U.S. Markets open in 3 hrs 44 mins

Edited Transcript of IVAC earnings conference call or presentation 30-Apr-18 8:30pm GMT

Q1 2018 Intevac Inc Earnings Call

SANTA CLARA May 17, 2018 (Thomson StreetEvents) -- Edited Transcript of Intevac Inc earnings conference call or presentation Monday, April 30, 2018 at 8:30:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Claire McAdams

Headgate Partners LLC - IR

* James P. Moniz

Intevac, Inc. - Executive VP, CFO, Treasurer & Secretary

* Wendell T. Blonigan

Intevac, Inc. - President, CEO & Director

================================================================================

Conference Call Participants

================================================================================

* Benjamin David Klieve

NOBLE Capital Markets, Inc., Research Division - Senior Government Services and Defense Technology Analyst

* Mark S. Miller

The Benchmark Company, LLC, Research Division - Research Analyst

* Nehal Sushil Chokshi

Maxim Group LLC, Research Division - MD

* Peter Peng

B. Riley FBR, Inc., Research Division - Associate Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good day, and welcome to Intevac's First Quarter 2018 Financial Results Conference Call. (Operator Instructions) Please note that this conference call is being recorded today, April 30, 2018. At this time, I would like to turn the call over to Claire McAdams, Intevac's Investor Relations Council. Please go ahead.

--------------------------------------------------------------------------------

Claire McAdams, Headgate Partners LLC - IR [2]

--------------------------------------------------------------------------------

Thank you. Good afternoon, everyone. Thank you for joining us today to discuss Intevac's financial results for the first quarter of 2018, which ended on March 31. In addition to discussing the company's recent results, we will provide financial guidance for the second quarter of 2018 and our outlook -- current outlook for the full year.

Joining me on today's call are Wendell Blonigan, President and Chief Executive Officer; and Jim Moniz, Chief Financial Officer. Wendell will start with a review of each our businesses and our outlook going forward, then Jim will review first quarter results and discuss our financial outlook before turning the call over to Q&A.

I'd like to remind everyone that today's conference call contains certain forward-looking statements, including, but not limited to, statements regarding financial results for the company's most recently completed fiscal quarter, which remain subject to adjustment in connection with the preparation of our Form 10-Q as well as comments regarding future events and projections about the future financial performance of Intevac. These forward-looking statements are based upon our current expectations and actual results could differ materially as a result of various factors, risks and uncertainties, relating to these comments and other risk factors discussed in documents filed by us with the Securities and Exchange Commission, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The contents of this April 30 call include time-sensitive forward-looking statements that represent our projections as of today. We undertake no obligation to update the forward-looking statements made during this conference call. I will now turn the call over to Wendell.

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [3]

--------------------------------------------------------------------------------

Thanks, Claire, and good afternoon. Today, we reported Q1 results in line with guidance, with revenues of $18 million and a loss of $0.23 per share. Revenue showed relative strength in our hard drive equipment business and lower-than-forecasted Photonics sales. The results in our Photonics business negatively impacted gross margin, but with close control of operating expenses, bottom line results were within the range.

On our last call, as we recap 2017, I highlighted that we had delivered 3 consecutive years of growth, both in revenue as well as bookings. And last year, we achieved our objective to return to profitability without relying on capacity additions in the hard disk drive industry. Also during the call, we communicated our expectation for the continuation of growth and profitability in 2018.

Since then, there have been several developments that transpired in both Photonics and Thin-Film Equipment that have caused our outlook for 2018 to moderate since our last forecast. I will walk you through these development details in the business-specific portions of the call.

In Photonics, we experienced delays in certain funded R&D releases as well as a temporary production slowdown in the Joint Strike Fighter program. In Thin-Film Equipment, our near-term VERTEX system revenue outlook has decreased for the year as the initial application for our second customer that has been under testing and evaluation over the last year will require an approved version of oDLC, which we are now addressing with our 2.0 version.

Our expectations for revenues from the hard drive and solar markets remain consistent from last quarter. And in total, we now see 2018 as a pause in our revenue growth trajectory as we position our VERTEX oDLC 2.0 and our new ISIE 19 photonic sensor to drive the resumption of growth in 2019. Given the developments in the first quarter, we took significant actions across the company to reprioritize engineering programs and reduce operational expenses, all while ensuring that we can continue to drive our growth initiatives on VERTEX and ISIE 19 without impact.

In equipment, we suspended all work in solar products, except the support and installation of the tools currently in backlog, put on hold projects and concept and feasibility and extended the development time line of our MATRIX PVD system for advanced packaging. Our equipment operations in Asia are now and will continue to be fully utilized to manufacturing hard drive systems and upgrades and providing installation and service support. In our Santa Clara equipment operations, we reduced headcount by 12%, primarily in engineering and administration.

In Photonics, we reorganized to increase focus on engineering program capture and execution, installing longtime Intevac veteran, Tim Justyn, into the role of General Manager. In Photonics, we reduced headcount by 8%, primarily in manufacturing administration, as the engineering staff, via funded development programs, are generating a significant portion of the revenue stream this year. In addition, vice presidents and above have reduced their salaries by 10% for the year, which has allowed the company to retain key technical positions deemed critical to drive our VERTEX and ISIE 19 initiatives. While this change in our short-term outlook is disappointing, taking a longer and bigger-picture view, significant progress continues to be made in our expansion of our Thin-Film Equipment business and the development of our ISIE 19 Photonics sensor to capture our opportunity pipeline.

