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Nanometrics Incorporated (NASDAQ:NANO)

Q3 2012 Earnings Conference Call

October 30, 2012 16:30 ET

Executives

Claire McAdams - Investor Relations

Dr. Timothy Stultz - President and Chief Executive Officer

Ronald Kisling - Chief Financial Officer

Analysts

Mahesh Sanganeria - RBC Capital Markets

Patrick Ho - Stifel Nicolaus

Tom Diffely - D.A. Davidson

Chris Blansett - JPMorgan

Weston Twigg - Pacific Crest

Edwin Mok - Needham

Operator

Good afternoon and welcome to the Nanometrics Third Quarter 2012 Financial Results Conference Call. A question-and-answer session will be held at the end of the call. Until that time, all participants will be in a listen-only mode. Please note that this conference call is being recorded today, October 30, 2012.

At this time, I would like to turn the call over to your host, Claire McAdams. Please go ahead.

Claire McAdams – Investor Relations

Thank you and good afternoon everyone. Welcome to the Nanometrics third quarter 2012 financial results conference call. On today’s call are Dr. Timothy Stultz, President and Chief Executive Officer, and Ronald Kisling, Chief Financial Officer. Shortly, Tim will provide a recap of the third quarter and our perspective looking forward. Then, Ron will discuss our financial results for the third quarter and fourth quarter outlook. After which we will open up the call for Q&A. The press release detailing our financial results was distributed over the wire services shortly after 1:00 PM Pacific this afternoon and is also available on our website at www.nanometrics.com.

Today’s conference call contains certain forward-looking statements including, but not limited to financial performance and results including revenue, operating expenses, margins, profitability, and earnings per share, customer concentration, tax rates, and technology and product adoption.

Although Nanometrics believes that the expectations reflected in the forward-looking statements are reasonable, actual results could differ materially from the expectations due to a variety of factors including general economic conditions, changes in levels of industry spending, the adoption and competitiveness of our products, industry adoption of new technology and manufacturing processes, shift and timing of orders or product shipments, changes in product mix, our ability to successfully identify, complete, and integrate acquisitions to realize operating efficiencies and to achieve reduced tax rates, and the additional risk factors and cautionary statements set forth in the company’s Form 10-K on file for fiscal year 2011 as well as other periodic reports filed with the SEC from time-to-time. Nanometrics disclaims any obligation to update information contained in any forward-looking statements.

I will now turn over the call over to Tim Stultz. Tim?

Dr. Timothy Stultz - President and Chief Executive Officer

Thank you, Claire. Good afternoon everyone, and thank you for joining us on the call today. Before beginning, we want to take a moment to recognize the extraordinary challenges and suffering that are taking place on the East Coast as a result of Hurricane Sandy and express our sincere hope that conditions will return to normal as soon as possible.

Now, turning to my prepared remarks, Nanometrics third quarter revenues were generally in line with guidance. Our bottom line performance exceeded our guidance largely due to stronger than expected gross margins and lower than forecast OpEx. Ron will provide you with more detail on these items during his remarks.

In addition to our performance against plan however, two notable milestones occurred within the third quarter. The first was the full acceptance of our first 450-millimeter Atlas OCD tool. The superb execution of our engineering, manufacturing and service teams resulted in a smooth delivery and installation of this first of its kind product, which met out-of-the-box specs and resulted in tool acceptance in a relatively short timeframe. Though it is still very early in the 450-millimeter conversion cycle, metrology tools such as our Atlas will play a key role in the evaluation of new 450-millimeter process tools and the development of new processes on larger wafers.

Further, we believe the early adoption of our Atlas OCD platform positions us well for future 450-millimeter business. The second milestone was that for the first time in Nano’s history, the revenue contribution from our leading pure-play foundry customer exceeded 10% of our total revenues for the quarter. As many of you are aware, gaining traction in this important segment of our industry has been high in the list of our key initiatives for the last few years and reaching this milestone is a good indicator of the progress we are making.

While we still have a long way to go to meet our objective of achieving business levels and market share consistent with overall spending in the foundry sector, our multiple strategic engagements are finally beginning to play out in our favor and we are confident that this business will continue to grow in the years to come.

