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II-VI Incorporated (NASDAQ:IIVI)

F1Q2013 Results Earnings Call

October 23, 2012 9:00 AM ET

Executives

Craig Creaturo - Chief Financial Officer and Treasurer

Francis Kramer - President and CEO

Analysts

Jim Ricchiuti - Needham & Company

Avinash Kant - D.A. Davidson & Company

Jiwon Lee - Sidoti & Company

Mark Douglass - Longbow Research

Operator

Good day, ladies and gentlemen. And welcome to the II-VI Incorporated Fiscal Year 2013 First Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. (Operator Instructions)

As a reminder, this program is being recorded. I would now like to introduce your host for today's program, Mr. Craig Creaturo, CFO and Treasurer. Please go ahead, sir.

Craig Creaturo

Thank you, Jonathan, and good morning, everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI Incorporated. Thank you for participating in the first quarter fiscal year 2013 II-VI Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, October 23, 2012.

The forward-looking statements we may make during this teleconference speak as of today, and we do not undertake any obligation to update these statements to reflect events or circumstances occurring after today.

Francis Kramer

Thank you, Craig. I'm Francis Kramer, President and CEO of II-VI Incorporated. My prepared remarks today will discuss operational results for each of our businesses. During the just completed quarter, we experienced softness in most of the markets we serve and we are responding to orders for shorter time durations and normal.

While our first fiscal quarter is normally one of our lighter bookings quarters of the year, the quarter we just completed was even lighter than we had projected. Resulting impact on our backlog drove the reductions to our outlook for the fiscal year. In spite of these market conditions, our businesses did have some bright spots that I’ll highlight in these comments.

During the first quarter our Infrared Optics segment, which includes HIGHYAG had bookings of $47.5 million, which is down 7% compared to the first quarter of fiscal year ’12, primarily due to reductions and new laser build especially in Japan.

We did not see reductions in bookings from the aftermarket especially in North America, which indicates steady laser utilization. However, military spending is down in the U.S. due to the proposed sequestration and budget cut, and the uncertainty related to the upcoming election.

For our Infrared Optics business excluding HIGHYAG in the U.S. orders from domestic OEMs decreased 15% quarter-over-quarter. This was a result of timing of blanket orders from high-power OEM, despite the orders decrease shipments to the high-power OEMs increased 17% quarter-over-quarter.

Bookings from power OEMs were flat quarter-over-quarter and shipments declined 32%. The low power market is expected to be weak into the third quarter due to inventory adjustments in global economic conditions.

European bookings for the first quarter were down 14% compared to the fourth quarter due to a delay in receiving a large diamond order that will be receive in the second quarter.

In addition to the typical seasonal effective of the summer holiday period in Europe. We are now hearing that several high-power OEMs are experiencing a softening in orders attributed the unfavorable economic conditions resulting in a decrease in their current production rates.

Asian bookings were up 5% quarter-over-quarter. However, we continued to experience much lower demand from Japan with high-power OEM bookings dropping to a yearly low in September.

Total Japan bookings in the first quarter were down 6% quarter-over-quarter and 33% year-over-year. The stagnate Japanese economy in conjunction with the stronger Yen has created a challenging environment. This trend is expected to continue for at least the next few quarters.

China bookings increased 8% quarter-over-quarter, while the Chinese economy continues to grow at a slower pace. We are seeing increased activity in the [Fuzhou] drilling market in variable radius mirrors. In addition, we have seen favorable results in the aftermarket due to our increased efforts to service this growing segment.

At HIGHYAG, bookings for the first quarter were up 7% quarter-over-quarter and revenues exceeded $8 million in the first quarter, which established a record for the quarter.

We have increased capacity in streamlined key processes to enable volume production. We continue to see growth opportunities in all addressable markets, including one-micron welding, beam delivery systems, laser light cables and one-micron laser cutting heads mostly driven by the auto industry.

In summary, our IR Optics business segment including HIGHYAG continues to see bookings pressure driven by the worldwide economic uncertainty.

During the first quarter, at our new Infrared Optics segment which now excludes our VLOC business, bookings compared to the same quarter last year were up 10% to $35.1 million, while segment revenues were up 31% to $40.6 million.

The bookings increase was mainly attributable to increased demand for Photop-related green laser devices and Aegis-related optical channel monitors. Revenue increase was driven by improvements across most of the Photop and Aegis product lines.

Compared to the fourth quarter FY ’12, bookings were down sequentially by 21%. This was the result of order timing in three areas, green laser devices, medical optics and certain China and North American telecom orders. Revenues were up 2% from the fourth quarter of FY ’12, marking the fifth consecutive quarter of revenue growth for the near-IR segment.

Now at Photop, revenues grew 3% from the fourth quarter of FY ’12, despite the continued broader market softening in the optical component business for telecommunications. Revenue increase was led by shipment of green laser devices, display products in our contract manufacturing business and optics for industrial and medical applications.