So now I'd like to give you more detailed description of our business environment and the progress we are making, starting with Thin-Film Equipment. The biggest growth opportunity for our equipment business continues to be our VERTEX tool and the deposition of protective coatings on display and backside cover glass for cell phones. During the first quarter, we made several strategic moves targeted to accelerate and improve our capture rate of customers for the VERTEX systems.

Over the last year, while we've made progress with our current VERTEX customers, it became clear that we had a chicken-and-egg problem in penetrating additional cover glass suppliers. End customers need verified capacity to commit projects and cover glass makers needed end customers to commit to the capital. We are now driving a strategy to place seed VERTEX assets with key cover glass makers and generate end customer demand, which after reaching a threshold in volume, will be purchased. We have also added regional sales manpower to the VERTEX program and increased our sales and marketing efforts directly with handset and electronics manufacturers in an effort to raise awareness not only of our capability, but the traction we are seeing in the marketplace.

We added 2 new board members, Kevin Barber and Mark Popovich, both of which have deep experience and knowledge in the cell phone and/or advanced packaging markets. They now provide our board with up-to-date information in activity and trends in key target markets and will act in a technical advisory role for management as we drive our equipment growth initiatives forward.

So let's talk about recent traction. In March, we issued a joint press release with our first oDLC customer, Truly Opto-electronics, announcing the launch by a top 3 handset manufacturer of new phone models incorporating our film for backside cover glass protection. The VERTEX is depositing oDLC on a portion of their recently launched flagship handsets, protecting the vibrant and striking decorative color coatings deposited on the outside of the back cover glass. We'll be keeping a close eye on success of this application in the marketplace, which if successful commercially, should lead to demand for additional VERTEX capacity systems, which could come from Truly, other cover glass makers, or both.

Truly, who currently has 4 VERTEX systems installed, along with this application is also applying oDLC for front cover glass, wearables and point-of-sales applications among others. In addition to cover glass applications, we've been working with Truly on a new application involving different substrate material. The plan at the time of our last call was to install 2 additional VERTEX tools in a new production line, with 2 systems shipping by the end of Q2. Unfortunately, after the Lunar New Year, we were informed that the new line was put on hold, and those 2018 opportunities have pushed. We have suspended work on this application but intend to resume the program when the overall business environment improves as we believe it could drive significant cost savings if successful.

On the strategic front, in a move to increase the visibility and applications of our coating solutions, we are finalizing an agreement with a top 3 cover glass manufacturer to install a VERTEX system by midyear and co-market the capabilities to their customer base, which is a superset of the base we can currently access. This is a very important development for us as this cover glass manufacturer is an established supplier to the world's largest handset companies, providing access to, and validation for, additional volume cover glass applications around the globe. This customer knows our tools and volume production, our oDLC film is in demand and being deployed in the marketplace by a top 3 handset maker.

Our second customer, who currently has one system installed, continues to evaluate our films for multiple applications. The first application for our film at this customer has gone through exhaustive testing, including 6 months of user trials. The evaluation was over a year in completing and a learning experience for both companies. After oDLC was initially qualified about a year ago, additional requirements were developed. And ultimately, a final test was devised to simulate 2 years' worth of wear and tear for this application. In March, we had a final review of the project, and it was determined they would like to see improved performance for a particular type of scratch that will require a different and thicker underlayer for our oDLC. I'll discuss in a minute how we're addressing this.

Our relationship with this customer, and our projects continue. And as I have mentioned, this is just one of several applications being looked at for our oDLC at this customer. It is important to note that every application, as well as each customer, have different requirements, tests and adoption criteria. Some focus on abrasion and lubricity, some more focused on cosmetics, and some for functionality and durability. Our growth strategy is based on leveraging core technology into new markets and once we have a foothold, to branch into adjacencies within that market. Under our product development process, we identified the need for a durable anti-reflective coating, or AR, as an unmet need in the cover glass market.

Over the past 1.5 years, we have been working on a high-durability film stack, the hardware to deposit these films and configurations for the VERTEX for volume production. We announced in January, the upcoming availability of a new deposition source that deposits hard AR films that can also deposit the decorative coatings that we're currently protecting with oDLC. This ability provides us new applications for VERTEX and also makes the tool an integrated solution to deposit these films and protect them with oDLC. The current implication -- implementation requires 2 separate tools. An integrated solution provides a significant cost out of the multiple film stack, which is important for cost-sensitive applications such as cell phones. And the abrasive surface of hard anti-reflective coatings and decorative films require protective coatings, such as our oDLC, as the current anti-smudge films cannot protect them well.

As I mentioned earlier, we strengthened and evolved our sales and marketing strategy to emphasize creating end customer demand. During the last 2 weeks of April, our sales and marketing team has been in Asia meeting with multiple cell phone manufacturers, introducing them to our new upcoming capabilities to integrate additional films, including AR and decorative coatings protected with oDLC, and this capability has been met with very positive response. In fact, the tool we expect to install soon at a top 3 cover glass maker will be configured to deposit decorative coatings protected by oDLC in an integrated tool.