Turning to the overall business climate, as observers of our industry are aware, the weak macro environment has clearly had a negative impact on demand and the subsequent investment activities of leading device manufacturers. We have seen pronounced decrease in capital spending and entered a period of heightened uncertainty and reduced visibility. This is further exacerbated by the increase in concentration amongst leading chip manufacturers, which leads to greater volatility as changes in single customer investment plans can swing overall CapEx spending by 10%, 20% or even 30% within the given period. Running our business during the period of depressed spending and increased uncertainty is never pleasant and in itself presents significant operational challenges.

We need to constantly strike a balance between responding to the current business environment versus the necessity of investing in long-term business initiatives, which in turn formed the foundation for future growth and value creation. At Nano, we believe these times could be ones of great opportunity. They are periods when customers are evaluating new technologies and innovative products that are required to address their future needs and product roadmaps. They are opportunities for us to strengthen our tool of record positions with our top customers to expand our position with existing and new customers and to drive increased adoption of our most advanced platforms.

So, in spite of these challenging business conditions Nanometrics remains committed to four long-term key objectives that will drive incremental revenue growth and our performance. We are sustaining our market leadership in OCD, further expanding our market share in the foundry sector, growing our advanced packaging business, and gaining traction and market share for our inspection business. In support of these objectives, we are continuing to invest in R&D and the development of new products and innovative solutions across our entire product portfolio. These systems and solutions are targeted to intersect key technology and industry inflection points such as advanced 3D devices and architectures, 3D packaging, 450-millimeter and EUV lithography.

If we take a moment to reflect on how Nano has progressed over the last several years and how we are positioned during this industry slowdown, we have stronger positions with the top chip manufacturers in the industry, a broader portfolio of process controlled products and solutions, and a greater breadth of engagements in advanced technology applications than ever before. We have made continuous progress against our strategic initiatives as evidenced by recent announcement of product wins, tool adoption and growth of our foundry business. And we have a world-class team of scientists and engineers, a strong balance sheet, and a management team that knows how to execute through industry cycles. So, simply stated, Nano today is stronger than never before, and in spite of the economic headwinds that are affecting our near term business outlook, we are seizing this opportunity to further strengthen our business and business prospects in order to position the company to deliver above average growth and stockholder returns when the next investment cycle takes place.

Now, turning to our business outlook, we do see continued near-term weakness in spending across most of our served markets. Although we are experiencing modest improvements in advanced logic spending as investment for their next generation technology node take place, it is not sufficient to offset the decrease in investments in the foundry and memory sectors. And though our position in foundry has indeed been improving, we do not expect strong sequential growth until investments in next generation devices and leading-edge capacity get underway. As a result, our fourth quarter guidance is for revenues in the range of $28 million to $32 million and non-GAAP gross margins of 42% to 46%. At these business levels, we expect a non-GAAP loss of $0.12 to $0.19 per share.

Finally, with regard to a longer term horizon directionally reduce the improvement in spending in the first quarter of next year. However, as we have been experiencing a much greater range of puts and takes, then it’s typical for us in our quarterly customer demand, our forward outlook – our forward-looking outlook needs to be characterized as one of guarded optimism.

With that, I will turn the call over to Ron to discuss our results and guidance in more detail.

Ronald Kisling - Chief Financial Officer

Thank you, Tim and good afternoon. Before I begin my comments, I’d like to remind you that a schedule which summarizes GAAP and non-GAAP financial results as well as revenue segment information provided on this conference call is available in the Investors section of our website.

In the third quarter, revenues were $43.9 million, coming at above the midpoint of our guidance, but down 17% from the second quarter and 25% from the third quarter of 2011. Total product revenues of $32.3 million, declined 22% from the second quarter of 2012 reflecting a significant decrease in spending by our three largest customers.

Service and upgrade revenues were $11.6 million flat with the record second quarter with continued strength in both core service and upgrades. Service and upgrade revenues were 26% of total revenues compared to 22% in Q2. By product area, sales of our automated metrology systems, which are the primary systems sold into our largest customers and where our all-time record levels for the first half of 2012 declined 28% quarter-on-quarter to $26.6 million and comprised 61% of total revenues in the quarter.

Integrated metrology sales increased 7% from Q2 level and comprised 6% of total revenues. And sales of our materials characterization products, which primarily served the LED, solar, and silicon substrate market – end markets increased 56% over low Q2 levels to comprise 7% of total revenues, but remained well under year ago level with the decline of 64% from Q3, 2011.