During the first quarter, the telecom component business experienced a slowdown in legacy products and 4G components due to the government delay of broadband network deployment in China and softening of orders in North America. This partially offset by increased demand for high-end components in Asia and Europe for 4G/LTE and 100G networks.

Photop continues to invest in R&D for high-end components and module products for customers in their next-generation high-speed network requirements. Also during the first quarter, Photop continued the integration with Aegis Lightwave with the pursuit of joint R&D programs which will allow us to optimize our global resources and better service our customers, further manufacturing consolidation and joint sales and marketing efforts that should result in greater sales to the China market.

The Photop Laser business shipments surged again in the first quarter due to the volume delivery of green laser diode devices for several key contract wins. These contract wins covered various applications in the biomedical, law-enforcement and government contracting areas. We expect to see continued growth in this area over the next couple of quarters.

The Photop Optics business also continued growth in the first quarter, which was up 8% sequentially from the fourth quarter of FY ’12. Photop continues to seek key design win -- key design wins in areas such as optical instrumentation and industrial optics, as a result of investing in new product initiatives and new capabilities such as optical -- opto-mechanical assemblies. We anticipate moderate growth in the optics product line in the near-term.

Overall, for the second quarter of FY ’13, we expect Photop revenues will be flat as compared to the first quarter, given the overall market dynamics and product mix. Photop will continue to put more resources on new product developments such as laser modules, optical-mechanical assemblies and 100G components.

At Aegis, the first quarter revenues were down 6% related to the fourth quarter of FY ‘12 were up 13% over the same quarter one year ago. Aegis has seen some reduced demand within its core optical communications market as a result of the broader market softening, but continues to see strong growth in its industrial market segments that are addressing the high-power fiber-laser markets.

To meet customer demand, Aegis is expanding its manufacturing capacity at Photop for optical channel monitors for the ROADM market and high-power fiber laser combiners for the industrial fiber laser markets.

Aegis also continues to invest in research and development of next-generation products including high-performance, flexible bandwidth optical channel monitors for transmission networks with high rates of 100 gigabit -- excuse me, 100 gigabit per second, 400 gigabit per second and beyond. Similarly, AOFR is expanding its portfolio of high-power fiber laser combiners for used in fiber laser applications.

Based on recent work with customers in Asia, North America and Europe, we expect to gain design wins and market share from our line of fiber laser combiner products. We believe this product will be synergistic with a broader fiber laser optics portfolio that the Near-IR team is developing. In the first quarter, we achieved optical channel monitor and fiber laser combiner wins with major customers in North America.

For the first quarter, our Military and Materials business segment which now includes our VLOC business. Bookings of $17.7 million were up 33%, as compared to a year ago and sequentially lower by 17%. The drivers for these reductions were the timing of orders related to Military business, lack of market demand for selenium products and the delay of our new rare earth metal production lines start up.

Revenue for the first quarter of $23.9 million decreased 11% from the fourth quarter of FY‘12. This reduction is attributable to both the Military business and the Materials business. Our Military business is comprised of Exotic Electro-Optics, VLOC which was recently transferred from the Near-IR segment and Max Levy Autograph.

The primary driver of the lower order rate in the quarter as compared to a year ago is attributed to a follow-on order for the current generation of UV filter assemblies, which is used in the missile warning system on helicopters. We now expect this follow-on order in the second quarter.

Generally, we continued to see softness in our Military business attributable to federal budget uncertainty, the threat of sequestration and the political climate durations. While we have some insulation from the overall U.S. defense budget since our products are primarily used in ISR defense applications, we continue receive favorable funding. We are experiencing longer contract negotiations, slower order awards and increased competition.

The bottom line is our current market environment is challenging, and we remain focused on improving productivity, cost control and winning market share and introducing new products. During the past quarter, we’ve had several significant design wins. These include opto-mechanical assemblies and intricate prism assembly for a multi-spec of targeting system for manned and unmanned platforms, small diameter optical components for flu applications, next-generation laser slab assemblies and optical components for foreign military customers. And additionally, we have seen orders for continued R&D funding for our Sapphire product line, orders for certain legacy programs and strong orders for our heritage products at MLA.

In our Materials business which is our PRM’s SiC rate, experienced lower tellurium product demand in the photovoltaic market this quarter. However, this was more than offset by increased demand in the thermal electric cooling market in China, which helped to stabilize the tellurium index price after 12 months of erosion.

Selenium product demand was slightly lower than expected due to lower usage in agriculture feed applications. Our new rare earth production line failed to come on line as soon as expected during the quarter, due to technical challenges related to the manufacturing process.

