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Photronics, Inc. (NASDAQ:PLAB)

F2Q08 Earnings Call

May 14, 2008 8:30 am ET

Executives

Michael J. Luttati - Chief Executive Officer

Sean T. Smith – Senior Vice President and Chief Financial Officer

Dr. Christopher Progler – Chief Technology Officer

Analysts

Jagadish Iyer – UBS

Brian Lee – Citigroup

Unknown Analyst – J.P. Morgan

Jay Deahna - J.P. Morgan

Brett Hodess - Merrill Lynch

Matthew Petkun - D. A. Davidson & Co.

Operator

Ladies and Gentlemen, thank you for standing by. Welcome to the Photronics Second Quarter Earnings Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. At that time, if you have a question, press the * key followed by the digit 1 on your touchtone telephone. If at anytime during the conference you need to reach an operator, please press *0. As a reminder, this conference is being recorded, Wednesday, May 14, 2008.

I would now like to turn the conference over to Mike Luttati, Chief Executive Officer. Go ahead, Sir!

Michael J. Luttati

Thank you, and good morning! This is Mike Luttati, Chief Executive Officer Photronics. I’d like to thank everyone for joining our Fiscal 2008 Second Quarter Earnings Conference Call. Before we begin, I’d like to remind everyone about the safe harbor statement provision under the Private Securities Litigation Reform Act of 1995. Thus except for historical events, the information we will cover during this call may be considered forward looking and may be subject to certain risks and uncertainties that could cause actual events to differ materially from those projected. This call will remained archived on our web site until we report our fiscal 2008 third quarter results after the market closed on Wednesday, August 13, 2008.

I will open the call with some brief comments about the company’s performance and strategic positioning. Following my opening, Sean Smith, our Chief Financial Officer, will provide an overview of Photronics second quarter results and third quarter guidance. I’ll then moderate the Q&A session. Joining Sean and me during the call will be Dr. Chris Progler, our Chief Technology Officer.

Second quarter revenues of $110.3 million were in line with our guidance projections and consistent with our annual plan. Market factors aside, we are very pleased with our consistent execution and the progress that we are making against our strategic objectives. On a regional basis, we had sequential growth in every region, with US sales increasing by nearly 21%. Overall semiconductor mask revenues were slightly down, with the biggest decline in Asia, primarily as a result of the slowdown caused by the Lunar New Year. High-end 90-nm and below sales were up 35% sequentially and represented 14% of total semiconductor mask sales, compared to 10% in Q1. The ramp of the US NanoFab and the additional share gains in Asia contributed to this growth. Flat panel sales also increased by 33% over Q1 and reached a record level for the company for a quarter. High-end FPD sales G6 and over increased by 53%. Performance enhancements for large-screen TVs and conversion from G5 to G7 for monitors were some of the key drivers for these new flat panel designs.

With respect to the priorities that we had set for 2008, here’s where we stand through the first half of our fiscal year. As I stated in our last call, first and foremost on our priority list is to monetize the investments that we made during 2006 and 2007, specifically our flat panel display facility in Taiwan, our semiconductor mask facility in China, and the US NanoFab. Year to date, we have made very good progress on two of the three fronts. In FPD, we have qualified all of the major Taiwan FPD panel makers, adding a second riding tool and giving us additional capability and capacity. During Q2, we took advantage of this by increasing overall FPD revenues in Taiwan and in Korea. This increase is the result of strong market conditions and further share penetration especially among Taiwan panel makers. In China, while we continue to improve operationally, we are not progressing at the pace that we had planned. We still intend to ramp through 2008, although we expect to be below our initial annual projections. We are currently evaluating various alternatives to increase revenues and to reduce costs. At the US NanoFab, we’ve made excellent progress. As planned, we began shipping revenue-generating products over the last 6 weeks of the quarter, and this included products to 5 separate customers including Micron IM Flash, 2 OEMs, and a 45-nm logic customer. Considering that the ground-breaking of this most advanced site was approximately 1-1/2 years ago, we consider this accomplishment to be extraordinary. We have also increased the customers engaged in qualification and evaluations from 6 to 10, excluding Micron. Although we’re working with a limited data set operationally, we’re tracking statistically to all manufacturing metrics being achieved inside of them being met.