Turning to total revenues by geographic region, we report revenue based upon the ship to or first-in-use destination. In the third quarter, revenues from South Korea were 42%, North America 16%, Taiwan 14%, Japan 13% and 14% for the rest of our geographic regions. Four customers contributed 10% or more to our revenues in the third quarter with SK Hynix our largest at 24%. Samsung and Intel comprised 17% and 15% respectively. And for the first time, TSMC comprised over 10% of our quarterly revenues at 13% in Q3.

Turning to the end markets which are segmented by product revenue only, sales to the memory segment were down 23% from Q2 and comprised 44% of product revenues, with both flash and DRAM spending down from Q2 levels to comprise 29% and 14% of product sales respectively. Sales to our logic and other IDM customers were 29% -- were up 29% from Q2 to comprise 30% of product sales, while sales to our foundry customers decreased 53% from the second quarter to comprise 18% of product sales due to a significant drop in foundry spending by one of our largest customers. We continue to see weakness in capacity spending in the LED, solar and bare wafer end markets. So, despite the quarter-to-quarter increase in materials characterization products, this end market comprised just 8% of our product revenues in the quarter.

Turning to our financial performance for the quarter, my prepared remarks regarding the Q3 income statement and comparisons to prior periods will refer to non-GAAP information, which excludes the impact of the amortization of acquired intangible assets unless identified as a GAAP measure. Gross margin was 51.8% compared to 47.8% in the prior quarter with the sequential improvement driven primarily by an increase in standard tool margin as well as a decrease in warranty and other manufacturing costs. While the improvement in our standard tool margin was predicted in our forecast, we exceeded our gross margin guidance primarily due to this decrease in warranty and other manufacturing costs arising out of quality improvement and manufacturing efficiency initiative, which drove our product margin well above our forecast.

Importantly, consistent with our plans we have realized continued improvement in Atlas II gross margins, which met our target for Q3 principally through supply chain negotiations and manufacturing efficiencies. Essentially all of the volume purchase agreements for this product are now in place. However, lower than expected shipments in the fourth quarter will result in the delay in meeting our stated objective, which is to bring Atlas II realized margins to 55% by the end of the year. In total, product gross margins were 51.2%, up 560 basis points from 45.6% in the second quarter, while service gross margins were 53.7%, down from 55.6% in Q2 on a slightly lower mix of upgrades.

Operating expenses were $18.3 million, more than $2 million below guidance. While ongoing operating expenses were lower than forecast due to reductions in discretionary spending in response to industry condition, the majority of the difference between forecast and actual is due to adjustments and reversal made to first half annual incentive plan accrual as a result of the revenue decline now expected in the fourth quarter. Additionally, included in operating expenses of $18.3 million were approximately $400,000 of cost related to organizational changes in consolidation, which also came in below forecast. These changes were focused on centralizing certain operations and aligning company resources to expected revenue growth and market opportunity. And as we stated on the Q2 call are expected to reduce our ongoing operating expenditures by at least $500,000 a quarter on an ongoing basis. So, even with the 17% decline in third quarter revenue, our operating margin improved to 10.1% compared to 9.6% in the prior quarter.

For the fourth quarter due to the adjustments to incentive compensation accruals were unique to the third quarter, we do expect operating expenditures to actually increase sequentially in the range of $400,000 to $900,000. This puts the midpoint of our Q4 guidance at approximately $19 million, down $1.3 million or 6% from Q2 level as we continued to tightly manage cost and reduce discretionary expenses in this customer spending environment.

Our tax provision for the third quarter was $1.4 million. This represents a tax rate of 41.6%. For Q4, as a result of the anticipated pre-tax loss, we expect to realize a tax benefit at a similar rate. For the year as a whole, as a result of our lower estimate of annual pre-tax income as well as one-time tax benefits taken in prior quarters, we expect our GAAP tax rate to be between 5% and 10%.

Third quarter net income was $2.4 million or $0.10 per diluted share, compared to $3.1 million or $0.13 per share in the second quarter. Our cash, cash equivalent, and short-term investments increased by $9.1 million to $104.8 million or approximately $4.48 per share based on 23.4 million shares outstanding at September 29. In addition, we paid down the mortgage on our headquarters by 20%, the third straight year we have paid down the mortgage by the maximum amount permitted and our existing balance is now $5.5 million.