In parallel with our efforts in high-durability AR, we have been working to improve our oDLC to protect against sharp point impacts as the current formulation is tuned to protect against abrasion and provide extended lifetime of the anti-smudge coatings. Using the deposition source and films developed in our AR work, we have engineered a new underlayer for our oDLC film that greatly improves point-impact resistance. We call it oDLC 2.0, and we are optimistic that applications we have not yet captured with our original DLC will be in reach with the new technology. Beyond this, we recently filed our provisional patent for a novel, ultra-high durability film stack for AR and decorative coatings and have developed a hybrid concept for VERTEX that would enable this novel film stack to be produced at high volume and low cost. All this activity, coupled with our now patented oDLC deposition source, completes our differentiated long-range technology road map for the display cover glass market.

The new configurations of VERTEX that enable oDLC 2.0 and AR and decorative coating deposition carry the burden of not only the film qualification cycle but also the requirement of customer acceptance prior to revenue recognition. We still expect to see orders for VERTEX this year, but given the hold on the 2 systems forecast for the first half of 2018 and the need for oDLC 2.0 with our second customer's first application, visibility for the 5 to 10 systems order in our previous outlook has clouded and is certainly at the lower end. That being said, we're just now out sampling our new offerings so we need to see how that plays out over the year as new technology becomes available, see end market reaction to our current decorative coating protection project with Truly and progress with our new top 3 cover glass manufacturer.

Our February revenue guidance was inclusive of the expectation that 5 to 7 VERTEX systems would revenue in the year. The majority of these systems in our prior guidance have now shifted to new technology and will require a new qualification cycle and customer acceptance for revenue recognition. Therefore, at this time, we're forecasting 2 VERTEX systems to revenue in our 2018 outlook and will add back systems when we are confident that, case by case, the revenue events can occur in the fiscal year. We will update you on our progress as we announce orders as well as on our quarterly conference calls. As for the balance of our Thin-Film Equipment business, we feel comfortable that our prior expectations of revenue for the HDD segment as well as for our solar products remain on track.

Our hard disk drive business has continued to be strong in the first quarter. Revenues included 1 200 Lean systems and continued strong levels of upgrades, spares and field service. In the overall industry, nearline high-capacity drives hit a new record in Q1 with sequential growth over Q4. This is another positive sign for our HDD business, given the significant numbers of disks in each nearline drive. The most recent estimates in our industry show strong growth in exabyte shift on both HDD and SSDs through 2022 with HDDs still representing at least 90% of the total exabytes shipped during that period.

While excess disk manufacturing capacity still exists today, the capacity crossover point is currently forecast to occur in 2020, after which our hard drive customers would need to add more 200 Lean systems to meet the growing demand for high-capacity nearline drives. These forecasts change, as we all know, but the overall sentiment in the HDD market is as bullish as it's been in many years. In the meantime, our multiyear technology upgrade programs underway have resulted in strong demand for both systems and upgrades. We have 2 200 Leans in backlog for 2018 revenue and are forecasting another strong year in our HDD business similar to 2017 with the business more weighted towards upgrades rather than tools.

In our activities in the solar market, we are still working with our customer to finalize the delivery schedule for the remaining 9 ENERGi ion implant tools out of their 12-tool order last year. 3 were shipped in the second half of last year remain in backlog awaiting customer installation. While the schedule and timing are not finalized, at this time, we continue to expect 3 more tools will ship midyear with 6 in revenue for 2018 and the other 6 in 2019.

In addition to the implant tool, we continue to make progress in capturing booking opportunities for the MATRIX PVD tool targeted for existing line upgrades with the current solar customer of MATRIX PVD. Last quarter, we talked about our launch into the advanced packaging market with our MATRIX PVD platform. This is a market where our advantages in high productivity thin-film processing solutions provide a compelling advantage over current ones. In particular, our solution reduces the cost of the redistribution seed layer by 2/3 compared to the existing process technologies. The MATRIX presents a cost-reduction path for the industry OSATs, as they move from wafer to panel-level processing, at -- as the same MATRIX platform can be configured for today's 300-millimeter wafers or panels up to 890 millimeters wide.

Consistent with our product development process, we are currently engaged with Tier 1 OSATs and have an ongoing activity for both wafer level and panel-level demonstrations and evaluations. We have participated in a number of industry conferences and completed the major -- majority of our development work on the process modules for this market in 2017. I look forward to updating you on our progress addressing this new market for Intevac over the coming quarters. At this point, we don't expect any revenue, any MATRIX systems for this market this year and have delayed some development activity, but our objective remains to book the first tool from a foundation OSAT customer before year-end.

In total, for our a thin-film business, our hard drive business remains strong, and we still expect to revenue at least half the ENERGi systems in backlog. Due to anticipated delays in revenue recognition timing on new VERTEX orders, we now expect our Thin-Film Equipment revenues will be down around 5% to 10% from what we recorded in 2017. While we will drive to improve the revenue numbers through the year, it's important to understand that in our equipment business we build to order, and lead times on equipment are 5 to 6 months for standard product, and new systems requiring customer acceptance can push orders revenue timing to 7 or 8 months, making it difficult to add big chunks of revenue in short time spans, despite the majority of the cash for the tools being collected at shipment.

