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FSI International, Inc (NASDAQ:FSII)

F2Q08 Earnings Call

March 25, 2008 4:30 pm ET

Executives

Benno Sand - Executive Vice President - Business Development and Investor Relations, Secretary

Don Mitchell - Chairman and Chief Executive Officer

Pat Hollister - Chief Financial Officer

Analysts

Peter Gray – Global Capital Partners

Clinton Morrison - Feltl Company

Christian Schwab - Craig Hallum

Operator

Welcome to the FSI International second quarter fiscal 2008 financial results conference call. (Operator Instructions). With us today, is Benno Sand, who will begin our call. Sir, you may begin.

Benno Sand

Thank you, Melissa. Good afternoon and welcome to the FSI International second quarter conference call. With me today, is Don Mitchell, Chairman and Chief Executive Officer and Pat Hollister, Chief Financial Officer. We will have a telephonic replay of this conference call available for the next several days. That phone number is 1-800-391-9852. Investors will also have an opportunity to listen to the conference call over the internet through CCBN’s individual investor center. A webcast replay of this call will be available shortly after the call is completed and remains available for 30 days.

In compliance with Regulation FD, we have provided advance notice of this call so that all interested investors can participate via the internet consistent with the requirement that this call will be publicly available. Under the Securities Reform Act Safe Harbor provision we will be making forward-looking statements during this conference call including expected third quarter fiscal 2008 financial performance.

Actual results may differ materially from those projected in the forward-looking statements. As you know, these statements involve various risks and uncertainties. Please refer to our press release from this afternoon, and to our recently filed SEC documents, including the latest 10-K annual report, and 10-Q quarterly report in which we discussed risk factors that could affect these forward-looking statements.

To begin the call, Don will provide a brief summary of second quarter performance and current industry conditions. Pat will then provide a more detailed review of second quarter financial results and third quarter expectations followed by Don’s review of second quarter activities and initiatives going forward. We will all be available for questions at the end of the call.

Now let me turn the call over to Don.

Don Mitchell

Thank you, Benno. Good afternoon, everyone. Second quarter orders increased significantly $25.4 million from the $15 million first quarter level and we are within the guidance range we had previously provided. During the quarter we generated $2.4 million in cash from operations. Recently we received an evaluation order for our new ORION single wafer wet cleaning system and anticipate delivering the system in the third quarter of fiscal 2008. Second quarter 2008 revenues were $21.4 million as compared to $33.4 million for the same period in fiscal 2007 and $22.4 million last quarter.

Second quarter revenues fell short of our guidance and breakeven level as the customer pushed out the delivery of the system from second quarter to third quarter. Second quarter shipments were $23.7 million as compared to $31.9 million for the same period in fiscal 2007 and $20.7 million last quarter. As a result, the quarter end backlog and deferred revenue was $17.2 million as compared to $13.4 million at the end of last quarter.

Our 2008 second quarter net loss was $1 million or $0.03 per share, this compares to a net loss of $4.3 million or $0.14 per share in the prior year second quarter, which included a $3.6 million or $0.12 per share asset impairment charge associated with our investment in mFSI. Last quarter we reported a net loss of $2.1 million or $0.07 per share.

From the industry perspective our customers have limited visibility on demand for their products. Recently analysts reported that a modest build up in semi-conductor inventory occurred late in calendar ’07, which has led the lower factory utilization and reduced spending and many device manufactures. Industry analysts are forecasting semi-conductor demand to grow slightly in 2008 driven by demand from memory and microprocessor device.

However, current macro economic division and the impact of such conditions have on consumer spending would cause alarmed weakness in the semi-conductor industry. In general analysts continue to have the mixed view on calendar 2008 forecasted equipment spending. The analyst consensus is a 15% decline; some analysts are forecasting a decline of 20% to 25% calendar ’07 levels.

The calendar 2008 expects a decrease in capital spending is being influenced by a significant reduction and spending, SDRAM and flash memory producers. And whilst do not anticipate that significant of decrease in spending by manufactures of logic devices run by foundries.

Our customers continue to manage their capacity increases carefully. They remain cautious when it comes to placing new equipment orders and continue to request shorter lead times and other sales concessions. Worldwide orders for surface conditioning products the market we serve appear to have bottomed in July 2007 at a monthly run-rate of approximately $140 million down nearly 45% from the January 2007 peak.

Surface conditioning product order levels as reported by SEMI remained in the $140 million to $160 million range from July 2007 through January 2008. Based upon current macro economic and industry conditions, it is too early to project the strength and timing of any recovery and equipment spending from the customers in the segments we serve.