Bookings for the quarter were lower, due primarily to the rare earth metal production startup delays, which prevented booking additional contract commitments based on a 12-month booking policy. Selenium product demand was up, but this was offset by improved tellurium product demand.

Revenue and profits were significantly up for the quarter due to the high cost of inventory, aggressive pricing tellurium products and the delay in our rare earth production.

The selenium index price was volatile during the quarter, dropping 9% from $43 a pound to $39 per pound, and then rebounding to $43 per pound towards the end of the quarter. The tellurium index price was stable at a $110 per pound for the majority of the quarter. The changes in pricing combined with the timing of supply deliveries resulted in inventory adjustment of $500,000 for the quarter, which negatively impacted earnings.

The lower demand for tellurium product in the photovoltaic market, along with significant inventory and the overall supply chain has led to very aggressive product pricing for high purity tellurium metal. Premiums over the index price for our high purity tellurium metal products have declined as competition has increased.

These lower premiums coupled with high inventory costs, resulted in a significant loss for the quarter. Since the end of the quarter, the tellurium index price has increased to $120 per kg. Although there are several factors which may impact this index price, we generally feel an index price of a $110 to $150 per kg will be the range for the next couple of quarters.

Given the start-up challenges in our rare earth production line, we are revising our fiscal year ‘13 annual revenue projection for this product to $5 to $7 million for the year, down from the $8 to $10 million annual rate in our previous projections. Over the past 30 days, we have begun to ship product and we believe that production volume will begin to ramp during this quarter through the end of the fiscal year.

In our Advanced Product Group, Marlow Industries’ bookings for the first quarter were down 39% year-over-year, primarily due to reductions in the gesture recognition market. Overall, bookings for the quarter were flat when compared to the fourth quarter of fiscal year ’12, where the reductions in defense offsetting the increases in gesture recognition.

Revenues for the first quarter were down 44% year-over-year again, primarily due to the reductions in the gesture recognition market. Revenues decreased 1% in the first quarter over the fourth quarter of FY’12.

We’ve continued to develop our personal comfort market entry with the shipment of prototype product to two large customers. Our recently introduced Climatherm product line continues to sell well in Europe, and we have achieved multiple design wins this quarter.

In the second quarter, we are introducing a third product line that is directed at the lower end -- lower power end of the industrial market. We continued to see an increase in activity and interest in our EverGen energy harvesting solutions introduced earlier in the calendar year. We are harvesting energy from temperature differences that exists in a variety of different environments like air, liquids, steam, gas, et cetera to power wireless sensors and actuators.

Lastly, we continue to align our cost with our revenues to mitigate market uncertainties, and to focus our efforts towards the most promising markets and to better position Marlow Industries for increased future growth and efficiency in an increasingly competitive market.

In our Wide Bandgap Group, year-over-year first-quarter product bookings were up 78%. However, quarter-over-quarter bookings were down 50%, largely as a result of timing of a large blanket order in the previous quarter.

Quarter-over-quarter total bookings were also down substantially, due to receipt of a large DoD contract in the previous quarter. Total revenues for the first quarter were down 7%, compared to the previous quarter, down 6% year-over-year.

The first quarter shipments of 100-millimeter diameter semi-insulating substrates for our applications were down 18% from the prior quarter and were flat year-over-year. Customer demand for product deliveries and the completion of qualification programs of their devices on our substrates for both the wireless infrastructure market and the defense sector continues to slow. We foresee slower demand in the second quarter and third quarter, followed by increases in shipments rate in fiscal year '13.

During the second quarter, at the 2012 European Conference on silicon carbide and related materials, which was held September 2nd, Saint-Petersburg, Russia, WBG was the first silicon carbide vendor in the world to introduce n-type 150-millimeter substrates for the power device market. It was the first silicon carbide vendor in the world to announce 150-millimenter semi-insulating substrates for the gallium nitride RF and power markets.

We have begun low-volume shipments of 150 millimeter n-type silicon carbide substrates to a number of major OEMs and expect to begin low-volume shipments of 150-millimeter semi-insulating substrates to several major OEMs in January of 2013. Growth in the power device market continues to be driven by high-voltage diodes for power factor correction in industrial motor drives and the promise of more energy-efficient products and solutions.

According to recent industry reports, silicon carbide power electronics are projected to take a 10% to 20% share of the $50 billion market over the next decade, which is currently dominated by a lower-cost silicon-based devices.

Rapid advance and early introduction of 150-millimeter diameter substrates will enable device manufacturers to lower their device costs and enable them to manufacture using existing 150-millimeter diameter silicon and gallium arsenide device processing lines and affect expanding the potential market share for silicon carbide devices and accelerating the transition.

In September, we celebrated the grand opening of our new 10,000 square foot facility in Starkville, Mississippi. The new facility is fully operational and will support the expansion of capacity for wafer finishing, cleaning and packaging.