Now we'll move over to Photonics. Last quarter, we communicated that our objective was to deliver similar revenue levels in 2018 compared to 2017, but that we needed to remain vigilant for possible changes driven by political gridlock or budget shortfalls. As it turned out, over the past 2 months, various programs within Photonics have been impacted by several factors, which, together, will have a negative impact on 2018 revenues. We see that most -- all of the impact in 2018 to be push-outs in timing and not subtracting from the long-term revenue opportunity pipeline for our Photonics business.

During the last conference calls, we've been discussing the transition of our Photonics business from a primarily product-driven one to a funded R&D profile. The funded R&D programs, whether coming directly from the government or via a prime contractor, can be a complicated flow down, driven by both political and business situations. The lifting of the continuing resolution and the release of the military budget on or about March 22 was a significant delay of almost 6 months in the government's fiscal year. Beyond that, it can take 30 to 45 days for the budget to flow down through the bureaucracy and finally get allocated to individual contracts.

In the first quarter, our government-funded programs moved forward, but several will require the next tranche of funding in Q2. Given the current pace, we anticipate some breaks in funding to occur, which will push the activity to the right along with the revenue. While there still remains time to get the funding in place to avoid this scenario, it's completely out of our control, and we have forecast breaks in some programs based on current status. We expect, as we move to the government's fiscal year, that sweep up funding will free up for development programs as money in the budget must be allocated or spent or it is lost when we move into fiscal 2019.

Last year, we booked around $400,000 of funded development activity for the Striker II program with BAE. And in the first quarter, we completed that work. But delays in funding for the next task order caused the program to stop until the next funding release for the program. The Striker II is a significant program in our pipeline and is the future night vision system for the Eurofighter as well as targeted for several other airframes. After recent discussions with our customer, we will be resuming the development activity shortly via a funding bridge to keep the project moving until the major contract award is released this summer. This larger award, with expanded content and revenue flow, was forecast to begin in Q1 and is now delayed, pushing the revenue to the right.

Lastly, in regards to the Joint Strike Fighter program, we have been impacted by the lack of an awarded contract for LRIP 11 from the government to the F-35 prime contractor. This lack of award has now flowed down through the supply chain and the subcontractor we supply our night vision cameras to has taken monthly unit deliveries down to contractual minimums until they are placed on contract by the prime. This slowdown in deliveries cuts our JSF forecast in half for the year and is the most significant change in our current Photonics outlook. The JSF program is complicated, and negotiations difficult, to say the least.

In November 2016, the F-35 Joint Program Office forced LRIP 9 contracts on the prime via a UCA, or unilateral contract agreement, as negotiations drug out. We would assume, given the fact that LRIP 11 aircrafts are being produced under an interim contract awarded in July of last year for about half the LRIP 11 aircraft, that a UCA option is on the table to close this stalemate. Overall, the funding development award delays and the reduction in JSF night vision camera deliveries have caused our Photonics revenue outlook for the year to be down about 20% from the 2017 levels.

Although 3 months ago, we did not expect to be down in revenue and the reduction in JSF deliveries were never on the table, it's important to note that nothing has fundamentally changed in our Photonics business besides the timing of revenues. There is still over 225 F-35s to be produced through 2020 and 2,000 more after that. Striker II is coming and expanding beyond the Eurofighter. Our DELTA-I coalition warfare fused goggles programs is gearing to launch, and our goggles for the Australian Army is finalizing this quarter, preparing for evaluations. Our wireless head-mounted displays are finishing completion for field evaluations and projected product quantities requirements are only going up.

And most importantly, the development of our ISIE 19 next-generation digital night vision sensor continues. Our ISIE 19 sensor is the core technology for all of our new night vision technology products, including the pursuit of dismounted soldier digital night vision, and it is the technology upgrade path for all the current production programs we have and are currently delivering. Intevac digital night vision systems continue to be the technology of choice for the premier fighting platforms for the United States military.

So in summary, Q1 was a rough quarter for us. There's no getting around that. And we now expect 2018 will be a pause in our revenue growth trajectory after 3 straight years of growth. As events developed over the quarter, we took strong real-time action in aligning our spending and strategies while ensuring we did not disable our growth initiatives. Today, we now expect total revenues to be down around 10% to 12% in 2018, which will be below breakeven profitability. Despite the short-term setback, our growth story remains very much intact, and we are steadfast in our focus to return to growth and profitability in 2019 as we continue to gain traction in our growth initiatives this year.

I'll now turn the call over to Jim to discuss our Q1 results, our Q2 forecast and some additional commentary on 2018. Jim?

--------------------------------------------------------------------------------

James P. Moniz, Intevac, Inc. - Executive VP, CFO, Treasurer & Secretary [4]

--------------------------------------------------------------------------------

Thank you, Wendell. Consolidated first quarter revenues totaled $18 million, at the high end of our guidance range, as upside in our HDD business more than offset the decline in Photonics. Thin-Film Equipment revenue totaled $12.8 million and included 1 200 Lean system, along with upgrades, spares and service. Photonics revenues of $5.2 million included $2.7 million of product revenues and $2.5 million of contract, research and development revenues.