Our DSO was 62 days down from 68 in the prior quarter and inventory levels declined by $2.5 million in the quarter. Our tangible book value increased to $199.6 million or $8.54 per share, up from $8.36 per share at the end of the second quarter. We ended the quarter with a headcount of 545 employees, a net decrease of 24 employees from the prior quarter.

And with that, I’ll turn the call over for questions. Operator?

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question comes from the line of Mahesh Sanganeria from RBC Capital Markets.

Mahesh Sanganeria – RBC Capital Markets

Thank you, guys. Tim, a question on the foundry revenues increasing becoming more than 10%, can you talk about little bit what product group that is where we are getting traction in the foundries, is that – does that include the 450-millimeter tool? Can you give us some color on that one?

Dr. Timothy Stultz

Hi Mahesh, thanks for calling in. Yeah, I’m giving a little bit color with regard to our penetration of foundry, no, it doesn’t, it’s not part of the 450-millimeter platform, but we have made inroads and I’ve gotten tool acceptance across multiple platforms, including our OCD, our UniFire product, our SPARK platform, and our integrated metrology. So, we are making inroads on we are coming in every door that’s available to us.

Mahesh Sanganeria – RBC Capital Markets

And on the OCD – OCD is it on, I would think that you are winning some of the applications and is that related to 20-nanometer or it’s in 28 nanometer?

Dr. Timothy Stultz

Yeah, most of our opportunities are in the 20-nanometer, some of it in the early part of the 20-nanometer, some of it will be targeted at the second phase 20-nanometer as they move into 3D-dimensional devices, but it definitely is in the advanced technology nodes.

Mahesh Sanganeria – RBC Capital Markets

So, that would imply that the actual the production ramp up probably happened towards the end of next year at the new win situations?

Dr. Timothy Stultz

Yeah. I think that’s why we understand the spending patterns too to the extent that they have been shared.

Mahesh Sanganeria – RBC Capital Markets

Okay. And then on one of the comments you made that seems like things will improve sequentially in Q1, but you don’t think that the pace will be so strong. So, can you give us your sense of what your customers are saying by segments as to when do you think that inflection is likely and what will drive that beside system macro? It seems like that the ramp right now is focused more on 28-nanometer foundries, where you don’t have use exposure and so is that the memory has to come back for your revenues to really pickup significantly?

Dr. Timothy Stultz

Well, memory plays a very big role as kind of the big swing factor. As you know that there is a lot of wait-and-see spending and investment in that sector. There is a little more predictability to logic. That’s been a little more consistent in the way the deployment of their capital on investments and with our tool record positions in leading-edge logic, we expect to benefit accordingly. We do see some improvement in the spending based on fab investments in memory, but in terms of the actual timing of deployment, there is probably big and uncertainty bars, there is a kind of the sweet spot for where it’s going to be. And as you have seen in this industry, this could be – it may not manifest itself and on the other hand it could snap back. And we are just that’s what we say, we are guardedly optimistic as we believe that well there will be some improvement, the magnitude, which is probably equal to the uncertainty.

Mahesh Sanganeria – RBC Capital Markets

Thank you very much. I’ll get back in the line.

Dr. Timothy Stultz

Thanks, Mahesh.

Operator

Thank you. And our next question comes from the line of Patrick Ho from Stifel Nicolaus.

Patrick Ho – Stifel Nicolaus

Thank you very much. First off, Tim, in terms of just the outlook that you provided both the Q4 and just a little bit of the call you provided for Q1, how do you see the memory manufacturers as they shape up exiting 2012, which obviously ended up on it down now? How do you see them entering 2013 and some of the opportunities there given your pretty strong exposure to that customer segment?

Dr. Timothy Stultz

Yeah, that’s a really good question. We are all trying to – we are trying to sort that out. I’ve had direct meetings with our largest customers in the memory space. And the way they characterized it is that they have got money, they are ready to spend, but they are doing a wait-and-see until they see some recovery in the pricing and the demand on the market side and they are encouraging us to be ready to respond in a very strong notice.

Patrick Ho – Stifel Nicolaus

Yeah, great, that’s really helpful. And I was great to see that you guys are expanding up your foundry customer base looking forward not only in 28 and 20, but as the foundry segment starts moving to the FinFET technology. Do you see that tame expansion coming for you as well and increased penetration has put that type of process technology?