Our other priority has been to expand our successful mainstream business, where we have several well-defined objectives outlined. While excess capacity in the mainstream business has continued to put pressure ASPs, we have in fact increased unit output through a combination of share gains and expanded applications. Finally, we continue to lean out the business model wherever possible in order to maximize profitability and cash generation. Despite some of the gains we have achieved thus far, this has been offset by an increasing cost structure as a result of our strategic investments. We continue to evaluate and will act responsibly as business conditions dictate to further reduce costs.

In the short term, we continue to remain cautious as both macroeconomic and semiconductor industry-specific indicators raise concerns on prospects for at least the balance of 2008, maybe longer. While these factors will clearly impact our performance, we remain optimistic that the sources of revenue generated from our new investments will continue to support our plan for growth this year in 2008.

I’ll now turn the call over to Sean to review our Q2 financials and our Q3 guidance, after which I’ll moderate the Q&A session of the call. Sean?

Sean T. Smith

Thanks, Mike, and good morning everyone! I’ll provide a brief analysis of our financial results for the second quarter of fiscal year 2008. I’ll also review our balance sheet and cash flows during the period and discuss our outlook going forward.

Net sales in the second quarter amounted to $110.3 million, as compared to $109.6 million in the second quarter of last year. Revenues for IC photomasks were $80 million as compared to $88 million in Q2 ’07, while FPD revenues were a quarterly record of $30.3 million as compared to $21.4 for Q2 ’07. The year over year decrease in IC sales is related to decreased ASPs principally for mainstream products. FPD revenue improved year over year as a result of increased high-end demand.

Sequentially, sales increased $7.1 million, or 6.9%, virtually of which was related to the increased revenues for FPD photomasks. Sales of advanced FPD and IC photomasks were approximately 20.6% and 10.2% respectively of total sales for the quarter. Included in this percentage are mask sets for semiconductor design at and below 90 nm and FPD sets used to fabricate flat panel products using G6 and higher technology. On a sequential basis, sales of high-end IC photomasks were up 35%, primarily as a result of the sales generated in the US NanoFab. As a percent of total sales in the second quarter, sales were approximately 60% in Asia, 24% in North America, and 16% in Europe.

The gross margins in the second quarter of 2008 was 18.4%, as compared to 23.9% in Q2 ’07. The decrease was associated with an expanding manufacturing base including manufacturing costs in the US NanoFab. Sequentially, gross margins decreased 160 basis points as a result of increased costs including depreciation associated with the NanoFab.

Selling, general, and administrative expenses for the second quarter were $13.6 million, as compared to $14.4 million last year, with the decrease related to reduced compensation expense in Q2 ’08 as compared to Q2 ’07. On a sequential basis, SG&A decreased $2.7 million as a result of the commencement of manufacturing in the NanoFab and rebidding of costs from SG&A to COGS during the second quarter of ’08. Additionally, overhead expenses decreased due in part to cost reduction programs.

R&D expenses which consist principally of continued development of advanced process technologies were $4.6 million in the second quarter. Sequentially, R&D increased by about $400,000.

During the second quarter, we generated operating income of $2.1 million, as compared to operating income of $56,000 in the first quarter of 2008. In our February call, we mentioned that during the next few quarter, we were likely to experience some fluctuations on the operating margin lines as we work towards monetizing our new manufacturing facilities in the US and in Asia. Incremental fixed costs in the third quarter related to NanoFab are projected to be in the range of $2.0 to $3 million. Our operating costs should reach a plateau in the third quarter, as it will be the first fully loaded quarter with the NanoFab. While we work through this expansion and customer qualifications, I assure you that we’re continuously driving to reduce our costs. Additionally, we continue to assess our global manufacturing strategy as our customer base continues to evolve and migrate. If this ongoing assessment warrants the management team to decide that there’s a need to evaluate future facility closures as to redeployment and further workforce reduction, we will do so; however, all these actions will be predicated by market conditions and customer requirements.

Net other income and expense for the second quarter was an expense of $3.2 million, as compared to an income of $400,000 in the second quarter of ’07. The decrease year over year is related to increased interest expense associated with our increased debt year over year and decreased investment income associated with reduced investment balanced and increased foreign currency losses year over year. During the second quarter, we recorded tax provision of $930,000, and the next loss was $2.5 million, or $0.05 per share for the second quarter.