Q1 consolidated gross margin was $4.9 million or 27.1% and lower than our guidance of 29% to 31%, driven by a significant decline in Photonics' gross margin on the lower revenue volume. Q1 R&D and SG&A expenses were $10 million, up from Q4 due to normal seasonal increase, but below our guidance due to tight control of development spending in response to the revenue forecast. This resulted in a net loss of $5.1 million or $0.23 per share, within our guidance range.

Our backlog was $66.9 million at quarter end. Thin-Film Equipment backlog of $55.6 million included 2 200 Lean hard drive systems, 12 ENERGi solar ion implant system and nonsystems HDD backlog. 3 ENERGi tools are awaiting installation at our customers' factories at quarter end and are awaiting customer acceptance. The backlog in our Photonics business was $11.3 million.

We ended the quarter with cash and investments, including restricted cash, of $40.7 million, equivalent to approximately $1.82 per share based on 22.4 million shares at quarter end. Cash flow used by operations was $4 million during the first quarter. Q1 capital expenditure were $592,000, and depreciation and amortization was $1 million for the quarter.

Now turning to the full year outlook for 2018. Given the factors Wendell discussed related to VERTEX revenue recognition and Photonics program funding delays, we now expect our Thin-Film Equipment revenues will be down about 5% to 10% from 2017, and Photonics revenues will be down around 20% from 2017. This will reduce overall revenues by around 10% to 12% from the 2017 levels. At this overall revenue level and given the mix impact, we would expect gross margins of around 33%.

Last quarter, we were forecasting operating expenses of between $40 million to $41 million for the year. With the reduction of forecasted revenue, we took actions to reduce our operating expense to below $38 million. We also reevaluated a couple of projects and will incur small write-offs this quarter that are expected to bring our total operating expenses to between $38 million and $39 million for the year.

Below the operating line, we expect to see interest income of about $400,000 and net taxes of about $900,000 for the full year. For Q2 specifically, we are projecting consolidated Q2 revenues to be between $24 million and $26 million. We expect second quarter gross margins to increase from the first quarter and to be between 30% and 32%. Q2 operating expenses are expected to be between $10 million and $10.5 million, inclusive of the write-offs mentioned earlier. We expect interest income of about $100,000 and net taxes of about $300,000 in the quarter. For Q2, we are projecting a net loss in the range of $0.11 to $0.13 per share on an estimate of 22.5 million shares.

This completes the formal part of our presentation. Valerie, we are ready for questions.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Your first question comes from Nehal Chokshi of Maxim Group.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [2]

--------------------------------------------------------------------------------

Yes. So how long have you guys been working on this oDL 2.0 -- oDLC 2.0?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [3]

--------------------------------------------------------------------------------

Well, Nehal, this is Wendell, and thanks for the question. As I said in the script, we've been actually working on a high-durability, anti-reflective coating. That was a complete separate project from the DLC. And as we moved through the different processes with different customers and had solidified some of the films that we were putting down for AR, we identified that, that could be -- those -- that activity could be translated on to the -- for a 2.0 version that has a thicker underlayer and provides better protection for a sharp-point impact. So it's been -- the actual activity and the source development was -- has been going on for well over a year, but that was specifically related to anti-reflective coating development versus DLC. And we transitioned that over to the DLC program around the end of last year and started some development there.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [4]

--------------------------------------------------------------------------------

Okay. And when you -- to put that into context of -- been working on the AR for about a year, which you brought into the oDLC program, the 2.0 program, I guess, when you originally developed oDLC, how long did that take?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [5]

--------------------------------------------------------------------------------

The original oDLC was probably done over about a 3-year time span, which includes the source development and the platform.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [6]

--------------------------------------------------------------------------------

Okay. Right. So the obvious question then becomes is, what's the -- this seems like a compressed time line for bringing oDLC to market faster than the original oDLC. What's the confidence around being able to do that?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [7]

--------------------------------------------------------------------------------

Well, I think one way to look at it is the fundamental platform, VERTEX, is already present. We have to make some modifications in how it operates, but realistically, that's more software, motion profiling and things like this. The sources have been worked -- have been being worked on for well over a year in the AR program. And the actual DLC process, which is the carbon process, is the same as DLC 1.0. It's the underlayer between that and the glass which is being changed in 2.0. We wanted to keep all of the functionality that we had with the current DLC and provide that along with a better protection against point scratching, and that required a thicker layer. And without -- maybe that's too complicated of an answer, but we believe that the 2.0 implementation is not a 3-year implementation.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [8]

--------------------------------------------------------------------------------

Great. Okay. And to be clear, the original oDLC did have an underlayer? Or it did not? And now you're implementing an underlayer? And then you come back and realize, you know what, we need a thicker underlayer in order to be able to withstand the sharp-point contacts.

