings in the NanoElectronics segment both in terms of semi conductor orders versus data storage orders and then the memory orders within the semi conductors segment. Could you guys provide that data this quarter?

Don R. Kania

Matt, I think what we need to say is with respect to semi conductor, we’re not segmented out so much like most of the volume equipment suppliers are. We’re very technology oriented so we see no correlation between memory and not memory and our performance overall so it’s just something not worthy of us reporting so we’re not going to do that.

Matt Petkun - D.A. Davidson & Co.

You provided that in the past.

Don R. Kania

Yes, a small number.

Matt Petkun - D.A. Davidson & Co.

That’s fine, but data storage versus --

Don R. Kania

Data storage was very small. We’ll just say that.

Matt Petkun - D.A. Davidson & Co.

And what are your expectations for data storage for ’08?

Don R. Kania

Very minimal.

Matt Petkun - D.A. Davidson & Co.

Okay, and then my final question, Don, is just trying to get a sense of how you view the NanoBiology business. That business has been a very nice order number you guys saw in Q4. It’s all over the map in terms of bookings and I don’t know if there’s any way to get a real sense of how you forecast that from quarter to quarter but do you guys have a better sense of what the drivers are for that business? Obviously introducing new products would be important but do you have a strong sense of the channel there and really your market opportunity going forward?

Don R. Kania

I think we do. I think we’ve put a team in front of that business in the beginning of ’07 to focus the strategy and we now have honed our strategy to focus on what really what the Titan does, 3-dimensional measurements at the molecular and cellular level primarily and that’s what the Krios serves. The drivers behind that are significant in that it’s becoming important in understanding what hey call correlative, that is the ability to tie what happens on the molecular scale to human disease. So we’ve worked closely with the National Cancer Institute several places in Europe and there are some smaller companies springing up who look at this area and the second driver becomes Nano Particle Drug Delivery which is heavy in the pipeline, that new drug delivery systems for both therapeutics and diagnostics that are oriented around Nano Particles. The measurement, the characterization of those Nano Particles becomes important so we feel that those drivers on that side and the new product at the right time should be an excellent driver for ’08 and beyond.

Matt Petkun - D.A. Davidson & Co.

Okay, thanks Don.

Operator

Dave Duley with Merriman Curhan Ford. Please go ahead with your question.

Analyst for David Duley - Merriman Curhan Ford & Co.

Thanks. This is Chris on behalf of Dave. I think I might have missed something in the opening remarks in regard to NanoE. You said something was going to be up plus or minus 10%, was that orders or?

Don R. Kania

We said orders would be down 10% plus or minus 10%.

Analyst for David Duley - Merriman Curhan Ford & Co.

Right and you mentioned gross margins being affected by the Euro next quarter. Is it primarily do the Euro exchange rate, is that assuming then constant product mix 4Q to 1Q?

Don R. Kania

We don’t really see tremendous mix shift in Q1 so yes, the primary driver and gross profit margin guidance of 40% is the unfavorable dollar-Euro exchange rate and less currency hedging gains.

Analyst for David Duley - Merriman Curhan Ford & Co.

And in regards to the OpEx plans on saving, do you have any plan on how that’s going to ripple out through 2008?

Don R. Kania

Well our target for Q1 is $50 million and until we can see significant change in revenue ramp, that’s pretty much where we’re going to drive costs to.

Analyst for David Duley - Merriman Curhan Ford & Co.

That’s it for me. Thank you.

Operator

Thank you. Tom Diffely with Merrill Lynch. Please go ahead with your question.

Tom Diffely - Merrill Lynch

Good afternoon. Quick question on the service business. I noticed it was down a little bit from an on order point of view in the quarter. Isn’t the fourth quarter typically fairly strong for you?

Don R. Kania

It’s typically Q1 so if Q1 is sort of the end of the year, contracts are still running and if you look at last year I think we had quite robust with $39 million in the first quarter last year. So it’s the first quarter that’s the big pump.

Raymond A. Link

In the first quarter of ’07 we did have one fairly substantial multi year order.

Tom Diffely - Merrill Lynch

Okay. Typically these orders are for the entire year when they’re placed or is it a rolling basis?

Don R. Kania

Generally, yes. Generally when people take a service contract it is one year and we generally have a little bit more in the first quarter simply because it’s the new year and people take a look and renew it. Also we generally have higher revenue in the fourth quarter so those tools have now come off warranty and people are taking service contracts so we have a little bit of a bump up in the first quarter.

Tom Diffely - Merrill Lynch

All right and then switching gears here, when you look at the total served available market, how do you think that splits on a geographic basis? I know you guys are much stronger in North America and Europe, I just wonder how big you think the actual Asian market is.

Don R. Kania

Our total served market, is that the question? So if we take all the pieces. I would say, let’s split it out, I would say certainly US and Europe are probably 50+%, Japan another 20+%, so 70%, and I’d say the emerging world 30%.

Tom Diffely - Merrill Lynch

Okay, so when you look at business over the next couple of years, do you think a large percentage of your growth will come from the Asian market that you under serve today?

Don R. Kania

Yes, for two reasons. Because we under serve and also if you put the growth rates on those regions, the rest of the world will by far exceed and in that I’m lumping in Russia, places like that as well, so that’s really the whole emerging marketplace for us.

Tom Diffely - Merrill Lynch

Okay and maybe just one more question on the gross margin. Ray, do you think that if you had the same mix today or for the first quarter this year versus the first quarter last year that your gross margins would be fairly close? We were I think 43%.

Raymond A. Link

Yeah, they would be close. I think they would possibly be off a little because of currency.