As we exited the second quarter, we had approximately 1465 employees, equating to sales of approximately $300,000 per employee on an annualized basis. Total head count since the beginning of our fiscal year has been reduced by 5% on a global basis.

Now taking a look at the first 6 months year-to-date operating results, net sales for the first 6 months of ’08 were $214 million, a decrease of approximately $2 million from the first six months of last year. The decrease is the result of reduced IC sales of $13 million associated with reduced ASPs for IC mask principally from mainstream products. The decrease was mitigated by an increase of $11 million year over year from sales of FPD photomasks, principally high end.

Year to date gross margin decreased to 19.1%, from 25.9% as a result of our increased manufacturing base and reduced ASPs. Selling, general, and administrative expenses decreased by $1 million to $29.9 million, and research and development costs were $8.9 million for the first six months of ’08 as compared to $9 million last year. Net other income and expense amounted to an expense of $3.8 million in ’08, compared with income of $145,000 in ’07, as a result of increased interest expense and decreased investment income. For the first half of 2008, we recorded a tax provision of $2.8 million, and our net loss for the first six months of ’08 was $5.4 million or $0.13 per share.

Now turning to the balance sheet, cash and short-term investments at the end of the quarter amounted to $70 million, with working capital of $42 million. Accounts receivable increased $7 million, as compared to the end of the first quarter due to the increased sales during the second quarter, and accounts payable and accrued current liabilities on April 27, 2008, amounted to $117 million, as compared to $115 million at the end of the first quarter. Total debt at April 27, 2008, was $222 million. The principal component of outstanding debt includes $115 million outstanding on our revolving credit agreement, approximately $30 million of foreign term loans, and approximately $77 million in capital lease obligations including the US NanoFab.

During the second quarter, we paid off our 2-1/4 $150 million bonds, thereby reducing our outstanding debt from $259 million at the end of the first quarter and improving our net debt position in the second by $11 million to $152 million at the end of April 27, 2008. In reviewing our 2008 cash flow and capital needs, we will continue to explore various options should we determine the need to obtain additional financial flexibility. We remain confident that our access to capital will not inhibit our growth plans.

Taking a look at our cash flows, cash provided by operations for the second quarter of ’08 was approximately $23 million and amounted to $35 million year to date. Cash flow used in investing activities during the first half of ’08 amounted to approximately $77 million, of which $78 million represents cash payments for capital expenditures. Total CapEx for the first half of ’08 on an accrual basis was $114 million and includes our capitalized NanoFab lease obligation.

Taking a look ahead, our short-term visibility as always continues to be limited, typically one to two weeks. Turning to our outlook for the third quarter, many industry factors reflect continued softness while we do expect to see a moderate improvement environment for design activity, especially for advanced IC and high-end flat panels. We feel it is prudent to remain cautious. Based upon our best analysis, our revenue guidance for the third quarter is in the range of $112 to $118 million. Capital expenditures for 2008 on a cash basis are forecasted to be approximately $120 to $130 million, with the vast majority of which already installed. Most of the new installed CapEx is related to the US NanoFab and for additional high-end capacity in Korea.

During 2008, our tax rate will be impacted by the flow of income from jurisdictions for which we don’t have tax holidays or credits and upon our limited ability to recognize tax benefits in years in which we are taxable. Accordingly, in the third quarter of fiscal 2008, this will equate to a range of $1.0 to $1.8 million in whole dollar terms. As a result, based upon our current operating model, we estimate earnings per share for the third quarter of fiscal ’08 to be in the range of a loss of $0.11 to a profit of $0.01 per share.

That concludes my prepared remarks, and I’d like to turn the call over to Mike.

Michael J. Luttati

Thank you, Sean. We are now prepared to your take your questions.

Question-And-Answer Session

Operator

Thank you, gentlemen. The question-and-answer session will be conducted electronically at this time. (Instructions). We’ll take our first question from Tim Arcuri with Citi.

Brian Lee - Citigroup

Hi guys, this is actually Brian Lee calling in for Tim. Thanks for taking my question. I had a couple of things—first off for Sean, how should we be looking at the breakeven levels here in Q3 ’08. I think last call you mentioned that it’ll be going to about $108. Is that still the view, and would you expect that to go up again in Q4?