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [9]

--------------------------------------------------------------------------------

Yes, the original oDLC has an underlayer, but it's very thin. And it's made very thin for its optical characteristics.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [10]

--------------------------------------------------------------------------------

I see. Okay. Got it. Understood. So as a result, essentially there's no new chemistry that you need to develop for source technology. It's really just tweaking the thickness of the various layers?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [11]

--------------------------------------------------------------------------------

The answer to that question is yes. We have a core set of films that we develop for AR, but we are also working on some different ones. And it's really about controlling refractive index versus the hardness of the film. And without making it too complicated, when you put these hard films down on a -- in a -- thickly on a piece of glass, the hard films tend to have higher refractive index, so you really need an anti-reflective function on that underlayer in order to eliminate that. And that's how we were able to port our AR work over to DLC.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [12]

--------------------------------------------------------------------------------

I see. Okay. All right. And then 2 years ago, when Truly had accepted their first system from you guys earlier than expected, it felt like you guys had a pretty high degree of confidence that this was going to get adopted. But it's still early in the cycle, right. You hadn't secured that second customer yet. And I guess -- is this sort of where we are with the oDLC 2.0 in terms of level of confidence and you hope that will grow as you get further into the program? Or you think we're further along in terms of the confidence level there it was?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [13]

--------------------------------------------------------------------------------

Well, we can certainly see that we have now been -- we are now able to retain all of the DLC characteristics and improve its point. At some point, there was a compromise that needed to be made either in how well it protects against abrasion versus how well it protects against a point contact. We think we're by that now. And we certainly at the -- the array of testing that we do on these films, whether that's sand shaker or TABER or these 2-year simulated usage testing, we can certainly see marked improvement in some of these characteristics without losing the original functionality.

Now, a number of the applications don't require that, and you can put down a less-expensive film with oDLC 1.0 because it's only using a very thin layer -- underlayer. And that's completely adequate for some applications, including the application we talked to about the top 3 handset maker. That's too -- that's oDLC 1.0, and that passes all of the tests that that particular customer wants to have it pass.

--------------------------------------------------------------------------------

Operator [14]

--------------------------------------------------------------------------------

Our next question comes from Craig Ellis of Riley FBR.

--------------------------------------------------------------------------------

Peter Peng, B. Riley FBR, Inc., Research Division - Associate Analyst [15]

--------------------------------------------------------------------------------

This is actually Peter Peng calling in for Craig Ellis. Just on the first quarter gross margin's variability, it seems like Photonics is down, but software's went up significantly. So can you just kind of help reconcile the gross margin difference? It seems like, net-net, that would cancel each other out.

--------------------------------------------------------------------------------

James P. Moniz, Intevac, Inc. - Executive VP, CFO, Treasurer & Secretary [16]

--------------------------------------------------------------------------------

Yes, what happened in Photonics is we actually had some cost growth in one of the programs. And on lower revenue it gives you much higher percentage of revenue. And so that was really the most significant development in Q1 was we had some challenges on the cost. And we had to take a forward loss provision, and the revenue only being $5 million had a higher impact, which is why the gross margin was at around 6%.

--------------------------------------------------------------------------------

Peter Peng, B. Riley FBR, Inc., Research Division - Associate Analyst [17]

--------------------------------------------------------------------------------

And then on the systems and upgrades, if I kind of take your equipment backlog and just kind of take out all the equipment tools, it seems like the upgrades went up significantly. Looks like, at the high single digit kind of millions. Given that, why aren't you more positive on that part of the business?

--------------------------------------------------------------------------------

James P. Moniz, Intevac, Inc. - Executive VP, CFO, Treasurer & Secretary [18]

--------------------------------------------------------------------------------

We are positive on it. We're very positive, which is why we had said that we would expect to see a similar level of hard drive revenue, which was very strong last year. I think in the mid-50 millions, but on less systems, so we have more upgrades. And we saw a lot of that -- those orders happen in Q1. We don't expect that same level of high orders every quarter, but that gives us a lot of backlog going into the next 3 quarters. So we're feeling very comfortable about that.

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [19]

--------------------------------------------------------------------------------

And I think, Peter, also, this is Wendell, that when we look at the latest forecast that are out there, and we highlighted in the script as well, that we're now seeing a company like Trend Focus forecasting a growth rate that will extinguish the excess capacity out there in a reasonable time frame, in 2020 is where their current forecast shows that crossover point, which is not where we were at a year or 2 ago. So that's really been a lot of positive sentiment inside the HDD and some good projected growth rates of exabyte shipments on hard drives.

--------------------------------------------------------------------------------

Peter Peng, B. Riley FBR, Inc., Research Division - Associate Analyst [20]

--------------------------------------------------------------------------------

Okay. And then kind of -- just taking your -- the growth rate for the thin film, and if I kind of back out the expected -- 2 more VERTEX in the second half, it seems like you're going to -- you're expecting 2 more Lean shipments in the second half. Is that right? 2 to 3 Lean systems in the second half?

--------------------------------------------------------------------------------

James P. Moniz, Intevac, Inc. - Executive VP, CFO, Treasurer & Secretary [21]

--------------------------------------------------------------------------------

We actually -- in our guidance for Q2, there's actually 2 Leans in Q2, and we're expecting a third one after that. So really, 3 more -- one in the second half and 2 in the second quarter is what's in our current forecast.

