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Brian Smith - Director of IR

Nick Konidaris - President and CEO

Paul Oldham - CFO

Analysts

Andy Aranda - Analyst

Henry Hooper - Analyst

Matt Petkun - Analyst

Electro Scientific Industries, Inc. (ESIO) F1Q09 (Qtr End 6/28/08) Earnings Call Transcript July 24, 2008 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the ESI Fiscal 2009 First Quarter Earnings Release Conference Call. My name is Gwen and I will be your operator for today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder this conference is being recorded for replay purposes.

I would now like to turn the call over to Mr. Brian Smith. Please proceed, sir.

Brian Smith

Thank you, Gwen, and good afternoon everyone. My name is Brian Smith, Director of Investor Relations for ESI. With me today are Nick Konidaris, our CEO, and Paul Oldham, our Chief Financial Officer. This conference call will cover our fiscal 2009 first quarter results.

Before we go into the details of the call, I’d like to remind you that some of what we say on this call will include forward-looking statements concerning customer orders, shipments, revenue, gross margin, expenses, non-operating income and taxes.

These statements are subject to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. These statements include a number of risks and uncertainties that are discussed in more detail in today’s press release and our filings with the SEC. Actual results may differ materially from those forward-looking statements. This call also contains time-sensitive information that we believe to be accurate as of today July 24, 2008 and which could change in the future. This call is a property of ESI.

Now, I’ll turn the call over to ESI’s CEO, Nick Konidaris.

Nick Konidaris

Thank you, Brian, and good afternoon everyone. Q1 was a good quarter for ESI despite the tough market environment. Savings and earnings per share were both at the high end of our guidance. Also, we introduced several key new products that deliver on our strategy to expand into new and fast-growing markets and applications. Lastly, we took the necessary actions to align our cost structure with the lower business levels which already brought results.

Orders of $60 million represented 16% sequential growth. Sales were $64 million down, 9% sequentially. Earnings per share were $0.09 on the non-GAAP basis. On a GAAP basis, net loss was $0.10 per share, driven by the write-down of a portion of our auction rate securities consistent with the deteriorating conditions in the financial markets.

Our semiconductor group continued to operate in a weak capital spending environment. Still, customers are embracing our new dual beam memory repair systems as they work to improve their production efficiencies and gifs [gifs]. Also, last week we introduced our new Cignis product which marks our entrance into the wafer singulation market.

Our Interconnect and Micro-machining Group delivered record orders, shipments and revenues in Q1 as we expanded our Micro-Machining product line to address new applications and materials with the recently introduced Model 5800. In our Passive Components Group, the new Model 3550 high-capacity tester continued to gain share in a soft market.

Looking at our end markets, the cyclical downturn in the memory market continues to pressure the order activity in our Semiconductor Group. Further, macro-economic uncertainties, is slowing the growth in consumer electronics which drives demand in our passive components segment.

We project a slowdown in both of these end markets to last through the rest of the calendar year. As a result, during Q1 we continue to take actions to streamline our cost structure but preserve the strategic investments that will allow us to expand into new applications and grow our addressable market, positioning the company for growth when markets recover.

This concludes my opening remarks. I will now discuss an overview of our first quarter business by segment.

In our semiconductor segment, orders were down both sequentially and year-over-year due to the continued contraction of capital spending for production of memory chips. Analysts estimate that DRAM chip prices have bottomed and bit growth remains strong. But the timing of the recovering in our capital spending remains uncertain.

There continues to be some capacity expansion in our Flash, but most of the demand for memory repair is being driven by new technology needs. Orders for LED wafers scribing and LCD repair products, were down slightly off a peak in Q4. In Q1, we introduced the AccuScribe 2150, the industry’s first real-time dynamic auto-focus scribing solution.

This product expands our addressable portion of the fast-growing LED wafer scribing market. Also, our Polaris 300 laser, introduced in Q4, showed good acceptance in the generation 7 and 8 LED, LCD repair market.

Last week, we announced our new Cignis laser-based system for wafer singulation. This marks our entry into the broad and emerging markets of laser-based processes for wafer dicing, for next generation technology nodes and new 3-D packages driven by demand for high-performance mobile and consumer electronics products. Our patented technology, which includes a picosecond laser, clearly differentiates us from other solutions.