Dr. Timothy Stultz

Yeah. That’s a good question. All along, we believe that this maybe a card that plays well for us, since we have the only high volume manufacturing deployment of OCD in the FinFET world. And so as other companies adopt that architecture, we would like to believe that our experience and proving capabilities will give us an edge in the competitive environment.

Patrick Ho – Stifel Nicolaus

Right. And final question from me, I see the advanced packaging market obviously growing over the next several years and it could be a large opportunity for you guys. Can you give us a little bit of color on where you see TSV at this moment, and when you believe the adoptions were more, I guess, high volume manufacturing or high volume process, when do you see that adoption achieving that?

Dr. Timothy Stultz

So, that’s a good one question also, and we are still bottom at the bottom of the S-curve on the ramp on advanced packaging. There we are clearly are engaged on TSV on multiple customer sites. We have a wonderful tool position and production position with our UniFire, which has capabilities really are unparalleled with other products on the field and the question then becomes timing. And also as they move been through the 2.5D or the interposer model on to their full 3D packaging, again discussions with our most advanced customers do indicate that they have a continued commitment and they see this becoming a deployed technology. It’s driven by the need in the form factor, and we think we are well positioned. Timing the uncertainty, I don’t know is it one year, is it two years, it’s very hard to say. It’s one of these things that when they go, it will go at a pretty quick pace and we think we’ll be in a ready in a position to respond to it.

Patrick Ho – Stifel Nicolaus

Great, thank you very much.

Operator

Thank you. And our next question comes from the line of Tom Diffely from D.A. Davidson.

Tom Diffely – D.A. Davidson

Yeah, good afternoon. Couple of more I guess clarifications on the memory side, would you say NAND was 14% and DRAM was 29% in the quarter?

Ronald Kisling

DRAM was 14% and NAND was 29%, yes.

Tom Diffely – D.A. Davidson

Okay, I think that was backwards.

Ronald Kisling

Reverse of what you said.

Tom Diffely – D.A. Davidson

Yeah, alright. And then it sounds like you expect those to decline in the fourth quarter as well before rebounding sometime next year. So, my question is do you have a relative exposure or relative benefit from one or the other NAND versus DRAM, are you more highly leveraged to one or the other?

Dr. Timothy Stultz

Now, they agree. The DRAM products tend to be more complex and have a higher capital-intensive requirement in general, but NAND has a higher volume in the fabs, they build bigger fabs. And so when we kind of just take a kind of squint at it, opportunities are pretty balanced. I just think that the overall – the global demand suggest that NAND is going to be more important for all of us as spending in investment and demand improve, and it’s only mobile DRAM which is not enough to pickup and replace the decline in DRAM demand for the weak PC market that will be complemented to that.

Tom Diffely – D.A. Davidson

Okay. And it sounds like most of the equipment guys expect NAND spending to come back at some point in the first half of next year. On the DRAM side though, when you hear news about you guys went from the 4X node to the 3X node, does that spur demand for you specifically or do they have tools at the 4X node that they can use or reuse?

Dr. Timothy Stultz

Yeah, Tom we actually, when they are making a node movement, it will increase the demand of our tools. We are going to see increase both the capital intensity as well as the use of process control. So, we believe it does give us increased demand. And why you are on the topic you might saw one of the other topics that does come up is this whole issue of tool reuse and that’s across and I want to just make kind of a general statement across the industry is that for those of you who have been following the company for the last 3 to 5 years, you realize that our key positions in our tool-of-record positions are all relatively new in the most advanced nodes. And we have gotten some very important wins in the last few years, but they are the most advanced fabs. And so our exposure to tool reuse is relatively low, because tool reuse is usually at least two technology nodes if not three technology nodes behind if they can bring the tools forward. In addition to that, what drives the most advanced nodes and are the most advanced technology capabilities and we are continuing to invest and develop new tools to address those as well, and so that also plays against the concern about tool reuse going forward.

Tom Diffely – D.A. Davidson

Okay, that’s helpful. And then Ron, you talked about the very strong margins in the quarter, would you have reached your fourth quarter goal if the actual volumes were flat quarter-over-quarter?

Ronald Kisling

Yes, if the volumes were flat, we would have reached the goal.