--------------------------------------------------------------------------------

Peter Peng, B. Riley FBR, Inc., Research Division - Associate Analyst [22]

--------------------------------------------------------------------------------

Okay. Great. All right. And then on -- a question on the VERTEX. It's -- it seems like with 24 million capacity at Truly and then if we add 2 more that can add about 6 more, 8 million. So I -- if the customer wants to adopt for, say, 20%, 30% of the smartphone, would you have the ability to ramp up?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [23]

--------------------------------------------------------------------------------

Well, we are going to put another tool in the field, as we talked about. That would be the next tool. We would be able to build up one additional -- I think, we, as a management team, want to keep one in finished goods so we can react quickly. And then we do have some long-lead parts that are -- that still remain on order -- are in-house, actually, so we can react within a 3- to 4-month time frame on a next couple of -- 2 to 3 tools from there, But we'll certainly be monitoring what the capacity is being consumed in the VERTEX and how the programs look coming in, how the acceptance of this decorative coating protection that Truly is doing now, how customer capture's going with this third Tier 1 cover glass maker as well as how Truly is doing with their program. So we feel comfortable we can react.

--------------------------------------------------------------------------------

Peter Peng, B. Riley FBR, Inc., Research Division - Associate Analyst [24]

--------------------------------------------------------------------------------

Okay. And one more question before I hop back into the queue. The 2.0, are these ASPs going to be much higher? Or are they relatively similar with the 1.0?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [25]

--------------------------------------------------------------------------------

That's a great question. So we -- in the -- for the 2.0 version, it's a similar price. We have done some cost reduction on that platform already. Because the source technology is a bit more expensive than the current underlayer source. And then if we move to an integrated tool that does the decorative coating, now that has multiple sources, that will be a more expensive tool, but it also is doing the function of 2 separate tools. And in our latest sales and marketing work over the last few weeks in Asia, there's a lot of interest in being able to combine those tools and taking out the handling of the substrates between those tools. That's a big cost reduction. And like we said on the script, the tool we plan on having out here and installing with this new cover glass maker, they want it to be configured with the decorative coating capabilities.

--------------------------------------------------------------------------------

Operator [26]

--------------------------------------------------------------------------------

Our next question comes from Mark Miller of Benchmark.

--------------------------------------------------------------------------------

Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [27]

--------------------------------------------------------------------------------

I just wanted to clarify something on the decorative coatings. Is there a unique decorative coating? Or are you also combining what you call decorative coating with the anti-reflection coating? Is that what you're terming the decorative coating? Or is that something separate?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [28]

--------------------------------------------------------------------------------

Well, that's a great question, Mark. Because it's the same source and it's the same type of films, but when you're doing -- say you are doing a front cover with oDLC on it. You'd want that to be an anti-reflective-type coating. But on the back covers, what you're really looking for is a reflective coating. So you use those same types of layers, but you terminate with a different refractive index. So you're actually reflecting certain colors or transition the colors. So it's the same hardware, fundamentally the same type of films in both applications, just done in a different way to get a different effect.

--------------------------------------------------------------------------------

Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [29]

--------------------------------------------------------------------------------

Just wondering if you could kind of address the situation, all the saber-rattling about that tariffs between United States and China. What impact, if any, is it having on the solar market? And also, if you can talk about the n-type cell market, what's happening there? Has that continued to slow down from previous expectations in terms of opportunities?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [30]

--------------------------------------------------------------------------------

Okay. So from a tariff perspective, we're not actually seeing any impact to the business that we're looking at. Certainly, we're waiting to see where these exemptions come out, because I know there's some U.S.-based companies that are affected that are petitioning to be excluded from that. That could have some impact. I know that there was one particular company that was talking about a certain amount of manufacturing capacity in the U.S. space being impacted if those weren't lifted. There has been dialogue with customers in China. There's some concern about what ultimately happens, but it hasn't been impacting any deals or moving anything forward there. And could you restate the second part of your question again?

--------------------------------------------------------------------------------

Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [31]

--------------------------------------------------------------------------------

What's going on with the ramp of n-type cells?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [32]

--------------------------------------------------------------------------------

Okay. So n-type, we're seeing -- well, one of our -- the tools that we have out there right now that are waiting for installation is an n-type ramp, so we're seeing that come back to life. We're seeing some tools installed there, and we anticipate getting installed, the first tools, in a reasonable period, once they move in some other equipments. So we see that moving. Certainly, we're not hearing anything formal from the premier n-type guys as far as additional new capacity. They're usually pretty good about announcing that in their supplementary materials on their conference calls, but we have been in discussions for some cost-reduction activities where we do some replacement and upgrades of existing lines to make them more cost effective. Beyond that, I don't have any current information on the resumption of the China frontrunner on the n-type, but we're expecting that, I think, relatively shortly, to hear about that coming back into play. Whereas at the end of last year most of that money got shifted to PERT cell manufacturing capacity installations.

--------------------------------------------------------------------------------

Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [33]

--------------------------------------------------------------------------------

And finally, any expanded opportunities you see coming out of the new Trump budget for you guys?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [34]

--------------------------------------------------------------------------------

The new Trump budget, I think what we see is -- of course, everybody -- the sentiment is better. There's more -- there's money there. The continuing resolution is lifted, so there's the ability now to create new program starts. There is concern that as soon as we get into October, they'll put a new continuing resolution in place, if they can't get a budget to be agreed upon prior to the end of the fiscal year. Most of the -- the plus-up in the military budget that came at the end, a lot of it was significantly around platforms. Some of those platforms which we are involved with, including Apache and the Joint Strike Fighter. However, on a near-term basis, those platforms won't be built for several years. I don't think we've seen a plus-up at this point in LRIP 11. I think that's staying right around 200 -- I forget the exact number. 275, or something like that, units. But it's certainly positive. But it doesn't equate for us to any kind of a short-term move in the supply chain for the night vision systems for those platforms. Yes, there was a little bit of military sales in that budget that we've quoted on as well. That's positive.