Sean T. Smith

Our breakeven level in Q2 was actually a little bit higher than that. Looking at the operating income line, it would have been about $108 or $107. Our breakeven point for the third quarter, at the operating income line, would be in the range of anywhere from $115 to $116 as a result of the additional depreciation coming on with the NanoFab being fully ramped for a full quarter.

Brian Lee - Citigroup

Okay, and would you expect that to go up again in Q4?

Sean T. Smith

No, I would not, Brian. We expect to plateau with respect to our operating costs in Q3, and we look to additionally pull some costs down – some additional costs – but with respect to depreciation which is the key driver to such costs, that will plateau in Q3.

Brian Lee - Citigroup

Okay, great! On the business mix, it looks like, on the last call, you guys were talking about semis and flat panel both being up in Q2 – it looks like flat panel came in better than expected, and otherwise you would have been closer to the low end of guide on revenue, so all in all, it looks like you’re ahead of expectations on flat panel. Can you talk about what drove the better revenue trends there and what sort of trajectory we can expect in that business in the second half?

Michael J. Luttati

Sure, Brian. It’s Mike. As I mentioned in my prepared remarks, there was a big drive obviously in the high-end TV market and also a conversion of the display market from Gen 5 to Gen 7, so we saw a lot of new designs pop out as a result of that. Our best indicator is that that will continue at least through June, maybe more into the summer, and that Olympic Games is driving a lot of the CD demand, but there’s a lot of new improvements in resolution, scan speed, viewing angle, brightness – a number of tweaks that are being made in designs that are driving these applications, and so fortunately because of the strength of our position in the high-end FPD business, we’ve been able to take advantage of that, and the timing of having our facility and additional rider in Taiwan really allowed to capture share that we might not have had had we not had that tool in place, so we really benefited from that. We think not only did we ride the market, but we also gained share as a result. In the IC side, as Sean mentioned, in his prepared remarks, we had a nice uptick in high-end IC sales, and the thing that really took the hit on the IC piece was that the decline in ASPs over in the mainstream business, although unit volumes continued to be up – we had strength in unit volumes in every region.

Sean T. Smith

I would say too, Mike, when we did the forecast – to answer Brian’s question about the uptick, we didn’t predict such a big increase in flat panels, but we did expect it to go up sequentially. On the IC side, Asia was a bit slow returning back from the Lunar New Year, which we had forecasted which we had forecasted to be somewhat muted, but it was down slightly what we thought it would be.

Michael J. Luttati

Yeah, good point.

Brian Lee - Citigroup

Okay, great! And then one last quick one from me – given the run rate you guys saw out of the gate in Q2, is there any change to the $15 million run rate by Q4 that you got it to on the call for NanoFab?

Michael J. Luttati

Well, a lot of it’s going to depend. Obviously, as we’ve said before, we depend heavily this year on Micron IM flash as a big percentage of the revenue. With the DRAM flash market being what it is, there may be some softness; however, frankly their design activity has continued to be reasonably good. It may be down some from that level, but we still expect to see continued ramp through the end of the year, and we’re trying obviously with the additional customers that we now have both in terms of qualification and evaluation, as I mentioned in my prepared remarks, from 6 to 10 to pull some additional revenue in from those customers to make up the difference.

Brian Lee - Citigroup

Okay, thank you.

Michael J. Luttati

You’re welcome.

Operator

Our next question will come from Matthew Petkun with D. A. Davidson & Co.

Matthew Petkun - D. A. Davidson & Co.

Hi, good afternoon! Mike, you commented that you did have one 45-nm qualification at the NanoFab this last quarter. Can you tell us what the results were from that, and whether or not you expect that customer to continue to use you on a go-forward basis or if you feel like, at least in the near term, you are more of a back-stop to their own internal capacity?

Michael J. Luttati

Well, let me just say that that customer – it was actually a revenue shipment, so what I referred to as the 5 customers for the quarter – the 2 OEMs, Micron IM Flash and the 45-nm customer – we did actually get paid for that, so it was revenue shipment. So we have qualified to a certain level. We do expect ongoing business there, and that’s about all I can say at this point, Matt.

Matthew Petkun - D. A. Davidson & Co.

Okay, great! And then, Sean, on the interest expense, did you give us specific outlook for how that should look – the net interest income and expense as we head into Q2 and into next year?