We’re very pleased to have entered this market with our first order in place with a premier technology partner, STMicroelectronics. Looking ahead, the memory chip market continues to suffer from severe price pressure brought on by excess capacity. Although bit growth continues to be strong, capital spending by DRAM manufacturers in 2008 is expected to be down more than 50%, with capacity expansion not expected to resume until 2009.

Equipment purchases will continue to focus on shrinking to the sub-70 nanometer technology node to lower production costs. Our success in this market will be driven by our products and surpass productivity, low cost of ownership and strong technology roadmap.

Turning to the Inter-connect and Micro-machining Group, orders were up significantly from a very strong Q4 to a record high. This result reflects several key customer wins including a large multi-system order for the new Model 5800 dual-beam high-power micro-machining system which we announced in June. This product can engineer a broad set of features on a wide variety of materials and allows us to pursue new applications and expand our addressable market.

We do want to mention that order activity in this segment can be lumpy, driven by capacity expansion for customer specific applications. While we do not expect the large orders we shipped in Q1 to repeat every quarter, we’re pleased with the results and see this market as a source of long-term growth.

In our Passive Components Group, orders were down sequentially in a weak demand environment. Capacity expansion in this market is paced by demand for consumer electronics which has been impacted by the slowing of a global economy. We project that expansion in this market will resume in 2009 in line with general economic recovery. In the meantime, our new Model 3550 continues to capture markets share with its combination of hybrid activity and lower operating costs.

During the quarter we largely completed our planned cost reduction actions to streamline our business in this difficult market environment. In addition, we accelerated our offshore manufacturing initiative and now expect approximately 50% of unit production to come from Asia this year. However, we’re disappointed in our overall level of gross margin. We will continue to focus on improvement in this area and believe that the results this quarter were impacted by several factors which should not repeat going forward.

Turning to the overall outlook for ESI, we expect economic uncertainties and cautious capital spending to continue to weigh on the demand for our products. As a result we expect Q2 shipments and revenues between $50million to $60 million. Non-GAAP earnings per share are expected to be between $0.00 and $0.05, excluding the largely non-cash impact of purchase accounting, equity compensation and restructuring costs.

Although we face a tough market environment in the near-term, we’re committed to developing new products that will address new applications and grow our addressable market, positioning us for growth when market conditions improve. In addition, we continue to focus on managing our cost structure, improving gross margins, and increasing efficiencies across the company to deliver profit in tough times and strong earnings growth over the long-term. Now I will turn the call over to Paul for a detailed discussion of our results for the first quarter.

Paul Oldham

Thank you Nick and good afternoon everyone. The following information includes results from our first quarter of fiscal 2009 which ended on June 28, 2008. Due to the change in our fiscal year, we will make year-on-year comparisons against the fourth quarter fiscal of 2007, which ended on June 2, 2007.

In addition, to improve comparability, we are also providing earnings per share and related income statement results on a non-GAAP basis, excluding the impact of purchase accounting, equity compensation, restructuring expenses and non-recurring items.

Orders for the first quarter were $60 million, up 16% or $8 million from the prior quarter. As Nick mentioned, orders for our Inter-connect and Micro-machining products were at a record high and represented over 50% of our bookings for the quarter.

We penetrated new flex-circuit customers with our 5300 platform and expanded our breadth of micro-machining capabilities with our new 5800 dual-beam micro-machining system resulting in a large multi-system order. Semiconductor and passive component orders were both down sequentially with overall semiconductor orders at their lowest quarterly levels in several years. Geographically orders from Asia declined modestly consistent with the weakness in semiconductors and passive components. Both Europe and the Americas showed strong sequential order growth.

Shipments in Q1 were $64 million, up sequentially from $58 million in the prior quarter. The growth was driven by strong shipments of interconnect and micro-machining products and semiconductor shipments which were deferred by customers from Q4.

Backlog at the end of the quarter was $38 million, down $4 million from last quarter. Backlog declined primarily in semiconductors due to the lower sequential orders, partially offset by an increase in backlog for micro-machining systems.

Deferred revenue was up slightly consistent with historical levels. Revenue for the first quarter was $64 million, down 9% for the quarter. Semiconductor revenue declined 8% sequentially due to lower demand. Passive component revenue was down over 50% following a record fourth quarter in which we saw both strong shipments and recognition of revenue from new products shipped earlier in the year. Interconnect and micro-machining revenue grew over 50% as a result of strong demand for new applications.