--------------------------------------------------------------------------------

James P. Moniz, Intevac, Inc. - Executive VP, CFO, Treasurer & Secretary [35]

--------------------------------------------------------------------------------

Yes, for military sales, but we don't expect that order till late in '18, and they'll revenue in '19.

--------------------------------------------------------------------------------

Operator [36]

--------------------------------------------------------------------------------

Our next question comes from Ben Klieve of NOBLE Capital.

--------------------------------------------------------------------------------

Benjamin David Klieve, NOBLE Capital Markets, Inc., Research Division - Senior Government Services and Defense Technology Analyst [37]

--------------------------------------------------------------------------------

Quick follow-up question here on LRIP 11. My understanding was that, while there was delays in LRIP 11, that there's still being -- there's still a lot of pressure being put on the supply chain to ramp up capacity in advance of kind of 12 and 13. What are your customers saying about volume production beyond LRIP 11, beyond the near-term delay that they're seeing from the one -- from this one lot?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [38]

--------------------------------------------------------------------------------

We have been quoting on LRIP 12 and 13. Correct, Jim?

--------------------------------------------------------------------------------

James P. Moniz, Intevac, Inc. - Executive VP, CFO, Treasurer & Secretary [39]

--------------------------------------------------------------------------------

Yes. We quoted 12 through 14 actually, last year.

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [40]

--------------------------------------------------------------------------------

So the overall units are in line with the projected number of aircraft to be built. I have that chart, but I didn't bring it with me, on 12 and 13. But we don't see that slowing down. But we have to get past this impasse with LRIP 11 and get the full amount of LRIP 11 aircraft on order, which it's not today. Does that answer your question?

--------------------------------------------------------------------------------

Benjamin David Klieve, NOBLE Capital Markets, Inc., Research Division - Senior Government Services and Defense Technology Analyst [41]

--------------------------------------------------------------------------------

Okay. Yes, yes, it does. So basically, the sentiment is -- from your customers, is essentially that just -- they just have to work their way through 11. But once they think they have visibility, once we can transition to 12 to 14 here, to really ramp that back up again. Just over the next few quarters, challenges are going to continue due to delays in LRIP 11. Is that right?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [42]

--------------------------------------------------------------------------------

Yes. Maybe a better way for me to answer the question is that we, in our normal cadence of business, would be expecting to be quoting on LRIP 12 and LRIP 13 right now, which we are. So we're not seeing that process being delayed by the LRIP 11 deal.

--------------------------------------------------------------------------------

Operator [43]

--------------------------------------------------------------------------------

(Operator Instructions) Our next question comes from Nehal Chokshi of Maxim Group.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [44]

--------------------------------------------------------------------------------

So it's been about a month since the top 3 smartphone really went GA with your coating. Can you just provide some clarity on that? Was it on just 1 or 2 of -- I think there was 5 colors overall offered or was it on all of the colors?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [45]

--------------------------------------------------------------------------------

It certainly is not on all the colors. The -- they don't necessarily tell us everything. But certainly, there was one particular color that they were using as a test case. And then beyond that, we don't have a lot of visibility. But I don't have clearance to actually say which one of those colors it is.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [46]

--------------------------------------------------------------------------------

Okay. Understood. And I guess, you probably don't have an answer to this question then. But do you have any visibility into what's been the demand response for the colors that are utilized in the oDLC?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [47]

--------------------------------------------------------------------------------

It's a little bit early, but our understanding is there's one color that's not too popular, and it's definitely not the one that we're on. So I think there's been reasonable response to most of those colors. And I think one of the colors that I believe does a transition, I don't think is available quite yet. So they don't have any feedback on that.

--------------------------------------------------------------------------------

Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [48]

--------------------------------------------------------------------------------

The one that has the transition, is that the one that possibly has the oDLC on it? Or definitely not?

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [49]

--------------------------------------------------------------------------------

That, I don't know.

--------------------------------------------------------------------------------

Operator [50]

--------------------------------------------------------------------------------

I'm showing no further questions at this time. I'd like to turn the call back over to Mr. Blonigan for any closing remarks.

--------------------------------------------------------------------------------

Wendell T. Blonigan, Intevac, Inc. - President, CEO & Director [51]

--------------------------------------------------------------------------------

Okay. Thank you. Before I sign off, I'd like to thank our dedicated employees of Intevac all around the world for their tremendous effort and outcomes in this dynamic environment. I also want to thank our customers for their continued business and appreciated partnerships. And finally, I'd like to thank our stockholders for their continued support of Intevac during this pause in our growth trajectory. I thank all of you for joining us today, and we look forward to updating you again during our Q2 call in July. Until then, so long.

--------------------------------------------------------------------------------

Operator [52]

--------------------------------------------------------------------------------

This concludes today's conference. You may now disconnect.