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Advanced Energy Industries, Inc. (NASDAQ:AEIS)

Q4 2007 Earnings Call

February 7, 2008 5:00 pm ET

Executives

Hans-Georg Betz - President and Chief Executive Officer

Lawrence D. Firestone – Executive Vice President and Chief Financial Officer

Annie Leschin - Investor Relations

Analysts

Brett Hodess - Merrill Lynch

Edwin Mok - Needham & Co

Brian Lee – Citigroup

Jim Covello - Goldman Sachs

C.J. Muse - Lehman Brothers

Operator

Good afternoon, ladies and gentlemen, and welcome to Advanced Energy’s fiscal 2007 fourth-quarter conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions)

Now, I’d like to introduce Ms. Annie Leschin of Advanced Energy Investor Relations.

Annie Leschin

Thank you, and good afternoon. Thank you for joining us this afternoon for our fourth-quarter 2007 earnings conference call. With me on today’s call are Hans Betz, President and Chief Executive Officer, and Larry Firestone, Executive Vice President and CFO, who will both present prepared remarks.

By now, you should have received a copy of the press release that we issued approximately an hour ago. If you are in need of a copy, please visit our website at www.advanced-energy.com or contact us at (970) 407-4670.

Before we begin, I’d like to let everyone know that Advanced Energy will be participating in Piper Jaffray’s Third Annual Clean Technology and Renewables Conference on February 20 at 11:30 in New York City and the Goldman Sachs 2008 Technology Investment Conference on February 26 in Las Vegas. Additional events are scheduled this quarter. We will make additional announcements.

I’d like to remind everyone that except for historical financial information contained herein, the matters discussed in this conference call contain certain forward-looking statements subject to known and unknown risks and uncertainties which could cause actual results to differ materially from those expressed or implied by such statements.

Such risks and uncertainties include, but are not limited to, the volatility and cyclicality of the industries we serve; the timing of orders received from our customers; our ability to benefit from the continued cost improvement initiatives currently underway; and unanticipated changes in our estimates, reserves or allowances.

These and other risks are described in Form 10-K and 10-Q and other reports filed by the company with the SEC.

In addition, forward-looking statements are made based on information presently available to the company, and we assume no obligation to update the information that we provide you during this conference call, including the first-quarter guidance provided in our press release. Guidance will not be updated after today’s call until our next scheduled quarterly financial release.

I will now turn the call over to Hans Betz.

Hans-Georg Betz

Good afternoon everyone, and thank you for joining us. Advanced Energy had a challenging year in 2007, with sales of $384.7 million representing a decrease of 6% over the prior year.

Despite the drop in sales, we generated more than $61 million in cash and continue to penetrate the solar market. We believe that current efforts to diversify our business will eventually help limit the impact of semiconductor cyclicality.

However, we recognize the need for Advanced Energy to take additional steps to lower our cost structure. As a result, we plan to further improve efficiencies and implement cost reductions in 2008.

Despite the semiconductor environment during 2007, I would like to quickly acknowledge some of the company’s accomplishments. During the year, we moved more of our manufacturing to Shenzhen, China as we closed our Stolberg, Germany facility in an effort to continue to streamline operations and achieve greater efficiencies.

Sales to the solar market more than tripled to $26.5 million during the year, from $8.5 million in 2006. We expanded our solar product offering with the introduction of our Solaron inverter, which addresses the solar inverter market.

Our product has already picked up notable recognition and traction and we remain excited about the long-term potential of this product.

Fourth-quarter sales were in line with our revised guidance issued on January 22 at $83.8 million, a 7% decline over last quarter. We were disappointed by our performance in this quarter, as sales continued to be pressured by the softness in the semiconductor capital equipment market.

Lower sales pressured gross margins, which declined to 39.1% in the quarter. Additionally, operating margin was 5.1%. We generated $20 million in cash to end the quarter with $205 million in cash and marketable securities.

Sales to the semiconductor capital equipment industry declined 6% sequentially as orders from OEMs fell off during the latter part of the quarter due to push-outs from semiconductor manufacturers.

On a positive note, we are gaining tractions at key accounts and shares on selective tools that are critical for 65 nanometers and 45 nanometers, which should position us well for the next year.

Looking to the first quarter, nearly all of the key indicators for 2008 semiconductor market have recently been revised downward. As a result, we expect the weakness in the semiconductor industry to continue for the first half of 2008.

We remain confident in our position with key customers and next-generation products, which we believe will benefit us when the market improves.

Our non-semiconductor business includes solar, both inverter and thin-film deposition tools; flat panel display; data storage; architectural glass; industrial coating; and emerging markets.