Tom Diffely – D.A. Davidson

Okay. So, really it’s just a loading issue then on the factories?

Ronald Kisling

Yeah, exactly. That’s exactly what’s driving the decline in Q4.

Tom Diffely – D.A. Davidson

Okay. And then finally on the foundry side, did you say you did sell kind of your flagship OCD tool into that space as well?

Dr. Timothy Stultz

Yes, we did.

Tom Diffely – D.A. Davidson

Okay. And is that shipped late in the quarter or is that – has that been for a while?

Dr. Timothy Stultz

It’s actually they were shipped – it’s actually been shipped, installed, and accepted in the quarter.

Tom Diffely – D.A. Davidson

Great. Alright, thank you very much.

Operator

Thank you. And our next question comes from the line of Chris Blansett from JPMorgan.

Chris Blansett – JPMorgan

Hey, guys. Tim, just wanted to give a thought on the customer mix you are seeing in Q4, how you expect that to change as you had in the Q1 where you think your revenue is going to improve quarter-over-quarter?

Dr. Timothy Stultz

Okay. I think that we are going to see some improvement in overall logic spending in the fourth quarter based on the announced investments. And then going into the first quarter, we would expect that we would like to see a little bit of improvement in memory, but then it’s – again it’s the one with the greatest degree of uncertainty for us and that’s because it has the wilder swings with the shortest notices and lead times in changing outlook.

Chris Blansett – JPMorgan

When you say logic, could you give us some color over foundry versus IDM same two quarters?

Dr. Timothy Stultz

Yeah, well, most of its IDM.

Chris Blansett – JPMorgan

Okay. And then you mentioned that use of OCD is going to go up when you get to 20-nanometer versus 28 say for a foundry node, any sort of relative color you could provide there and it does sound like you are already selling some equipment for the 20-nanometer above R&D or pilots?

Dr. Timothy Stultz

Relative color in what way, what kind of color you are looking for?

Chris Blansett – JPMorgan

What kind of increase in OCD capital intensity you expect for 20-nanometer foundry versus 28, 32?

Dr. Timothy Stultz

I don’t have a good number for you. I’d like to rather than pull something out of my hip pocket, can I get back to you on that one and see if we can give you something that’s got a little more substance behind it.

Chris Blansett – JPMorgan

Sure.

Dr. Timothy Stultz

Alright.

Chris Blansett – JPMorgan

Last question for me really is given the trajectory of the revenue and the loss that’s going to occur in the fourth quarter, will this have a impact on next year’s tax rate, we are kind of just looking for modeling reasons?

Ronald Kisling

This is Ron. I wouldn’t expected it to have an impact on the rates for 2013 and that we would continue to be at around our structural rate that we have talked about, which is in the mid 30s.

Chris Blansett – JPMorgan

Even on a pro forma basis?

Ronald Kisling

We haven’t really other than when we made the election in the first half we haven’t really broken out sort of the pro forma impact. I think yeah, we’ll still see something in the mid 30s could move around a little bit based on the timing of the reinstatement of the R&D tax credits, but we should still see something similar to something in the mid 30s.

Chris Blansett – JPMorgan

Alright, thank you.

Operator

Thank you. And our next question comes from the line of Weston Twigg from Pacific Crest.

Weston Twigg – Pacific Crest

Hi. Thanks for taking my question. First, I just wanted to follow up one more time on the foundry business at TSMC, so was it 13% number in the quarter? Just wondering it sounds like it doesn’t stay their jobs back down. Is that revenue locked in when the actual 20-nanometer ramp comes or these still considered development maybe tools that are still under selection or you are pretty confident that this type of a quarter translates into real production revenue in within the next year?

Dr. Timothy Stultz

Yeah, Weston that’s good question. And we bought the tool wins that we are talking about are tool wins that will play out in a high-volume manufacturing environment. Timing is certainly out there when they start going into the 20-nanometer and then the second node on 20-nanometer, but we believe these are – we know these are solid positions. They are not just R&D they were tool selection for the advanced devices.

Weston Twigg – Pacific Crest

Okay, good. Very helpful. And then also just a couple of other quick questions, one, the service revenue in Q4, does that come down as well or is that relatively stable?

Ronald Kisling

The service revenues were relatively stable with, I guess Q2, but we do expect that the upgrade levels which in the last two quarters have been near record levels to be down in Q4.