As noted in today's earnings release, we are pleased to announce the appointment of Dr. Giovanni Barbarossa as the company's first Chief Technology Officer. Giovanni comes to II-VI with significant experience and will assist all of our businesses in their research and development efforts.

So in summary, despite market challenges and a world fraught with economic and political uncertainties, we are committed to identifying opportunities to capitalize on our competencies. We are continuing to make investments in organic growth as evidenced by our development work in free-standing diamond, which is facing an expanding opportunity in the EUV lithography systems.

We also are opportunistically exploring acquisitions to enable the company to benefit from near-term demand when worldwide economic conditions stabilize. Craig, this concludes my prepared remarks.

Craig Creaturo

Thank you, Franc. Here are the items I would like to highlight before we open up the question-and-answer portion of the call.

As we announced on October 3, 2012, effective for the beginning of fiscal year 2013, the company’s VLOC business unit is now included in Military & Materials segment for reporting purposes. This business is currently 100% dedicated to military-related products and is now being managed by the leadership of our Military & Materials segment.

Prior to July 1, 2012, VLOC was included in the company near-infrared optics reporting segment. All current and prior year information presented in our earnings release has been adjusted to reflect this change.

As described in today's press release, consolidated bookings for the quarter-ended September 30, 2012 were $114.4 million, 12% lower than the same quarter last fiscal year. Total company backlog at September 30, 2012 was $161 million, which was down 10% or $18 million from the June 30, 2012 backlog level.

The components of the backlog at September 30, 2012 were Infrared Optics at $44.5 million, Near-Infrared Optics at $36 million, Military & Materials at $58.5 million and Advanced Products Group at $22 million.

During the just concluded quarter, we saw signs of stability in the index pricing for both tellurium and selenium. In addition, we have taken measures to reduce our inventories of these raw materials.

As of September 30, 2012, the index price was $110 per kilogram for tellurium and $43 per pound for selenium. During the current quarter, the company recorded a lower of cost or market adjustments of $0.5 million or $0.01 earnings per share loss.

Profitability was also negatively impacted during the quarter from a strategic initiative to penetrate new markets for our tellurium material easing aggressive sale prices. As we disclosed in today's press release, during the quarter, the company repurchased $5.9 million of its common stock as part of the $25 million board authorized repurchase program announced in May 2012.

The number of shares repurchased during the September quarter was just over $317,000. Today, the company has repurchased approximately 619,000 shares for a total amount of $10.9 million. It is the intent of the company to continue with the Board approved repurchases for the remainder of the fiscal year 2013 in accordance with a 10b-18 rules.

We have not forecasted further decreases in our share count beyond the actual purchases made to date in the outlook that was provided in today’s press release. We’re planning to continue to report the actual repurchase activity as part of our future quarterly earnings releases.

During the quarter ended September 30, 2012, we did not receive further contractual or insurance proceeds from the flooding that impacted the facilities of Aegis' contract manufacturer in Thailand in October 2011. As we passed the one-year anniversary of the flooding event, we continue to work diligently to fully recover funds that are contractually due to Aegis and AOFR, the Australian subsidiary of Aegis.

Our outlook for the quarter ending December 31, 2012 and for the fiscal year ending June 30, 2013 excludes the potential recoveries of contractual and insurance proceeds because of exact timing and amount of recoveries have not been determined.

During the quarter, there were a few items that impacted other income line item on the income statement in a positive manner for a total of $800,000. These components included equity earnings from our minority investment in China-based fusion of $400,000, interest income of $300,000 and miscellaneous other income items totaling $300,000.

These positive items were partially offset by foreign exchange losses of $200,000 due to the strengthening of the euro against the U.S. dollar. The effective income tax rate for the quarter was 24.2%. During the quarter, there were no material changes to our tax reserves. We expect the income tax rate for fiscal year 2013 to range between 22% and 24%, which is unchanged from the original guidance for this fiscal year.

During the quarter, we generated $23 million in cash from operations, a 62% increase from the September 30, 2011 quarter. We also borrowed $5 million on a credit facility to help fund the share repurchases and to assist with working capital needs.

During the quarter, we used $6 million of our cash for capital spending and $6 million for the share repurchase program. During the quarter, our cash balance increased by $80 million and now stands at $158 million while our current debt balance is $80 million.

The interest rate on our borrowings at September 30, 2012 is approximately 1%.

Franc, this concludes my prepared remarks. Before we begin the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements which are based on current expectations. Actual results could differ materially. For information about factors that could cause the actual result to differ materially, please refer to the risk factor section of our Form 10-K for the fiscal year-ended June 30, 2012. Jonathan, we are now ready to begin the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Jim Ricchiuti from Needham & Company. Your question, please.