Sales to our non-semiconductor markets decreased 10% sequentially due to particularly large third-quarter sales in the industrial coating market. Our strategy to grow these markets remains intact.

Our sales of the flat panel display market were roughly flat, increasing 1% from the previous quarter. The next investment cycle has begun, as key manufacturers started putting in their planned capital expenditures over the holiday season and are continuing that trend in the first quarter.

We believe that Advanced Energy is well-positioned in this market with several growth drivers, including, first, flat panel manufacturers advancing to Shenzhen products; second, upgrades to existing products, which improve tools capacity; and, third, retrofits to existing tools, where Advanced Energy would replace current tools to improve capacity.

Weakness in the data storage industry continued and our business decreased 13% in the quarter, driven by the decrease in the magnetic disc market. Given the shift in the last year to perpendicular recording, the industry is just now implementing those investments.

Having retooled virtually every machine to this technology, we do not anticipate the next investment driver until late-2008.

The optical storage market continues to be soft because of the slow adoption of one HD format. Given the recent announcement by Warner Brothers, it appears the momentum has shifted sharply to Blu-ray’s direction as HD format of choice.

The recent adoption of this technology, as well as changes in our OEM competitive landscape, may enhance Advanced Energy’s position in this market.

As expected, sales to the architectural glass market has decreased by 35% sequentially, consistent with our projections as (inaudible) from budget cuts have caused some programs to be delayed.

Looking ahead, we have begun to regain tractions with a few orders in China and a new product for a customer in Russia. Additionally, since we sell our glass product directly to the end-users, we also are working to strengthen relationships with the OEMs in an effort to continue to grow in this market.

Sales to the industrial coating market decreased 39% sequentially, mostly due to strong performance in the third quarter driven by the emerging demand for thin-film deposition and manufacturing process for EMI shielding product ahead of the holiday.

We expect this market to remain mostly flat, with the next investment cycle projected to begin in the second half of the year.

Now, I’d like to move on to our solar business. This business now comprises both photovoltaic thin-film deposition tools and our new photovoltaic inverter product. Sales to the solar thin-film deposition tool market increased 32% sequentially.

Advanced Energy is well-positioned to benefit from this trend as our expertise in other markets enables the move to solar. Our OEMs are reporting strong demand and we expect this to translate into production orders for next year.

With seven Solaron inverters successfully installed on the grid, initial feedback has been very positive. Our inverter product is showing industry-leading conversion efficiency performance.

We are excited that one of our customers has agreed to serve as Advanced Energy inverted demo site in California. This will provide us the ability to show prospective customer our inverter product in action and should unlock new sales opportunities for us over the coming months.

In summary, although 2007 was a difficult year for Advanced Energy, we made progress diversifying our business in other markets. Given the challenging market conditions, however, we recognize the need to reduce our costs as we progress through 2008.

We will execute these reductions very strategically as we work to regain our growth trajectory. We will continue to invest in R&D for our next-generation product opportunities in semiconductor and clean energy markets.

This, combined with our efforts to achieve a more balanced revenue stream between our semiconductor and non-semiconductor markets, should position us well to grow at our five years CAGR of 20%.

I’d like to thank the entire Advanced Energy team around the world for their hard work.

I will now turn over the call to Larry Firestone, our CFO, who will elaborate on operating results and financial performance for the fourth quarter and provide guidance for the first quarter.

Lawrence D. Firestone

Thank you, Hans, and good afternoon everyone. I will review the results for the fourth quarter of 2007 and discuss our guidance for the first quarter of 2008.

Sales for the fourth quarter of 2007 were in line with our pre-announced guidance at $83.8 million. This represented a sequential decline of 7.4%, compared to the $90.5 million for the third quarter of 2007, and a 19.8% decline versus $104.5 million in the fourth quarter of 2006.

Total sales for 2007 declined 6% to $384.7 million. Sales to the semiconductor capital equipment market decreased 18.9% over the fourth quarter of 2006, representing approximately 68% of total sales in the quarter. Our non-semi business delivered 32% of the sales this quarter, consistent with the same period last year.

Sales for the flat panel display industry increased 5% of total fourth-quarter sales versus 4% in the third quarter as we saw key customers pooling their capital expenditures during the holiday season, and we expect this trend to build through 2008.

Data storage was consistent with last quarter at 4% of total sales as the magnetic disc industry continues to work through excess capacity. We expect this trend to continue throughout the end of the year, with a possible rebound in late 2008.

Sales to the architectural glass market declined to 1% of total sales from 3% in the third quarter. This was on track with our plan as this market will continue to fluctuate with the Low-E glass market.