Tom Diffely - Merrill Lynch

If you look at it on a year-over-year basis the biggest difference is mix. Okay, thank you.

Operator

Mark Miller with Brean Murray. Please go ahead with your question.

Mark Miller - Brean Murray Carret

Good afternoon. I wanted to talk a little about the Asian market, especially if sales last quarter were down year-over-year and sequentially while sales in your other two regions in December were up. I know you’ve been putting a lot of effort and you said you’ve seen order growth, I’m just wondering is this just weakness in the NanoElectronics business being reflected more on Asia?

Don R. Kania

Exactly. That’s obviously a big portion of that business and so we actually take some solace in the fact that we’ve had good order growth in the region and a weak semi environment and I think when we went through the numbers on Research and Biology outside of the US, Europe, and Japan, the gross rates there are compelling we believe, and we think that continues.

Mark Miller - Brean Murray Carret

The other thing on operating expenses you said you’re going to be trying to bring the down but I’m just wondering, last quarter they jumped up both SG&A and R&D. Was that dollar effects or the NanoPort coming online, I’m just wondering, you’re up I think 100 basis points on SG&A and 60 basis points sequentially on R&D.

Don R. Kania

Part of it was dollar based but that will continue with the weakening of the dollar but we did have some fairly substantial fourth quarter spend in R&D and that’ll back off a little bit as we go into Q1. Also we had slightly higher commissions because of the mix of agent versus direct sales so that was a little bit higher and we had a fourth quarter true up for our overall profit sharing bonus program because we after all did have a record year and as we go into the first quarter this year we are planning to be at 100% of our target as opposed to and in excess of our target as we did in 2007.

Mark Miller - Brean Murray Carret

Your reduction of $50 million roughly on operating expenses projected for March that’s basically just because of lower sales and bonuses and the Asian start up?

Don R. Kania

Also there’s some R&D spend that spiked up in Q4 that’ll be more normalized as we go into the first quarter.

Mark Miller - Brean Murray Carret

Do you think those numbers will be flat for the rest of the year or start coming back up again or going back down?

Don R. Kania

Well we’re really kind of targeting that relative to revenue. If you kind of take our guidance you sort of come close to $150 million, $140 million mid point, $50 million would be a third of that and until we can see our revenue growth north of that, we need to monitor and control it at a $50 million operating expense.

Mark Miller - Brean Murray Carret

Thank you.

Operator

[Phil DeSalamo with Capital Mansion] please go ahead with your question.

[Phil DeSalamo - Capital Mansion]

Thank you. We had a group of questions. First of all relative to the three new electronic products that are expected in 2008, to what degree do you anticipate or believe that those products will impact revenues in a notable fashion in 2008?

Raymond A. Link

Phil, only moderately on revenues, probably a meaningful amount on bookings and it’s really set up for ’09.

[Phil DeSalamo - Capital Mansion]

And are these products ones that are long lead times similar to the Titan or a little faster than Titan?

Raymond A. Link

Much faster than Titan. In response to the customer needs and our willing ness and ability to penetrate quickly.

[Phil DeSalamo - Capital Mansion]

And so if we’re talking about impacting bookings significantly more than revenues, does that imply that either products that are not going to become meaningful until the third and probably more like the fourth quarter?

Don R. Kania

I think that’s fair. Also the customers will buy and receive one and not want to schedule shipment for additional units until they have had time to play with the first unit or two.

[Phil DeSalamo - Capital Mansion]

That’s helpful and then I believe in the opening remarks there was reference to 2008 being a year that you would be reducing at a number of platforms. We were hoping that A) you could expound upon that comment and B) that you would be able to share with us what impact on gross margins you’re expecting from that change.

Don R. Kania

Just a little bit of exposition. We’re not going to reveal too much, but the company hasn’t had a very strong tradition of obsolete products and so we’ve had a very robust new product introduction pipeline over the past multiple quarters and we have embarked on a program to make sure that we can serve our market with a suitable distribution in price and performance such that we can maintain competitive advantage but we’ve found in that analysis, I won’t give a number, but we could significantly reduce the number of platforms and of course that will flow into margin. We’re not going to share any numbers on that with you at this point. This will be a multi quarter effort and so the impact on this year will be modest at best and really it’s an ’09 effect ultimately.

[Phil DeSalamo - Capital Mansion]

And to make sure that we understand the terminology, there are multiple products that would be part of a platform at least if you’re doing it effectively, I suppose there are some cases where you have single products that equal a single platform?

Don R. Kania

Usually the platforms have a multitude of variations so when we take out a platform we take out a fair number of products.

[Phil DeSalamo - Capital Mansion]

That’s helpful. And finally the Phenom, would you please provide an update there.

Don R. Kania

We aren’t talking about specific numbers on the Phenom but what we can say is the results we achieved in the fourth quarter were on plan.

[Phil DeSalamo - Capital Mansion]

Thank you.

Operator

Management, there are no further questions at this time. Please continue with any closing comments.

Don R. Kania

Well we’d like to thank all of you for dialing into the call and look forward to speaking with you through the quarter and certainly at our next call. I’d also like to thank all the employees of FEI around the globe for the great performance in 2007 and we’ll continue to grow the company through 2008. Thank you all very much and good evening.

Operator

Thank you. Ladies and gentlemen this does conclude the FEI Q4 earnings conference call. If you’d like to listen to a replay of today’s conference you can do so by dialing 1-800-405-2236 or 303-590-3000. Input the access code 11107863. Once again 303-590-3000 for international callers or 800-405-2236 input the access code 11107863. You may now disconnect. Have a very pleasant rest of your day.

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Source: FEI Co. Q4 2007 Earnings Call Transcript
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