Jim Ricchiuti - Needham & Company

On the comment that you made about the aftermarket business in North America and IR Optics, can you characterize that business? It sound like it was relatively stable in the quarter, so it doesn’t sound like you saw much in the way of weakness there, certainly versus the OEM business?

Francis Kramer

Exactly, right, Jim. We found that steady and the order intake we get in that aftermarket business is such a good indicator of how lasers are being utilized throughout the U.S. and it was steady which is a nice surprise let’s say because with all other factors being a little bit dormant like this year, you might think it would be not that good.

Jim Ricchiuti - Needham & Company

How does that compare with I would assume there was a different scenario in Europe and what you’re seeing in Asia?

Francis Kramer

Yeah. Europe is a little slower. And I think I made that comment a little slower. Asia holds in there pretty well except for Japan which has been slow now for what three to four quarter, so relative quarter-over-quarter about the same for Japan. But the one that picks up slowly, you think it be going more rapidly is China. It’s going well because they’ve deployed so many lasers.

So, for us we’re picking up more and more business. But I think its picking up business that was lasers. So we put out there two and three years ago and now the people are buying the optics as opposed to having them come from their OEMs.

Jim Ricchiuti - Needham & Company

Okay. And just a follow-up, are there trends that you are seeing in that portion of the business, it’s early in the quarter, but what can you say about what you are seeing thus far in Q2?

Francis Kramer

I think we are about on with what we just guided towards I think it will be an interesting quarter. It’s going to be up and down volatile. Our weeks, good week and a bad week and good week -- that’s been really we’ve been having here in the last two, three months and I think its going to be that way for while.

Jim Ricchiuti - Needham & Company

Okay. Thanks. I will jump back in the queue.

Operator

Thank you. Our next question comes from the line of Avinash Kant from D.A. Davidson & Company. Your question please.

Avinash Kant - D.A. Davidson & Company

Good morning, Craig.

Craig Creaturo

Good morning.

Francis Kramer

Good morning.

Avinash Kant - D.A. Davidson & Company

First question, in terms of the guidance that you have given for Q2, could you give us some idea how do you see the different business segment doing like, which one is going to be up and which one is going to be down?

Craig Creaturo

I would say Avinash, we are looking at a quarter that overall is shaping up to be very similar to the quarter we just completed. I would say, when you look at the kind of the outlook that we have. We do see some puts and takes. I think -- and during Franc’s comments, we talked about the continued strength that we are seeing in our telecom businesses, but we do expect that to be relatively flat.

We do expect some little bit further strengthening of some of our other businesses for instance HIGHYAG. We also have looked at all the other different businesses as well. And I think we are looking at a quarter that again shaping up to be pretty similar maybe even pretty similar business-by-business from the quarter we just completed.

Francis Kramer

Little further, which we really done always go describe it but we might have a little bit of improvement in Military & Materials. The rockiness on the price in selenium and tellurium might have bottomed out when we were having that feeling so that might take away that $500,000 hit we took this quarter, we might not have that next quarter.

And Advanced Product Group, I would like to think we can do some better there because we really have cut our cost. And we usually don’t go into a big discussion about where we’re cutting costs and a lot of people line up for a big cost program. We try to do a constantly among all of our 11 businesses, so we stay in tune.

So, we don’t too much cost compared to our revenue. And we now have to make another couple of adjustments in our Advanced Product Group and both our Marlow in our AP unit and our WBG Group. So I think we do a little better there.

Avinash Kant - D.A. Davidson & Company

Okay. And if you could comment a little bit about the JSF program, of course what are you seeing at this point and what kind of growth should we expect on a kind of year-over-year basis?

Francis Kramer

I think Avinash, we’re seeing continued demand there. We continue to be a good provider of the sapphire panels that we are providing to our customers that demand as has been well documented is over the last couple of years has been slower demand. But it isn’t demand what we’re continuing to be the sole provider on that program for the time being.

And I would say that our feedback from our performance from the customer is very, very strong and our team at EEO is doing an excellent job of delivering very tight tolerant panels for very critical military component. And so I think we are doing very well there, continuing to ramp that program up although be it at that lower level than what we’re expected, say one or two or three years ago.

Craig Creaturo

I have to say, so we are close to the running rate that we are going to plateau add for a maybe a couple of years. And the dilemma in what’s going to end up being funded after this election in the next big budgeting round, so I think we can say FY '13 and FY '14 and early FY '15 will produce that. And we are close to that rate, after that it’s not able to – we can not project what will happen but it’s not likely it will change. If it does, it won’t be upward.

Avinash Kant - D.A. Davidson & Company

And final question just checking, I think Franc was saying that you expect Photop business to be up 3% that was on a revenue basis sequentially?

Craig Creaturo

I think we said it, go back check that comment, I think it was that they did grow 3% in Q1, FY '13, Avinash versus Q4 of FY '12 was the comment.