Going forward, we believe we will see strength in the architectural glass market related to solar, which should lead to improved growth in this market based on the requirement for thin-film on glass to keep the solar efficiency at optimum levels.

Our industrial coating and emerging markets represented approximately 11% of total fourth-quarter sales, down from the 13% in the prior quarter. Sales to the solar market in the fourth quarter were comprised mostly of thin-film deposition tools and represented 9% of total sales, up from 6% last quarter.

We gained traction with our Solaron inverter product and plan to double our solar sales, including both the inverter and the tool sales, for 2008.

Global services, which are embedded in each of the different markets, were consistent at 16% of the lower total sales in the fourth quarter. These are sales of upgrades and out-of-warranty repairs to our growing installed base.

Our book-to-bill ratio for the quarter was 1.03:1, and our backlog ended the quarter up 5% at $46 million. Our backlog includes orders for Advanced Energy products not covered in our just-in-time agreements. And this is the first time in the last three quarters that our book-to-bill was above one.

Gross profit was $32.8 million, or 39.1%, for the fourth quarter of 2007. This compares to third-quarter gross profit of $36.7 million, or 40.6% of revenues in the fourth quarter of 2006 and gross profit of $44.9 million, or 42.9% of revenues in that quarter.

Gross margin was pressured by lower sales and absorption of factory overhead. R&D was $12.5 million, or 14.9% of the fourth-quarter sales, compared with $12.9 million, or 14.3% of third-quarter sales, and $12.2 million, or 11.7% of the sales a year ago.

This was due to investments in both new and existing products, and despite our lower sales growth, we continue to invest in R&D, as we increased our spending 12.4% in 2007.

SG&A was $16.1 million, or 19.2% of fourth-quarter sales, compared to $15.5 million, or 17.2% of third-quarter sales, and $15.5 million, or 14.9% of fourth-quarter 2006 sales. SG&A increased from the prior quarter due to professional fees and severance costs.

Fourth-quarter net income from continuing operations was $4.1 million, or $0.09 per diluted share, compared to $5.9 million, or $0.13 per diluted share, in the third quarter of 2007.

This compares to $40.4 million, or $0.89 per diluted share, in the fourth quarter a year ago, or $15.9 million and $0.35 per share from continuing operations, excluding the tax benefit of $23.5 million in the same period last year. The lower net income was primarily due to the lower sales.

Headcount at the end of the fourth quarter of 2007 was 1,707 versus 1,756 employees at the end of the third quarter of 2007. This reduction was due to the closure of our Stolberg, Germany facility.

Cash and marketable securities increased $20.3 million for the fourth quarter to $205.3 million, from $185 million in the third quarter. DSOs were 64 days at the end of the quarter.

Trade accounts receivable were $61.5 million at the end of the fourth quarter of 2007 compared to $69.7 million at the end of the third quarter of 2007.

Inventory turns were relatively consistent with the last quarter at 3.9 times. Inventory experienced a substantial decrease to $50.5 million from $57.4 million at the end of the third quarter of 2007.

Capital expenditures were $3.2 million and fixed asset depreciation was $2.6 million.

Our guidance for the first quarter is as follows: given the market conditions and the continued softness in the semiconductor industry, we project sales to be in the $82 million to $88 million range; gross margins will remain at similar levels to the fourth quarter due to product mix; and our earnings per share will be in the range of $0.07 to $0.11 per fully diluted share, using a 32% effective tax rate.

As Hans mentioned, we are proactively driving cost reduction programs in the following areas: mature product lines; manufacturing locations; workforce reductions, as well as infrastructure and discretionary spending.

These cost reduction plans are targeted to deliver a minimum of $10 million in annual savings to be fully realized in 2009. We expect this to impact cost of goods sold and operating expenses as well.

We will continue our research and development investments over the long-term we can maintain our technology and market leadership.

This concludes our prepared remarks for today, and I would like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from C.J. Muse - Lehman Brothers.

C.J. Muse - Lehman Brothers

First question, can you talk a little bit about flat panel display, the linearity you expect in 2008, and where your lead times are today?

Hans-Georg Betz

I think the flat panel display market is recovering. This is a consensus. And it’s mainly driven by the TV sets which are gaining traction now. The lead time – it’s hard to judge at this point.

Lawrence Firestone

Lead time on our products is anywhere between 8 and 13 weeks. But I think, C.J., maybe part of your question is when are we going to see the order cycle? I think that’s going to depend on the OEMs’ lead time and what they are quoting to their customers.

C.J. Muse - Lehman Brothers

Given that we are seeing strong uplift at pretty much every equipment company across the board, whether it’s CVD, DVD; this quarter I would think, then, you’d see it one quarter from now or would it be two?