Year-over-year revenue was down 11% with all of the decline attributable to the semiconductor group. These results reflect the benefit of our investment in a broader portfolio of products, as strength in micro-machining, helped balance the cyclical decline in our semiconductor and passive component segments.

Gross margin for the quarter was approximately 40% including $500,000 in purchase accounting and equity compensation reflected in cost of goods sold. On a non-GAAP basis, margins declined sequentially in year-over-year and were impacted by significantly lower production volumes, higher warranty costs and sales of low margin upgrades.

Warranty costs increased significantly in the quarter primarily as a result of specific supplier related laser failures, one-time transition costs of warranty support from Canada and Japan, and an associated increase in our warranty reserve. Although we can see some variability, quarter to quarter, in warranty activity, we do not expect the level of warranty expense, we saw this quarter, to repeat.

Looking forward, we expect margins to improve sequentially as warranty activity normalizes. We see improved mix driven by fewer lower margin upgrades and the full impact of our cost reductions to take effect.

Operating expenses were $25.5 million including $400,000 in purchase accounting expenses and $1.2 million in equity compensation. In addition, during the quarter we incurred nearly $750,000 in expenses associated with actions to reduce our cost structure.

Although we completed the majority of our planned actions, we expect the remaining $300,000, to be incurred during the second quarter. Excluding the impact of these items, non-GAAP operating expenses were $23.1 million, roughly $3 million below the prior quarter.

Overall expenses declined as a result of our cost reduction efforts and reflected lower labor and labor related costs, project expenses, discretionary spending and variable pay. Compared to the fourth quarter of fiscal 2007, Q1 expenses on a non-GAAP basis were up approximately $1 million reflecting the addition of New Wave Research acquisition which was made in fiscal 2008, partially offset by other expense reductions.

On a stand-alone basis, non-GAAP operating expenses were down $2.6 million. Operating loss for the quarter was approximately $200,000 compared to income of $2.8 million or 4% in the prior quarter. Non-GAAP operating income was $2.7 million or 4.2% of sales down from $6 million or 8.5% in the prior quarter, primarily due to a decline in overall revenue and related gross margin, partially offset by the lower spending.

First quarter interest and other income of $860,000 was down from the prior quarter primarily due to lower interest income, driven by lower average cash balances and yields on cash. Additionally a large foreign currency gain, reported in the prior quarter, did not repeat.

Looking forward, we expect to see interest and other income approximately flat based on projected average cash balances and yields.

In addition, during the first quarter we made a decision to write down our portfolio of auction rate securities by $5.1 million to $14.5 million in the income statement. Previously, we had taken a $3.9 million temporary reserve against these securities within the balance sheet.

Given the continued challenges in the financial markets and prolonged credit crisis, we cannot reasonably predict when these securities will become liquid. As a result, we’ve now reflected their status as other than temporary which results in a charge to the income statement under GAAP accounting rules.

Although, we believe that these securities will eventually monetize, we cannot predict the timeframe when that will occur. We have continued to receive all scheduled interest payments on these securities and have ample liquidity to hold them for an extended period of time.

Income tax for the quarter reflected a benefit of $1.7 million driven by the write-down in value of the auction rate securities. On a non-GAAP basis, the tax rate was 29% reflecting the implementation of our tax planning strategy associated with increased offshore manufacturing. Looking forward, we would expect to see our non-GAAP tax rate in the low 30s.

This resulted in a first quarter net loss of $2.8 million or $0.10 per share. Excluding the largely non-cash charges related to the auction rate securities, purchase accounting, equity compensation and restructuring expenses, non-GAAP net income was $2.5 million or $0.09 per share down from $5 million or $0.18 per share in the prior quarter.

Turning now to the balance sheet, cash and investments were $155 million, which includes the net $14.5 million in auction rate securities. During the quarter, we spent $3.3 million to repurchase approximately 214,000 shares of stock at an average price of $15.63 as part of our ongoing program to offset dilution.

In addition, we spent approximately $1.5 million in capital expenditures. Operating cash flow totaled $1.6 million for the first quarter driven primarily by the net loss adjusted for non-cash items and lower inventories partially offset by a reduction in accounts payable and accrued compensation.

Inventories declined approximately $9 million for the quarter. We were pleased with our progress in reducing inventories as we better align manufacturing activity with current business levels and see this as an area of continued focus. Inventory turns were 1.6 times on lower revenues.