We remain optimistic; capital spending will be higher in the second half of calendar 2008 and for the first half.

Now, I will turn the call over to Pat for a more detailed review of second quarter financial results and to provide our expectations for the third quarter of fiscal 2008.

Pat Hollister

Thank you, Don. Good afternoon. Approximately 73% of second quarter 2008 orders were from international customers as compared to 70% of orders in the prior year comparable period.

International customers represented approximately 71% of total orders for the first half of fiscal 2008 as compared to 69% in the prior year comparable period. International customers represented approximately 74% of total sales in the second quarter of fiscal 2008 as compared to 56% in the prior year comparable period.

The year-over-year increase in the percentage of international sales was led by a 20% increase in sales to Asian customers. International customers accounted to 80% of total sales for the first half of fiscal 2008 as compared to 66% for the same period in 2007.

Our gross profit margins will fluctuate from quarter-to-quarter and year-to-year depending on the international domestic sales mix and product mix. Other factors that can impact growth margins include our current manufacturing capacity utilization and the competitive pricing environment. The second quarter growth margin was 47.7% as compared to 42.6% in the prior year comparable quarter and 38.3% last quarter.

The improvement in gross margins from the first quarter related primarily to a shift and product mix slightly better factory utilization rates and improvements in certain other manufacturing variances.

SG&A expenses were $6.9 million in the second quarter of 2008 as compared to $8.9 million in the comparable prior year period and $6.7 million last quarter. The decrease from the prior year period related to cost reductions implemented in the second half of fiscal 2007.

Second quarter ER&D expenses were $4.8 million as compared to $6.1 million in the second quarter of fiscal 2007 and $4.3 million last quarter. The decrease from the prior year period after related to cost reduction. The quarter-over-quarter increase resulted from the continued developments of our ORION single wafer wet cleaning products.

Interest and other income net was $389,000 in the second quarter as compared to $297,000 in the prior year comparable period, the $299,000 last quarter. The quarter-over-quarter increase resulted from rental income.

Now, I will briefly discuss the changes and key balance sheet items from the end of fiscal 2007 to the end of the second quarter of fiscal 2008. Our cash, restricted cash, cash equivalent and marketable securities represented $24.4 million of our total assets at the end of the second quarter as compared to $24.5 million at the end of fiscal 2007.

Our investment portfolio at the end of the second quarter included approximately $8.5 million of auction-rate securities, which are investments with contractual maturities between 5 to 35 years. As of the end of the second quarter of fiscal 2008, these securities were re-classed from short term to long term as they are currently not trading. Conditions in the debt markets have reduced the likelihood that these securities will auction in the next 12 months. Of the auction-rates securities held by us, $7 million are backed by student loans and are guaranteed by the United States Federal Department of Education.

The remaining $1.5 million relates to manufactured housing that’s collateralized by the principal housing contract trust associated with related loans and are insured by third party. In addition, all auction-rate securities held by us are rated by the major independent rating agencies as either AAA or A, AA.

Beginning February 19, 2008 and forward, all of our auction-rate securities sales auction that sell orders exceeded by orders. These failures are not believed to be a credit issue but rather reflect a lack of liquidity. Under the contractual terms, the issuer is obligated to pay penalty interest rate due to an auction sale.

And that we need to access the funds associated with failed auctions, they are not expected to be assessable until one of the following occurs: the successful auction occurs; the issue or [redency] issue; a buyer is found outside of the auction process; or the underlying securities that matured.

We determine that no impairment losses existed as of March 1, 2008. However, if the issue of the auction-rate securities is unable to successfully close future auctions, it does not redeem the auction-rate securities or the United States government fails to support its guarantee of the obligation. We may be required to adjust the carrying value of the auction-rate securities and record impairment charges in future periods, which could materially affect the results of operation and financial condition.

During the second quarter, we generated approximately $2.4 million of cash from operation and had $817,000 of capital expenditure as we invested in our surface conditioning and laboratory capabilities to support our volume product development program. The company’s account receivable increased to $21.5 million at the end of the second quarter as compared to $17.6 million at the end of the prior fiscal year. The change related to the timing of shipment.

Inventory net was $24.3 million at the end of second quarter as compared to $29.6 million at the end of the prior fiscal year. The $5.3 million reduction reflects the inventory management initiative we implemented in late fiscal 2007. Given our current backlog deferred revenue and expected third quarter orders again have limited visibility with respect to the third quarter revenues.