Sean T. Smith

I did not, but I can give you some guidance on that, Matt. We do expect interest expense to increase quarter over quarter. The interest and other income line, all in, including FX, interest expense, interest income could fluctuate on a quarterly basis of up to $500,000 to $700,000 or so, depending upon rates and where we are.

Matthew Petkun - D. A. Davidson & Co.

Could you give us some more specifics on where that’s at relative to time or something like that?

Sean T. Smith

Well, we have a couple of different instruments that are out there. I can say that with the replacement of the $150 million bonds and our current interest rate on the revolving credit agreement because it’s LIBOR plus 1.5 which does fluctuate every couple of months, it’s probably about a 200-basis point increase all in.

Matthew Petkun - D. A. Davidson & Co.

Okay, and then I think you previously said something about ’09 CapEx being down. Is that right?

Sean T. Smith

Yes. Well, we haven’t finalized our ’09 plans. We certainly are holding to our discussion that we’ve been talking about over the last three quarters with respect to saying after Q2, the big spend in capital expenditures is over. We should get back to a maintenance level, unless we see a significant uptick in demand at the high end, but I think we feel we have enough installed capacity. Our projection at ’09, Matt, is probably in the rage of probably $60 to $70 million and certainly trying to achieve a target of not higher, or get it down to about 15% of annualized sales.

Matthew Petkun - D. A. Davidson & Co.

Okay, and so hopefully, the excess cash will help offset the interest expense, barring any other changes in the capital structure.

Sean T. Smith

Correct. In my prepared remarks, I said most of the equipment that we have for ’08 is installed. We paid about I think I said $78 million. We have about another 50 to go, and we certainly have cash flow from operations over the next two quarters to cover that, so don’t expect a significant change barring anything unforeseen in our overall balance, and hopefully that will go up by the end of the year.

Matthew Petkun - D. A. Davidson & Co.

Okay. Just finally, what was the exact depreciation and amortization in Q2?

Sean T. Smith

The exact depreciation in Q2 was $24.4 million, and amortization was $2.1 million.

Matthew Petkun - D. A. Davidson & Co.

Okay. Thanks, guys.

Sean T. Smith

Thank you.

Operator

(Instruction) We’ll move on to our next question with __________ from J.P. Morgan.

Unknown analyst - J.P. Morgan

Hi, thanks for taking my call, guys. One of the questions I had was if I could get your overall view of the semi end-markets. One of the big suppliers last night called their second quarter as the bottom – what do you guys see, and the second part of that question is the China facility ramping up slower – is that due to the overall slowness and softness in semi or is it something else operationally?

Michael J. Luttati

On the first, I don’t know that I can offer a lot more than everyone that you’ve talked to from the equipment side, and I’ll certainly from the customer side on what we’re seeing on semi. We’re seeing a fairly good strength in design activity pretty much across the board. The mainstream business is heavily driven by analog design activity in the US and Europe. Just because we haven’t had exposure to the high end until recently, we are obviously participating in a way that’s for us probably better than it would be for our competitors because we’re getting access to customers we didn’t have before. So, independent of the cycle, we’re participating in areas and available markets that we didn’t have. I think from everything I’ve heard, as I mentioned in my closing remarks, there’s cautiousness out there, particularly through the balance of the year. FPD, as I mentioned, looks to be good at least through the summer, from everything we can tell, and could continue even stronger.

With respect to China, we’ve had two issues. I mentioned this on previous calls. One is operational, and the other is just the softening of the market in China. We’ve actually done a good job of getting customers qualified. It’s just that it’s very competitive there, and there has been a number of existing suppliers into China. We’re just trying to get some momentum built. We think that there is significant potential in the China market. We believe we have made an investment in a facility that’s as good as any facility in mainland China, and we believe that we’ll be able to compete there. It’s just been taking a lot longer than we had hoped.

Unknown analyst - J.P. Morgan

Okay, and followup to that – in terms of gross margins, I feel that it dipped this quarter, and what’s the plan to bring it back up to the 20-something level? Is it going to be a combination of volume and ASP increases or what’s your thought on that?