Lawrence Firestone

We would probably be in the middle to maybe a little past the middle of the manufacturing cycle is where you would see the order and then the delivery of the product. Because they won’t need it on their floor until they are ready to fire the machine up.

C.J. Muse - Lehman Brothers

So you are saying strong ramp either June or September?

Lawrence Firestone

Yes, I would guess we would see some activity early in the year, but I don’t know if we have got a line where we would put that level of granularity to it.

C.J. Muse - Lehman Brothers

Okay. And moving over to solar, are you seeing first-generation production equipment orders yet or is it still all pilot line purchases?

Lawrence Firestone

Predominantly pilot line, but I think some of the higher volume hardware is starting to move out to the field.

C.J. Muse - Lehman Brothers

And what exactly do you need in terms of mix there to achieve I think you said the doubling for 2008?

Lawrence Firestone

We haven’t broken out the inverter versus the tool, but I think what we see is, inverter is starting from a pretty small base, so substantial growth on the inverter side, and I think still nice growth out of the tool side as well.

C.J. Muse - Lehman Brothers

Okay. And last question from me, on the OpEx side, I know there were four main areas of cost improvement that you were focusing on prior to the announcement this evening, and I am a little bit surprised that we are not seeing that savings in the 1Q guidance in terms of the implied OpEx and gross margin. So can you help me understand what the trajectory will look like now on the cost side?

Lawrence Firestone

There is a couple of things. When you are dealing with mature product lines or end-of-life decisions, there is timing that will be involved in that. Manufacturing locations and workforce reductions as well, as well as some costs associated with that.

So, I think what we will see is us working our way, probably seeing the effectiveness of some of those cost reductions in the second half of the year and then fully realized in 2009.

C.J. Muse - Lehman Brothers

Okay, thank you.

Operator

And your next question comes from Jim Covello - Goldman Sachs.

Jim Covello - Goldman Sachs

Thanks so much for taking the question. Just a quick one on the percentage of revenues that solar will ultimately represent with the target model. I think you said 9% in Q4, you are looking to double solar revenue.

If I assume that, because we are in an equipment downturn, your equipment revenues go down a little bit, maybe theoretically, we could be looking at about 25% of revenue coming from solar exiting 2008.

What’s the long-term target that you have for solar as a percentage of the total revenue?

Lawrence Firestone

I don’t know that we call that out, Jim. Your assumption of what it would exit 2008 really has a lot to do with maybe the trajectory that you have the annual revs at. So, and that’s where we have called it out on absolute dollar basis, at about doubling what we have done this year.

Long-term target for solar I think, again, without having called it out in specific numbers, with the angles that we play in solar and clean energy, between architectural glass, solar on the thin-film deposition tool side and then on the inverter side, there is probably not a bigger combined growth engine that resides in the company on a long-term basis.

So, again, we are very excited about it. But I don’t think we have got a number that we are going to put out there.

Jim Covello - Goldman Sachs

I understand you don’t want to commit to a hard number. But, could it get to be half of the company’s revenues at some point in the future?

Lawrence Firestone

We said non-semi will definitely get there and solar would, I think, would be a big, big part of that. So, it’s going to depend on what the other markets are doing as well and in what timeframe. But it certainly has the size and the strength and the diversity of products in the market to grow to those levels.

Jim Covello - Goldman Sachs

Thanks so much.

Operator

And your next question comes from Timothy Arcuri - Citigroup.

Brian Lee – Citigroup

This is actually Brian Lee calling in for Tim. I just had a few quick things. Sort of a follow-up on an earlier question, but is it fair to assume that there is about a two-quarter lag between the time that the OEMs start to see a pickup in orders on the flat panel side of the business and when you see it impact the P&L? Is that a fair assumption?

Lawrence Firestone

In when we see it impact our P&L?

Brian Lee – Citigroup

Yes.

Lawrence Firestone

The way I would address that, it would depend on the OEMs’ lead time out of the factory. If you have got some OEMs that are being aggressive in ex-factory in six months, then we’d see it a little sooner.

I think for the higher generation tools, the new stuff that’s going off the lines, you are going to see longer lead times, maybe nine months to a year, depending on where they are and depending on the specs and things like that. So it’s probably a mixed bag.

If I was to break it up geographically for you, I would say the orders that are going to come in through Japan and Korea, the OEMs in Japan and Korea are going to be a little bit longer than the ones that will come from Taiwan and China.

Brian Lee – Citigroup

Okay. That’s helpful. And then you are talking doubling the solar revenues again in 2008 off of the big growth you saw in 2007. Do you have a sense for what that mix of solar between the tool side and inverters could be in 2008?