Keep in mind that a portion of the third quarter revenue is subject to either receiving purchase orders or obtaining highly acceptance from our customers. We expect third quarter 2008 orders between $22 million and $25 million as weak industry conditions continue. We expect third quarter revenues to be between $21 million and $24 million. The audit achieved the revenue level will meet the gain acceptance, a system that is now being buyback customer. We see several anticipated system orders that can be shift and recognize those revenues in the third quarter. Those profit margins are expected to be in the 45% to 47% of revenue range but in the product mix it is similar to the second quarter of fiscal 2008.

We expect SG&A expenses to range from $6.9 million, $7.1 million in the third quarter as compared to $6.9 million in the second quarter. We expect third quarter ER&D expenses to range from $4.7 million to $4.9 million as compared to $4.8 million in the second quarter. Interest and other income in third quarter should come in between $200,000 to $250,000 given our current cash position and the anticipated interest rates. Assuming that we can achieve the guidance just provided we expect to report a net loss of $1.5 million breakeven in the third quarter of fiscal 2008.

We anticipate third quarter capital expenditures to be approximately $700,000 as we add profit margins, the ORION system now installed in our Chaska lab. We expect to report depreciation and amortization expense of between $1 million and $1.1 million. An expected run-rate assuming to continue to successfully manage our accounts receivable in inventory levels, we anticipate using less than a million dollars of cash in operations for the third quarter.

Thank you. Now, Don will provide you with a further review of second quarter activities and our new securities going forward.

Don Mitchell

Thank you, Pat. In the order and revenue risk we had going into the second quarter we were pleased with our other intake and financial performance for the quarter. We would have achieved or seeded our second quarter guidance across the board if not for a customer requested delivery delay during the end of the second quarter. Inventory and accounts receivable management enabled us to generate cash from operations during the quarter.

A noticeable portion of our second quarter revenue consisted of ZETA ViPR spray processing systems. Our enhanced ZETA ViPR technology continued to gain momentum during the quarter, and we provide customers with upgrade, transition from evaluation to production and customer stat and run customer demonstrations in our laboratory.

Then remains a closed correlation between the adoptions of flat film, DRAM, and flat production and our customer needs to remove these films using our ZETA ViPR technology. During the process of expanding the ViPR for Ash-Free wet resist removal for additional implantation levels and other film removal steps.

We received follow on orders for ANTARES CryoKinetic cleaning system during the quarter as our foundry customers continue to expand the applications for this product. Finally, as I mentioned earlier, we received an evaluation orders for a new ORION single-wafer cleaning system.

We believed that we achieve this one because of our differentiate design, which contributes to platform productivity and superior process performance in next generation Interconnect Technologies.

With the latest configuration aligned to on all our lab, we are happily demonstrating the two process capability to other leading device manufactures, and we anticipate placing additional tools, add customers before year end.

The launch of our aligned product remains the key strategic initiative for fiscal 2008. We also remained focused on winning additional process to the record status with the top spenders and expanding our presence at memory device manufacturers. I will pass to Benno now and I will be happy to take your questions. Thank you.

Benno Sand

And also we are ready for questions.

Question-and-Answer Session

Operator

Okay. (Operator Instructions) Our first question comes from Peter Gray with [Global] Capital Partners. Your lines are open.

Peter Gray – Global Capital Partners

Well, two questions first of all what is the company doing involving the auction-rate market at all that’s what came up here and secondly as the company address the issue of possibly hiring a consultant to aggressively cut cost and there is no why here that obviously margin whether they should be in the company is not doing well, should be doing so and should we get someone else involved? Is there any comment on that?

Benno Sand

I didn’t hear your first question; could you repeat that one please?

Peter Gray – Global Capital Partners

Well, the first question was just why is the company involved with the auction-rate market in the first place?

Benno Sand

We are not alone I guess in that type of investment hundreds of companies out there that very good AAA rated auction-rate securities there and so I guess a lot of companies made that same mistake if that’s a mistake. We’ll move out of those securities as time allows with respect to hire a consultant to cut cost as I said Don had a good understanding of what, what’s you’re guiding out there, we in vary aggresses in cutting our cost and lowering breakeven revenue level over the last 9 months and we believe that at this level we can sustain the operations of the company investment periods a time we believe industry will recover in the second half of calendar 2008. And that will allow to see significant financial leverage going forward.

Peter Gray – Global Capital Partners

Thank you.

Operator

Our next question comes from Clint Morrison, Feltl Company.

Clinton Morrison - Feltl Company

Hi guys, see the results for ORION you expect to place in Q3 any kind expectations is the how long that processes is going to be and when you might be able to revenue that product?