Avinash Kant - D.A. Davidson & Company

Okay. And what do you expect it to do the next quarter, kind of, stay at these levels?

Craig Creaturo

I think I had a comment in there. Then in the second quarter, expect revenues to be flat as compared to the first quarter and probably the areas that look better because of the combination of Photop with Aegis are optical channel monitors, which were producing more other Photop in the combiners. I think those might be products that might pickup a little bit.

It’s hard to predict our optical -- our passive optical component business out of China. We’ve had a nice run here for the last 90 days or so whether that will continue that’s. It might continue, might fall here that’s the part because if it would continue I think we would do a little bit better in Photop.

Avinash Kant - D.A. Davidson & Company

Perfect. Thank you so much.

Operator

Thank you. Our next question comes from the line of Jiwon Lee from Sidoti & Company. Your question please.

Jiwon Lee - Sidoti & Company

Thanks.

Francis Kramer

Good morning.

Jiwon Lee - Sidoti & Company

I just wanted to circle back on your -- around fiscal '13 outlook. Obviously it implies our fairly substantial rebound in the second half and just wanted to know how do we get there?

Francis Kramer

I think we do have again some use of where the strengthening of our business will be. We coupled -- that we touched on, couple greater spots relative to new products including for instance our various materials that we mentioned at PRM that would be kicking in, in the latter half of the year, continued demand from diamond optics and I think overall just a continuing strength that primarily from our industrial businesses, where we are expecting that to be stronger in second half. I think, we also have viewpoint past second quarter that we should be able to see some further growth from our Photop and Aegis businesses as well. So I think the areas where you’re going to see that strength is primarily in the industrial facing businesses and maybe to a lesser extend within Photop and Aegis.

Jiwon Lee - Sidoti & Company

And staying on the diamond optics, just wanted to get your thoughts, early thoughts on how your diamond window business with Cymer in light of, their acquisition may change positively, negatively over the same?

Francis Kramer

I think that whole business opportunity is very good for us. We’ve been really closely align with Cymer and their whole supply chain which gets all the way to ASML and Zeiss and others in the chain. So we are well aligned and this bias is probably good. Because the money to do all this is pretty expensive and we have been added for a number of years that we see a very, very good opportunity.

We are producing 3 and 4-inch diameter diamond optics. So these are very, very large and the prices are very, very high. And so the amount of money that’s been invested to maybe put out half a dozen of these systems in the next 12 months or 2012.

A lot of money and this helps the whole establishment get funded because everybody at times funding themselves, and we’ve been funding ourselves for many times. So I think its going to help. I’m not sure it changes how that money is flows down to us in this part of the food chain right away. But we do have good steady orders and we’ve got a lot of work to do to protect our product a little bit more.

And I think everybody in the food chain does because the wafers per hour that can be produced right now are just not where it needs to be. So very, very good opportunity, those, I think, we feel optimistic because of that investment.

Jiwon Lee - Sidoti & Company

Terrific. And Franc, just staying on the IR Optics side, the order decline that you saw and you continued to see into this quarter. How does that sort of a feel to you? Does that feel like your key customers are just temporarily tightening their cost or does that feel like everybody is trying to kind just to sustain lower demand?

Francis Kramer

I think it’s a just volatility, I mean, because we are so, CO2 lasers that are out there, doing work there, so tuned into the world-wide economy. If the economy is down, there is a less utilization, if it’s up, we are so closely align to consumer spending also that it’s hard to predict. So we have to say, it’s volatile, because it feel right. I’m afraid it feels the way it is with the economy. It feels that way.

We don’t have an idea, that there is anything substantially going wrong, just people don’t have the demand for the goods that they run the lasers for and that’s what kind of the OEMs are saying, when they are turning down their assembly line, they are producing less.

So that’s what they are telling us. They are going to be producing less. So if suppose the 5000 units a year, they might be turned them to 4. I don’t have that exact number, but we will by the next meeting, how things are being turned down.

But so the main assembly line is turning down that’s probably 5% to 10% of our optics demand. The other 90% is from this aftermarket laser utilization and people are starting to see their capacities more than adequate. They are going to stop buying new machines and we are seeing the tip of that.

Jiwon Lee - Sidoti & Company

Okay. Great. Very good. And on the margin front questions. I noticed your SG&A has spiked a little bit during the quarter. I wonder why that is and on the second question on the margin, despite the revenue pressure your margin, although at a smaller base has been ticking up. How should we view that product margins moving forward throughout the fiscal 2013?

Craig Creaturo

Yeah. I would say, we had some SG&A items. More I think from a SG&A perspective and it was just slightly up from where we were running. In the June quarter, we did about $25 million of SG&A in that quarter. We did $26.6 million in the September quarter, the quarter we just completed. I would say there were a few items in there.