Sean T. Smith

Joe, this is Sean. It’s volume-driven. As I mentioned, our operating cost structure will plateau this quarter, and to the extend we are at the midpoint or high end of our range, we should see sequential growth in our operating margin. We talked about in the fall that Q1 would be our trough quarter with respect to our operation margins, and despite the bottomline projection from the range, we do expect to see, to the extend we hit the midpoint to high end of the range, sequential growth in our operating margins. With the combination of additional depreciation coming on board, we’ll cover those costs with the volume, and then after that, the inflection point is quite high.

Unknown analyst – J.P. Morgan

Okay, very good. Thank you.

Sean T. Smith

Thanks, Joe.

Operator

Next we’ll hear from Merrill Lynch’s Brett Hodess.

Brett Hodess - Merrill Lynch

Good morning! Sean, regarding the breakeven being higher than the 108 projected last quarter – as you mentioned, it was because of the higher depreciation. Is depreciation higher than what you had planned because the NanoFab is coming on more rapidly? Did I get that correct?

Sean T. Smith

Let me try to clarify. We gave, Brett – and maybe there’s a miscommunication – we gave a range last quarter of 106 to 112, with a guide from $0.12 loss to $0.00 at 112, so the breakeven, I think, Brian referred to a few minutes ago, that was related to the first quarter run rate. We did expect end-project costs to go up, so nothing has really changed from our plans other than we do have some tools that are coming on a little quicker than what we had forecasted.

Brett Hodess - Merrill Lynch

Okay. And then secondly, when you look at the mature product where the pricing has declined – mainstream where the pricing has declined quicker than you though even though you’ve been picking up volume, Mike, you said that that’s mainly market share gain that you’re picking up volume, which indicates that there’s still quite a lot of capacity there. Do you see at any point any of the excess capacity in the mainstream side moving out of the market and allowing things to stabilize there, or do you expect it just to continue to stay pretty touch like this?

Michael J. Luttati

I think it’s going to be a little tough for a few more quarters. What we’re trying to do is do two things on the mainstream business. One is we have a very high share to begin with, so we’re incrementally trying to improve our share inside the customers whom we already have 60%, 70%, 80% share. It’s very hard to get 100% with many of these customers, so it’s sort of nibbling away at additional couple of points here or there, and then the other is there are some new applications that we’ve dabbled into – back-end masks and some other things to try and grow, but it’s all incremental. I think that this will stabilize over time, but there’s still a lot of capacity in the network.

Sean T. Smith

Just to add to Mike’s point, the increased volume that we’re seeing should certainly offset. On the mainstream side, margins were essentially either flat or up slightly except in Asia where the mainstream issue was more prevalent as a result of the drop in volume related to Lunar New Year.

Michael J. Luttati

Actually, we continue in these sites to ring out additional costs to offset the ASP erosion, so to add to Sean’s point, we’re able to maintain relatively decent margins.

Brett Hodess - Merrill Lynch

So, the real issue really was just, as Sean pointed earlier, the higher depreciation.

Michael J. Luttati

Exactly.

Brett Hodess - Merrill Lynch

Okay, and as you said, that’s going to plateau this quarter, and OpEx is going to go up, I guess, a bit after that, but after that we’ll start to see leverage as the revenues grow on a more steady basis.

Sean T. Smith

When you refer to OpEx, are you referring to SG&A and R&D?

Brett Hodess - Merrill Lynch

Yes.

Sean T. Smith

SG&A should not be going up sequentially. R&D may tick up slightly, but overall OpEx should remain essentially flat.

Brett Hodess - Merrill Lynch

Okay, and final question – If you’re looking at the customers that you’re qualifying in the NanoFab now, you said about 10 customers that are qualifying – 5 of which are already shipping revenues, or was that 10 customers in addition to the 5 that are getting revenues?

Michael J. Luttati

The 10 would include the 5, but exclude Micron from that, so effectively four plus….so we got an additional 6 in the pipeline.

Brett Hodess - Merrill Lynch

Okay, thank you.

Michael J. Luttati

Just to add a little more on that – that is starting to become more global in nature. Obviously, you know about some of the relationships that Micron has outside of the US, and so we’re getting exposure now to NanoFab business outside of the US and Europe.

Brett Hodess - Merrill Lynch

Great, thank you.

Michael J. Luttati

You’re welcome.

Operator

Next we’ll hear from Stephen Chin of UBS.