Weston Twigg – Pacific Crest

Okay. And then the final question, just wondering on the inspection side, Ultratech announced a new fast inspection tool that sounds very similar to the SPARK platform, and just wondering if you can comment at all on the competitive landscape if you see that changing or if you see these two tools budding hedge or maybe that even now the new entrants coming into that market?

Dr. Timothy Stultz

Yeah, we have limited real hands on information about the tool, but everything I know about the tool doesn’t indicate that it’s really the same as or similar platform to the SPARK. We think the SPARK is still very highly differentiated from what they are doing. And we also see the application space is more targeted towards overlay and implied overlay through stress and that really isn’t a direct threat to our competitive position for the products that we are selling.

Weston Twigg – Pacific Crest

Okay. So, you don’t really see a lot of overlap necessarily with the products even though they sound kind of similar?

Dr. Timothy Stultz

Yeah, not on the SPARK, there maybe some areas where we see some competition against the UniFire, but we believe that there are some uniquely different capabilities. UniFire is an absolute and direct measurement with as that gives you quantitative data. And the other tool is more of as we understand it has some implied measurement rather than an absolute measurement, where they play together on the fab is still to be seen.

Weston Twigg – Pacific Crest

Okay, very helpful. Thanks a lot.

Operator

Thank you. And our next question comes from the line of Edwin Mok from Needham.

Edwin Mok – Needham

Hi, guys. Thanks for taking my question. Now, coming back to foundries, so beyond that’s almost your largest customer in TSMC, you mentioned on your call right, are you making progress with the other foundries as well?

Dr. Timothy Stultz

Are we making progress with the other foundries?

Edwin Mok – Needham

Yeah.

Dr. Timothy Stultz

Yeah. Well, in fact if you look at – Edwin, if you look at our foundry revenues as a percentage of our total revenues, they have been between 40% and 50% or so for the last couple of quarters, I think. And so we have got – there is more than one foundry out there and we have had success with our largest customer in their foundry space as well as our TSMC.

Edwin Mok – Needham

Great. So, it sounds like good progress there on that end. I am just curious could you mention 3D design, that’s one of the driver for that right? (Indiscernible) has just talked about pushing 3D as a differentiator for them, right? Is that a big driver for you because you also mentioned that obviously you guys have the strong position in logic and have a lot of experience in 3D?

Dr. Timothy Stultz

Could you repeat the question for me again, please?

Edwin Mok – Needham

Yeah, I guess just curious beyond those two foundries right, it sounds like overall foundry could be a non-customer that you guys are targeting, because of your advantage in FinFET, is that a good way to think about that?

Dr. Timothy Stultz

Yeah, we certainly see that as an opportunity for us and it’s primarily in the 3D devices, it’s still early in their development phase, but we believe as they start to adopt the 3D structure, the FinFET structure again, this should be an opportunity for us to leverage and we see some other. We have some other engagements for it under tool evaluation that hopefully gains some traction in that front, but it’s still early with them.

Edwin Mok – Needham

Great, that’s helpful. And then moving on to also 3D for NAND, how do you see that transaction benefit or help your business?

Dr. Timothy Stultz

Well, I think the 3D NAND whether it’s the Toshiba version or the Samsung version like the VNAND brings to – brings forth some new challenges in our metrology. We are very engaged with that. We have got applications development and tool modifications to address that. What’s need to be sorted out is what are the measurements that are critical to tracking process and providing yield in that space. And we are working very closely with our customers who try to help them sort through that, at the same time as we bring the tools forth, but there is no doubt in my mind that it is going to be a very important metrology application.

Edwin Mok – Needham

Great, very good color there. And lastly just on backend packaging, you mentioned that you need to move past 2.5D interposer to see more (actually on) adoption. I am curious – well, I am trying to understand that comment is it because during the adoption, 2.5D is more limited and as customers moved to TSV you see a much bigger tame there?

Dr. Timothy Stultz

Yeah. So, most of our tools are currently used in the pillar and the micro-bump area, which applies to the 2.5D as well as the 3D, but when I think I was responding to the question about TSV. And TSV becomes a more prevalent technology and applied technologies will go into the – as we go into the full 3D packaging.

Edwin Mok – Needham

I see. Okay, great, that’s all I have. Thank you.