From a general administrative standpoint, we have been active in several different areas and we have been continuing for acquisitions and spending dollars on those fronts. And I would say that there is nothing too unusual about that again, I think pretty much a consistent level there or down a little bit.

The revenues down a little bit, kind of highlighted that as a percentage of sales going up, but still right around that 20%, 18%, 19%, 20% usually you will see that’s where that SG&A level is, and we were right end at the top end of that level right around 20% or so.

For the gross margin, we did see an improvement overall in gross margin part of that and part of that is due to a lighter low, if you’ve heard of the lower cost to marketing adjustment we had at PRM. So we were at about 37% this quarter.

We do feel like that’s probably about where we will be ranging for the year, maybe a little bit higher than that. I think we go back to our original guidance for the fiscal year, we said that we will be more so in the range of 38%, 39%, so somewhere in that 30%, kind of 37% to 38% to 39% range, I think is where we are going to be for the fiscal year.

Jiwon Lee - Sidoti & Company

Okay.

Francis Kramer

Other thing I would add to what Craig is, we had to take the M&A expenses and SG&A and this PRM right-off. But we had another charge you might want to mention. Craig, we took a provision and news that came to us in the last couple days, one of our accounts it’s going to go probably out of business and we had quite a receivable promise. We had to take a provision on that, could you talk about that?

Craig Creaturo

Yeah. We did really towards right at the end of the reporting process here. We did feel prudent to make a reserve for one of our customers for our silicon carbide, WBG business. This company as it was, I believe it was probably announced yesterday by another public company and they will be seizing a winding down operations. The company is [semi filed] and we thought it’s prudent to take some reserves, and that also impacted the SG&A for the quarter as well.

Jiwon Lee - Sidoti & Company

Okay. Thanks for the color and lastly for me, as much as you can, could you turn a little sort of, can actually put the sense for, is opportunity tied to the rare earth business once it starts kind of moving?

Francis Kramer

Would you repeat the question, please?

Jiwon Lee - Sidoti & Company

The market opportunity or your revenue opportunities tied to this rare earth.

Francis Kramer

Yeah. Okay. Yeah. And I do think we have put it in our comments that we have to reduce our, we’ll expect to maybe $8 million to $10 million of revenue this fiscal year and we had to reduce that to $5 million to $7 million just because we are now at three and a five months into the year. I do think second half of the year, we will be shipping on that much better.

We had some learning curve problems that we are starting to get behind to us, that we can make the product and we can do it in very high purities, which is what we’ve been working hard to do, and now we’ve cleared the hurdle that we can meet specification. Now to ramp that to the volume and we need to ship by month for the next six months, that will be our challenge here in the last couple months.

I think it’s a good platform for us and the opportunity is very good. And, can we prolate that into another rare earth product in a few years? Maybe that’s the reason why we are wanting to understand how to produce these products and we are gaining on the understanding.

Jiwon Lee - Sidoti & Company

Very good. Thank you very much.

Francis Kramer

You are welcome.

Operator

Your next question comes from the line of Mark Douglass from Longbow Research. Your question, please.

Mark Douglass - Longbow Research

Hi. Good morning, gentlemen.

Francis Kramer

Hi, Mark.

Mark Douglass - Longbow Research

Can you talk to the IR Optics margins, is that being impacted just from say pricing out there to a more difficult price environment or actually is it because of diamond windows or investments you are having to making environment windows, is that driving it down temporarily and so you get those profits as figured out. Discuss that a little bit?

Craig Creaturo

Yeah. I can start it and I may be let Franc add to it, Mark. I think you’ve got a couple of factors in there, you touched on one and that is diamond optics and that’s spending dollars on their own and working on that and ramping that product line up. I think every thing you’re starting to see in our Infrared Optics business is that these higher cost selenium starting to roll through the products that we make.

We obviously make quite a number of transmissive optics, mostly made out of zinc selenide that we grow here in Saxonburg and the selenium cost inside that zinc selenide has increased quite a bit. And that’s been a phenomenon that we’ve been seeing the increase in pricing of that material over last couple of years, now starting to see a flow through in a heavier way in our production costs.

So I think that’s the other component that we have in there as well and I’ll let Franc add to that as well.

Francis Kramer

Mark, just because how we reported in segment reporting in Infrared Optics, we include in the IR optics segment our HIGHYAG subsidiary or joint venture. And that has a lower margins than IR. So as we progress this year, HIGHYAGs had nice growth and it’s been just a little bit lower margins which does have a weighted effect. And I think maybe in overall IR might be down a percent gross margin from where we’d like to be, something like that.

Mark Douglass - Longbow Research

Okay. Thank you.

Operator

Thank you. Our next question is a follow-up question from the line of Jim Ricchiuti from Needham & Company. Your question please.