Jagadish Iyer - UBS

This is Jadadish on behalf of Stephen. Couple of questions, Mike and Sean. First question is have you given us the breakout of how much are the revenues or the shipments from the NanoFab please?

Sean T. Smith

Jagadish, this is Sean. For comparative purposes, we aren’t providing that breakout, but what we can say is, as Mike alluded to in his prepared remarks, certainly at 6 weeks of revenue-generating opportunity, everything is on track, and we do expect sequentially improvement over the next couple of quarters.

Jagadish Iyer - UBS

How should we think of margins once you start to fully ramp the NanoFab given that you’re at the leading edge in terms of supplying the IC masks? How should we think of margins ending up going forward please?

Sean T. Smith

Margins will trend up once we cover the additional costs coming on. I mentioned a few minutes ago, our operating margins should improve sequentially, and then once we reach our plateau in Q3, as we get into Q4, depending upon our projected revenue guidance, that will be indicative of how much gross and operating margins go up.

Jagadish Iyer - UBS

And the other question is what I wanted to find out you had a nice increase in North America. Could you elaborate on where was the strength from, particularly on the segment within North America please?

Sean T. Smith

Actually, sequentially North America increased both in the high end and in the mainstream product side.

Michael J. Luttati

So obviously we had the NanoFab contribution as well as some additional penetration in the mainstream business.

Jagadish Iyer - UBS

And how do you see that going forward please?

Michael J. Luttati

As I said earlier, there’s a lot of strength around the analog business where we’re particularly strong, and we feel that we’re very well positioned there. I don’t know that it’ll go up dramatically, but we certainly believe that it’ll be steady state and at least if we can incrementally get some share gains, maybe some modest improvement there as well.

Jagadish Iyer - UBS

Thank you.

Michael J. Luttati

You’re welcome.

Operator

Next we’ll hear from Jay Deahna of J.P. Morgan

Jay Deahna - J.P. Morgan

Thanks very much. Good morning! A couple of questions – first of all, of the 6 customers that you are referring to on Brett’s last question, how much of that is fresh business from existing customers or new customers, as opposed to cannibalization of business that you were doing at other facilities around the world at Photronics?

Michael J. Luttati

Jay, this is Mike. I would say that because this is technology that we were never able to ship before, there may be customers that we have supported on the mainstream business, but they’re all new high-end customers to us. Just to maybe to add a little more to help you there, there are I would say about three of those that we had not done any business with before.

Jay Deahna - J.P. Morgan

Okay, that’s certainly encouraging. Mike, if we take this to a high level, first of all, if you look at Photronics’ history, the company historically established its presence in the market with several facilities in the US and Europe, and if you look at the way business has trended over towards the Far East over the last decade or so, how do you feel about your spread of property, plant, and equipment, and what can we expect in terms of perhaps shrinking your cost basis or your footprint for manufacturing in the US and Europe as this NanoFab comes up?

Michael J. Luttati

We have done that. As you know, we had at one point 7 facilities in the US and we continue to do that, and you’re absolutely right. I think it was a couple of calls ago that we talked about the fact that my view of the footprint of the company five years from now will look differently as things migrate. What that will end up being in terms of number of facilities in each region, I don’t know, but we clearly have to, for efficiency purposes as well for keeping these facilities aligned to the customers and the demand of the customers, migrate some things over time, and I believe that will happen, and we’re continuing to look at all of those things. One other thing I would say is, as we’ve been asked this and I don’t know if this somewhat behind your question, with the NanoFab in the US, there’s been a lot of questions how we will be able to support the global business from the US at the high end. As it turns out, the high-end products tend to have a little bit longer cycle times in terms of order to shipment, and we believe that we are going to be in a good position based on the yield, and the manufacturing capability of that facility should be able to support the global business from Boise just as well as our competitors can from Japan.

Jay Deahna - J.P. Morgan

Okay. If you look over the last year or so, as you’ve made investments in your new facility and to a certain extent underutilized your older facilities, that’s had a negative impact on your margin structure. As you begin to ramp your new facilities, get better absorption from FPD, etc., better business out of the Nano center in Idaho, can you actually juice the margins in a reasonably discountable period of time – meaning later this year or into the first half of next year by actively reducing some of your cost structure in the underperforming areas? Are we actually going to see that happen, or is that something that’s still up in the air and needs to be decided later.