Lawrence Firestone

We know, but we are not going to tell you. We haven’t disclosed what the mix is and what part of the business is going to go to inverter versus non-inverter.

Brian Lee – Citigroup

Okay, okay. Fair enough. And then, last quick thing from me, we are hearing more about pricing pressure across the supply chain, given the weak macroeconomic fundamentals out there right now.

So how much of the margin decline this quarter was volume-related and maybe how much was pricing-related? Sales have been flat this quarter with the levels in Q3. Would margins have been flat off of the Q3 levels as well?

Lawrence Firestone

I think most of what you have seen has been volume-related.

Brian Lee – Citigroup

Okay.

Lawrence Firestone

I think the lion share of it is.

Brian Lee – Citigroup

Were there any share buybacks in the quarter?

Lawrence Firestone

No. We announced the share buyback program earlier this quarter. It might even have been right at the end of the year. But that hasn’t been engaged yet until after this earnings call.

Brian Lee – Citigroup

Okay. Thanks a lot.

Operator

And your next question comes from Edwin Mok - Needham & Co.

Edwin Mok - Needham & Co

Just a follow-up to the last question. In terms of pricing, have you seen any pricing pressure just across the semiconductor space?

Lawrence Firestone

We always see pricing pressure from our customers. I think it’s pretty consistent throughout the industry. I think we try and work on that. Typically we like to have lined up the next-generation product as a way for us both to gain from any reduction in what they are looking at as cost reductions, but I would say it’s a pretty normal environment out there for that for us.

Edwin Mok - Needham & Co

Great. Given that you expect solar to grow, is that any margin differences between solar and the other groups? And also is there any margin differences between the inverter versus the two sides of your solar business?

Lawrence Firestone

I think the margins hold up pretty well. Our non-semi margins have a tendency to be a little bit higher than the semi margins. You have some early manufacturing runs that probably don’t leverage the infrastructure or get to critical mass quite as fast. But I wouldn’t look at those as being anything different than any other normal ramp. So, we are looking forward to the margins that we’ll get out of that section of the non-semi market.

Edwin Mok - Needham & Co

How about the inverter versus two sides?

Lawrence Firestone

Same.

Edwin Mok - Needham & Co

Thanks for answering my questions.

Operator

(Operator Instructions). Your next question comes from Brett Hodess - Merrill Lynch.

Brett Hodess - Merrill Lynch

Good afternoon. Two questions. First, on the semiconductor side, if you look at the current environment, are you still seeing your OEM customers at this point reducing inventories as their shipments are declining in 1Q and based on their order guidance likely to decline in 2Q? And does that taken into account with your outlook at this point in time?

Lawrence Firestone

Brett, especially as you look at Q4 in the ‘what happened’ range, most of what we do at the semi-OEMs is on a just-in-time basis. And as we got to the last weeks for the quarter we saw some just-in-time orders not get taken off the dock or picked up, if you will. So that’s a pretty fluid environment.

But I think overall we are pretty comfortable with the operating environment that’s going on with the deliveries that they are taking and also the guidance that we have given. So, we haven’t gone out into Q2, but I think you see, what we have guided for Q1.

Brett Hodess - Merrill Lynch

And then, when you look at the non-semi businesses, the last couple of years you had some single-digit declines overall in those businesses. Solar has being growing well but the other parts of the business all have proven to be pretty cyclical. Some are up and some are down and they have offset each other negatively and offset the solar negatively.

I am wondering, as you look at those businesses going forward, particularly things like flat panel and data storage and architectural glass that have proven to be really quite cyclical, at what point do you think that the solar side or, either that or one of those products lines, will prove to be a little bit more growth-oriented such that you are not getting this offsetting effect that masks the good diversification?

Hans-Georg Betz

If you look at the different markets we are in, you will always have some kind of cyclicality on the semi side and flat panel and data storage, just generically. I think the only market which is purely growth, at least for the next foreseeable future, let’s say for the next couple of years, is solar.

And the question is, are these different cyclical markets are dependent to each other? Most of the time they are independent. And in particular, data storage is completely separated from semi; it may be one link, which is on the PC side. But in general, you will see different kind of cyclicalities because it depends on the capacity being brought online.

So, I think you cannot get rates completely on this kind of cyclicality, and you cannot expect the firing of the different markets are compensating each other.

Brett Hodess - Merrill Lynch

Okay. Thank you.

Operator

You have no further questions.

Hans-Georg Betz

Thank you very much for joining us today. We look forward to seeing you at upcoming events, conferences and events. Thanks.

Operator

This concludes today’s conference call. You may now disconnect.

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