Jim Ricchiuti - Needham & Company

You touched on the strength you’re seeing at Aegis from the fiber lasers combiners and then I thought you made a comment. And I just wanted to pursue that a little bit about how this is complementary with some efforts that you have to overall broaden the fiber laser offering, the component offering. Can you elaborate a little bit more on that?

Francis Kramer

Around the fiber laser area, just because our CO2 business is straight in the middle of laser processing and our HIGHYAG business is taking output of a fiber laser and directing it to do work and the people who are building fiber lasers are the ones who are coming to us to build these combiners.

So we are building combiners for people’s fiber lasers and we look at it say well there are other things around the fiber lasers that we could do. And we’re working hard on one micron focusing optics with multispectral zinc sulfide as a material to that job maybe better and more cost effective if you look how easy it is to make optics with multispectral.

So we are looking at all ends of the fiber laser one micron beam delivery, one micron other products that around one micron that are needed. And I think there are some. That’s why we’re trying to be creative but we understand many of these high power issues on CO2 on 10.6 micron. So we are trying to take our knowledge and apply it to one micron. We’re just starting on that but I think we’re coming.

Jim Ricchiuti - Needham & Company

Got it. And then, this maybe a tougher question just in terms of your overall full-year guidance but is there any way you can give us what you’re assuming in terms of your overall military business this year and does that take into account the potential for the sequestration that we’re all hearing so much about?

Francis Kramer

I think our -- just a kind of step back into your question just a second here, Jim. We’re -- if FY '12 about 18% of our total business which really defined as military and I think as you know that really cuts across all of our segments that some component for the most part of military definitely most center came in our further reportable segment on Military & Material segment.

We do have some opportunities for some slight growth in that business. They are definitely looking at programs where we have good orders in hand. We continue to still have good visibility for our military product lines overall. But I think to your point, we have not appended a very doomsday type of an outlook, if there is a significant sequestration reduction or something like that.

I think we based to base on where we feel our customers are at again as Franc mentioned in his comments that kind of a more deliberate order pattern, a little more of the deliberate demand that we are seeing from -- demand process that we are seeing from these customers.

We’ve taken that into consideration, but we haven’t taken into consideration that, that there is going to be some sudden reduction in a particular product line or particular program that we are on. We are fortunate we are diversified on a lot of different programs covering air and ground and other platforms. So, we try to pick that in the consideration best we can.

But again, I think we’ve committed that this will be a tough business for the foreseeable future to grow. But we do have some things that will help foster that growth a little in FY '13, but again, we want to see one of our higher growth rate…

Jim Ricchiuti - Needham & Company

So, Craig just putting that issue aside at sequestration it sounds like you still, you could based on what you are seeing, you see not converging that modest growth in military this year?

Craig Creaturo

I think that’s pretty good. Because one part -- I made it in my comments that are lot of our products are directed or into what I called ISR, which are this Intelligence Surveillance and Reconnaissance and that’s the part that you see the defense willing to still spend money.

So, maybe some major programs that are a big plain or something like that might get turned back or slowed down. But the ISR program seem to be on track because that’s where we need these type of systems with all the terrorist activity and -- which we’ve then positioned for a good amount of the ISR stuff and we think we are well-positioned going forward.

So, that’s why I said we are little insulated. But what’s happened to us the -- we are down in the food chain and the prime suppliers. They’ve been installing and delaying in the placement of their orders to us. And that’s been going on now for maybe six months to a year at different times. So we are prepared for this, turned it on, turned it off, delayed but we have been experiencing it. So I don’t think it’s going to change FY '13 compared to FY '12 for military. We are going to have it.

Jim Ricchiuti - Needham & Company

Got it. And Franc, you mentioned the strength you are seeing in HIGHYAG coming impart from good strength in automotive, is that sustainable in your view?

Francis Kramer

Well, it sets your world towards 80 million cars built right now and only 14 in Americas. So a lot of the work that we have done that made a lot of progress, a lot of whelming heads in America maybe 25% of our HIGHYAG businesses, whelming heads here in America and some other countries that do not use this much laser processing in cars. We think we will get into it whether that’s year down the road or two or three, a lot of laser cutting also. So you can’t predict how different cars would be laser processed and it was gone through two or three different deteriorations of a lot of laser processing over the last 20 years, but right now it’s really headed towards one micron as far as we can see.

Jim Ricchiuti - Needham & Company

Okay. Thank you.

Operator

Thank you. This does conclude the question-answer-session of today’s program. I’d like to hand the program back to management for any further remarks.

Francis Kramer

If there are no more questions I would like to thank everyone for participating today. Our next earnings release for the quarter and fiscal year, excuse me, in the quarter ending December 31, 2012 is currently scheduled for Tuesday, January 22, 2013 before the market opens, with the conference call to follow that same day at 9 AM Eastern Time. Thank you for participating in today's conference call.

Operator

Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.

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