Accounts receivable were $50 million at the end of the first quarter reflecting DSO of 84 days. Although the accounts receivable balance was down slightly from the prior quarter, DSO increased six days due to lower revenues and timing of shipments late in the quarter.

Looking forward for Q2, we expect our shipments and revenue to be approximately $50million to $60 million reflecting the continued weak environment. Gross margin, excluding the impact of purchase accounting and stock compensation, is expected to be approximately 43%, up sequentially due to improved mix, the full effect of our cost reduction action and normalized warranty activity.

Non-GAAP operating expenses are expected to be approximately flat with Q1. As a result, non-GAAP earnings per share, excluding stock compensation, purchase accounting, restructuring and other nonrecurring items are expected to be between $0.0 and $0.05 per share.

Now I will turn the call back to Nick for a brief summary.

Nick Konidaris

To summarize, Q1 was a good quarter with sales and income at the high end of our guidance despite softness in several key end markets. This performance supports our strategy to diversify into a broader set of markets and applications and reflects the efforts we have made to manage our cost structure consistent to the current environment.

Although we will continue to face market headwinds, with slow capital spending, particularly memory and passive components, we’re executing our strategy to enter new markets and applications and have seen good customer response to our new products. We will continue to focus on increasing efficiencies across our business in order to leverage sales growth as the markets recover into even faster earnings growth.

This concludes our prepared remarks. We’re ready for your questions. Gwen?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Andy Aranda. Please proceed.

Andy Aranda - Analyst

Hi, this is Andy Aranda in for (inaudible).

Nick Konidaris

Yes. Hi, Andy.

Andy Aranda - Analyst

How is the pipeline for repeat wafer singulation sales with your current customer or other chip companies?

Nick Konidaris

At this point in time, we have a strong activity in terms of qualification. We are basically engaged with major semiconductor manufacturers in the both logic and memory areas. And this is a product that as we continue our partnership with ST and we expect partnerships with additional manufacturers, is going to start shipping towards the end of the year.

Andy Aranda - Analyst

Sounds great. Within the passive electronics component market, can you talk about your success in some of the customers that were previously relying on tools that they developed internally?

Nick Konidaris

Yes, absolutely. We have had significant successes in Japan with major in-house developers for tools as well as in Korea. In fact, this success continues despite the weak environment, which is primarily due to lower utilization rates of that equipment, which is in the [AITIS].

We do expect that as that utilization improves that as a result of the growing adoption of our 55 system high-capacitance tester throughout Asia. And the conversion that we already have accomplished in terms of captive producers that we’re going to see a resumption of strong business in this segment.

Andy Aranda - Analyst

That’s encouraging. You know just looking at the market, what is the capacity situation with some of the capacitor manufacturers and do you see a recovery in the surrounding capacitor market before the DRAM market?

Nick Konidaris

Yes, I think although they are somewhat linked, that phenomenon is a little bit different in the sense that in DRAM market you have an industry that somehow manages through intense competition to create significant imbalances between demand and supply. You have that to a lesser extent in the passive components market. But what is happening, the fundamentals in the market are basically strong. If you look at many reports such as we had one from DRAM Exchange, the various units where this analysis go, continued to grow, although at probably a lower rate; 98 million PCs in 2007 that are going to become 124 million PCs in 2008.

You see cell phones at 1.1 billion going to 1.250 billion in 2008, digital cameras from 115 million to 156 million, USB drives from 159 million to 178 million, MP3s from 166 to 174. All of these products are using MLCCs but also they are using memory. And we see that as the world rationalizes the overall market weakness not necessarily in those segments but the concerns about inflation as a result of higher energy prices, the concerns about the financial turmoil that is out of sub prime mortgages that these fundamentals are going to really drive the resumption of demand for MLCCs and memory.

Andy Aranda - Analyst

Sounds good. One last question and then I’ll jump back in the queue. Can you provide any time line on the introduction of some of your newer products, specifically the LDA product or the micro-machine system for the medical market?

Nick Konidaris

Yes, the last quarter we introduced a new system in the LED scribing, the AccuScribe 2150. We also introduced the 5800 dual-beam high-powered micro-machining system and we introduced the Cignis wafer singulation system.

As the time goes on, we expect to be introducing new systems in the semiconductor memory repair as well as new capabilities in the MLCC. Given that our products use a lot of a common core competencies that allow us to really pursue new markets, we believe that the current heavy product introduction schedule will allow us to, with minor modifications, to enter into solar and medical and other markets.