Sean T. Smith

Jay, this is Sean. We have slowly started that process. We’ve shrunk the infrastructure in the US and Europe over the last 6 months, I believe, between 7% and 9% in head count. We’ve also redeployed tools in areas where we felt we had excess capacity into Asia where we feel there is revenue opportunity. What we have existing in Europe and the US as far as the legacy sites, they are actually performing well and generating decent cash. We have not made significant investment obviously in those areas or those manufacturing locations in the past few years; it’s all been in Asia or in Idaho, but to add to Mike’s long-range plans, we will continue to be very active in determining how we can load our facilities, especially our green-field facilities, the one in Idaho, the one in PKLT in Taiwan and in China while we look to redeploy and maximize our profits in our legacy sites.

Jay Deahna - J.P. Morgan

Okay, then Mike, the last one – what do you view today as the sustained secular annual growth rate for this company compared to when you first joined the company? Is it higher or lower and why, and at the end of the day, are we just looking at kind of a one-time phenomenon here as you ramp up the NanoFab and experience a little bit of improvement in cyclical demand for flat panel or is something structurally and fundamentally changing for the company that’s going to allow you to break out of the sideways trend and deliver sustained growth for a multiyear period of time?

Michael J. Luttati

Yes. Jay, let me cover that. I think that what we’ve described and what I described when I joined the company hasn’t changed dramatically in terms of what we are trying to do in terms of the growth pieces that we’ve put in place. The high-end market is growing in double digits – the high-end IC business – in excess of 40%, if you look at over the next 5 years, sort of 90-nm and below, and it’s a business segment that we’ve had very modest under 10% market share. We really believe that we can participate in a big way there, not only with the NanoFab, but also with the investments we’ve made in Korea where we have a 65-nm line and also in Taiwan as that will be a follower to the Korea and NanoFab investment. The industry growth rate, as you said, is sort of a 3% growth rate from macro if you all-in look at it, so if you take the growth that we see in high-end IC add it on to what believe we can continue to grow on the mainstream business, that puts us into the low single digits, and then, you’ve got the flat panel business on top of that. I think this is a business that can grow in the double digit—at least the low double digits—and maybe higher if we can grow share.

Jay Deahna - J.P. Morgan

Okay, and then I actually do have one last one. If you look at the long-term growth rate in IC units, it is about 10% to 11% over four and a half decades, but over the last five years or so, it has actually been about 15% for digital ICs based on the consumerization of ICs, flash coming up, and the transition of bid densities in DRAM to 3 years from 2 years, and at the same time, it seems that the sustained growth rate for the photomask industry has actually gotten a little bit lower despite an acceleration in IC unit growth. What is the dynamic going on there? Is that a sustainable trend or can that turn based on, perhaps, new transistor architectures and what not as we move down to 45 and below?

Michael J. Luttati

I think it’s a combination of things, and maybe I’ll ask Chris to cover it, but from my point of view, it’s just improvements and better design methodology. First pass designs versus what we’ve seen in the past where there were many multiple iterations of designs, and so that drove some acceleration in the mask side of things. People are, with the escalating cost of design, trying to squeeze in every way and make improvements so that there is no multiple passes of mask sets. Chris, can you potentially add to that?

Dr. Christopher Progler

Sure, Mike. Yeah, I think that’s correct. I think programmable devices have also played a role, Jay, that you’ve alluded to. I think that’s kind of rung out now though. I don’t see that being very strong in the future. I think SOCs have played a role as well where multiple functions are combined on a single chip. One possibility favorable to mask is that as companies aren’t as committed to go to the next mode, they may be more pervasive in design activity to ring more out of an existing mode. We are seeing this with some of the mature customers already, so that is a trend that I actually expect will happen. To bump up design activity, companies will try to ring more life out of existing mode and differentiate through design. I think those are the two opposing dynamics that we are going to see in the next few years.

Jay Deahna - J.P. Morgan

Okay, thank you.

Michael J. Luttati

You’re welcome. Thanks Jay.

Operator

Okay, gentleman, there are no further questions.

Michael J. Luttati

Okay. We thank you all for joining us, and we look forward to talking to you at our third quarter conference call.

Operator

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.

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Source: Photronics, Inc. F2Q08 (Qtr End 04/27/08) Earnings Call Transcript
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