Benno Sand

Typically plant sales JVP lasts for 12 months so, we would expect to have some more timeline for this.

Clinton Morrison - Feltl Company

Okay, so nothing in a couple of quarters and you talked about that you would have made guidance accept for a customer push out, can you give us a sense as to sort of how large piece of business that was and are we pretty comfortable with that push out got pushed into Q3 and more in indefinite type push out?

Benno Sand

Well, actually it’s an order that we’ve received during the quarter it was for ZETA and it has been pushed to Q3 actually it’s in March because I just couldn’t accommodate that with our facilities during the quarter, they thought they could but, something came up on there.

Clinton Morrison - Feltl Company

Okay. So, typically on voting system what happened average selling price of you know, 1.8 million to 2.5 million, something like that?

Benno Sand

Okay, and it sounds like it’s a normal as pretty sure that it gets booked or that you we’ve recognized in this quarter.

Clinton Morrison - Feltl Company

Okay, and then on guidance, I kind of missed that did you gave before SG&A did you give kind of gross margin guidance expectations?

Patricia M. Hollister

Our gross profit margins are expected to be in the 45% to 47% of revenue range.

Clinton Morrison - Feltl Company

Okay. Very good, that takes care of me. Thanks.

Don Mitchell

Next one?

Operator

Our next question comes from Christian Schwab, Craig Hallum Capital Group. Your line is open.

Christian Schwab - Craig Hallum

Thank you, can you remind us what’s your gross margin are and how differently are by product line, the ZETA ViPR, MAGELLAN and the expected ORION when we get beyond selling, when we sell actually units for just the trial units?

Benno Sand

Christian our margin goals are 45% to 50% we’re within that goal, generally our flagship products all meet that goal with the exception of MAGELLAN, which is lower than that MAGELLAN has fallen in the 30% as you know, so when we have quarter without the MAGELLAN revenue as we did this quarter that have tempted to boost the margins up, our new products initiatives for any new product that we bring to market we are targeting the corporate goal of not less 40%/45%/50%

Christian Schwab - Craig Hallum

Great. And then Benno you’ve commented about the industry recovery in the second half of ’08, the comments really in the conference call talked about pretty weak industry conditions, no visibility etcetera, etcetera what makes you believe the industry will recover in the second half?

Benno Sand

I think, just looking at term lines of factory utilization rates now dropped down significantly but, you know, lot of that seasonal and generally that’s starts to pick up and I think it’s forecasted again to start to improve based on the data that you know, that I have been reviewing and utilization rates go up, I think we will start to see a little more loosening up the first strings by perhaps the foundries first, and logic players. Intel continues to spend in a pretty aggressive way that’s really in DRAM players that have been struggling but there is unit demand and this demand continue to grow. So, unless we have a catastrophic or macroeconomic event as we go through the reminder of calendar 2008, I’m optimistically so, what I’m seeing that the things will you know gradually improve. I’m not talking about a significant recovery but, gradual improvement has been going through the reminder of the calendar year.

Christian Schwab - Craig Hallum

So, I guess the follow up on that you are not hearing any specific customer dialogue from any of your customers that would give you high degree of confidence in that, you just kind of using your experience of reading all the tea leaves to come up with your optimistic viewpoint.

Benno Sand

I wouldn’t say encouraging that some of our customers are saying that they are asking the full factory utilization and the initiated their visibility is very, very poor right now.

Don Mitchell

And if you look back since 2000, we’ve had, you know, four softness in this industry, four soft cycles were in the fourth now. And generally when any one of those cycles is characterized by much lower factory utilization and existed in a much higher inventories than existing in the supply chain today. Those two metrics would support you know a gradual recovery as long as there is positive demand for chips. And you know that’s the Benno’s comment about our forecasting this growth to chip. But as you look at these, these four down trends over this 7-8 year period, generally there are two quarters to a three quarters and we are in the third quarter right now. So, with some precedent and towards to go much beyond that so, that’s just kind of another anecdote that, it gives us some satisfaction that you know the way she is behind us.

Christian Schwab - Craig Hallum

Can you elaborate on which of your leading customers, I know that you deal with I think 80% or 90% of the top spenders. Can you highlight which one of those leading customers are operating the full factory utilization that could come back in the second half?

Don Mitchell

I’d rather not comment on customer specific, customers, but I will tell you that there is mostly on the logic side.

Christian Schwab - Craig Hallum

Great. That’s very helpful. Thanks guys.

Operator

(Operator Instructions)

Don Mitchell

Well, there are no more questions we like to thank you all for participating on the call today and we look forward to talking to you again in June. Thanks very much.

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