Operator

Thank you. (Operator Instructions) Our next question is a follow-up from the line of Mahesh Sanganeria from RBC.

Mahesh Sanganeria – RBC Capital Markets

Thank you again. So, just thinking into the spending for the next year, it looks like memory is going to be a wildcard and how it is difficult to figure out right now, but what are your thoughts on the logic, do you think that logic spending will improve next year or you think it could be down?

Dr. Timothy Stultz

So, I think logic is actually going to be improved in spending relative to the total CapEx. So, it’s very – none of us really have a good, clear picture of what total CapEx is going to be, but it appears that a lot of the bricks and mortar work is being done and that we should see potentially a greater spend on equipment, WFE against that capital spend. And if it does that in the fab fan-outs and technology roadmaps, if they hold true to that, if our customers hold true to that, then we think that there is some – it’s a pretty steady and possible improvement for us.

Mahesh Sanganeria – RBC Capital Markets

And you expect that spending to be pretty linear throughout the year?

Dr. Timothy Stultz

It historically has been linear. We would hope it stays somewhat linear. It’s an easier model for us to run to, but like I said, we have seen more puts and takes on the quarterly basis and we have as a percentage of our total revenues than we have seen in long time. So, that uncertainty factor and the wildcard of what’s going to happen to memory still causes us to move forward with the cautious optimism.

Mahesh Sanganeria – RBC Capital Markets

Okay. Thank you very much, Tim.

Dr. Timothy Stultz

Sure.

Operator

Thank you. And we also have a follow-up from the line of Chris Blansett from JPMorgan.

Chris Blansett – JPMorgan

Tim, now that we are heading into the fourth quarter, I wasn’t sure if you had any relative thoughts on the growth of OCD versus other process control or all process control as a whole and then WFE now they have kind of a trajectory for the fourth quarter?

Dr. Timothy Stultz

Yeah. Are you talking about looking at the next year or what period or what time horizon you are looking?

Chris Blansett – JPMorgan

This year and then also your kind of initial thoughts for next year, I think last time you mentioned that OCD was kind of going to grow 40% year-over-year. I wasn’t sure what that ended up being for this year and then your kind of initial take on next year?

Dr. Timothy Stultz

Yeah, well the OCD growth will be probably be a little bit lower than we had originally thought just because of the slowdown in the market and a reduction in spending of our top customers, which drive our OCD business. And I think relative to total capital spending, I think that you’ve seen an increase in capital intensity somewhere to 12% to 15% of capital spend. I think process control continues to be an important player in that, and it’s gaining a little bit more percentage and OCD will continue before. But if you look at us in our competitive environment, there is one area where we don’t have a strong position in OCD has been with the largest pure-play foundry company. And so the shift in the emphasis of spending on OCD between that customer and our two largest customers is why it ultimately will roll up into where the OCD position is for all those involved.

Chris Blansett – JPMorgan

And the other question I had with (tied to) integrated generally, it sounds like you’ve had some wins there as we have exited the year and maybe just your thoughts of integrated revenue of next year versus this year, would it be your biggest growth area potentially?

Dr. Timothy Stultz

Well, that’s the beauty of small numbers. The integrated metrology business has really come down quite a bit from its historical levels along with our materials characterization. And in fact if you look at our overall business growth year-on-year, our decline most of that can be attributed to the IM and the MC. Now, (it’s about a) direct answer to your question, we do see some growth in IM, we do see some growth in MC, and because we are starting off at such a low base. Then on a percentage basis that probably is going to look like a large growth area, but the real revenue drivers and the real margin contributors are going to be our automated systems being in the SPARK, the UniFire and the Atlas platforms.

Chris Blansett – JPMorgan

Alright, thank you. I appreciate it, Tim.

Dr. Timothy Stultz

Sure.

Operator

Thank you. And I have no further questions at this time. I’d like to turn the conference back to Tim Stultz for any concluding remarks.

Dr. Timothy Stultz - President and Chief Executive Officer

Well, thank you once again for participating in our call. I again gratefully acknowledge the terrific contributions and commitment to our business objectives expressed each and everyday by the entire Nanometrics team. I look forward to reporting on the results of our operational and financial performance for the fourth quarter and full year next February, and with that, goodnight.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program and you may now disconnect. Everyone have a good day.

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