Andy Aranda - Analyst

Thank you very much.

Nick Konidaris

Thank you.

Operator

Our next question comes from the line of Henry Hooper. Please proceed, sir.

Henry Hooper - Analyst

Hi, This is a question for Paul Oldham. After the 214,000 shares that you bought this quarter, what is your current issued and outstanding share count?

Paul Oldham

Hi, it’s just a little bit over – let me see if I can get you the exact number. Current issued and outstanding is 26.990 million. So, it’s just under 27 million.

Henry Hooper - Analyst

Great, thank you. That’s my only question.

Operator

There are no more questions at this time. I apologize. The next question comes from the line of Matt Petkun. Please proceed, sir.

Matt Petkun - Analyst

Hi, good afternoon. Nick, on the interconnected micro-machining business, those are very impressive orders and congratulations on that. Could you share with us what percentage of those orders came from more legacy PCB interconnect via type applications and what percentage came from your newer micro-machining applications?

Nick Konidaris

Well, let me tell you how much we are prepared to share. In this market, basically we saw improvement both in the Interconnect which we call the legacy and as well as the Micro-machining which is primarily new applications based on new product.

The significant thing about the Interconnect is that we had significant number of new customer wins in the flex separate market, that is very, very pleasing to us because even if it is legacy, it is a solid market growing because as a result of a growth in the consumer products. Of course, we’re very pleased with the large order of the micro-machining with the 5800. That was a result of a new designing there and we expect that between the two products we’re going to be seeing continuing design-ins as we move forward. But again that business, keep in mind, is lumpy.

Matt Petkun - Analyst

Okay. Great. And I didn’t mean to convey that the legacy meant not growing. I just meant products that you had in the portfolio maybe a year or two ago. On that micro-machining side, were those customer wins primarily with UV tools and primarily for flex applications?

Nick Konidaris

Well, this 5800 is not a UV. It is a fiber laser IR wavelength high power.

Matt Petkun - Analyst

Not on the flex side, on the interconnect side.

Nick Konidaris

Sorry, these are – yes, UV.

Matt Petkun - Analyst

Okay. Great, and then could you guys be any more specific about the sequential change in orders in the semiconductor products group? I understand it was down but by what magnitude roughly?

Nick Konidaris

Hold on for a second.

Paul Oldham

As you recall – Matt, this is Paul. As you recall, bookings last quarter were down significantly and this quarter they were down another 20% roughly. And I would say that they’re running at the lowest level that we have seen in many years.

Matt Petkun - Analyst

Okay. That’s probably a good thing if you guys can put up a bookings quarter like this and have those levels in this business, so congratulations on that. And the margins, you explained some one-time issues in the margin structure. Has anything changed in terms of what your peak and trough margins should look like? Obviously you never really attained peak margins – your peak margin goals in this last cycle. But how close are we to seeing better and more sustainable margin improvement here?

Nick Konidaris

Well, if you look at our model, which is flexible and by that we mean that we shipped 50% at $90 million and we go down to 42% at $55 million. Next quarter if you draw that line, the model would call us to be at 43.5% margin. We are guiding around 43%. We’re not exactly at 43.5% but we are so close that we think we are almost at model.

Matt Petkun - Analyst

Okay, great. And then just finally one thing I missed, Paul, the specific numbers about your share buyback, how much did you spend? I know that you have bought back at an average price of $15.63 but beyond that – I missed the commentary.

Paul Oldham

Yes. The specific numbers were $3.3 million and it was 214,000 shares.

Matt Petkun - Analyst

And that was all during Q1?

Paul Oldham

That was all during Q1, correct.

Matt Petkun - Analyst

Okay. Fantastic. Thanks so much.

Paul Oldham

Thanks, Matt.

Operator

(Operator Instructions). There are no more questions at this time.

Nick Konidaris

Thank you Gwen. To reiterate, we would face near-term challenges as capital spending in our markets remain soft. Despite the market challenges, we are executing on our strategy to expand into new markets and applications which should enable the company to emerge from this period positioned for growth.

In the near-term, our focus on creating a lean operating model should allow us to remain profitable even at lower business levels and allow faster earnings growth as market conditions improve. Thank you very much for joining us. You’re welcome to call Paul, Brian or me if you have further questions.

This concludes our call. Thanks for your interest in ESI.

Operator

Thank you for your participation in today’s conference. You may now disconnect. Good day.

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