Coherent Corp. (COHR) Earnings Call Transcript & Summary

Here we go. All right. All right, we're off the clock apparently. And so I am Meta Marshall. I cover the networking space here at Morgan Stanley. We are joined here by Mary Jane Raymond, CFO of II-VI; and also Sanjai, who is Chief Marketing Officer at II-VI. We're pleased to have everybody here today later in the day.

And so we've been starting off kind of all the discussions with overall coronavirus and potential impact to the business. You guys have called out kind of a $50 million potential impact to your business. How have you seen workforces coming back? Do you still kind of assess the same impact as previously?

Right. So what we said was we expected to have at least a $50 million impact in the quarter. Keep in mind, we reported on February 10, so we were already knowledgeable that there's a second week of Chinese New Year. And that was probably the first day most people who had not traveled for OFC were back working in general. That was the end of the 3 -- 2-week Chinese New Year holiday. We had 33% of the staff there. We expected to have 100% of the staff back and working by March 15, and I'd say the trajectory is progressing in that way. So that's good news. That's not changed since our reporting. Supply chain, we said that one of the impacts that we could potentially see is the supply chain not being able to deliver. That -- there's a little bit of that. We were already seeing that. That could also change as time goes on. The one thing we were actually worried about when we set the guidance, at least the range of it, was that we were worried that once people came back to work and were kind of recongregated in different ways, not the hometown but the office building, that there might be spikes in the incidence of the coronavirus that would cause China do things like restrict working hours or whatever. So that's been going on. We've been back working for 2 weeks. We haven't seen that in China. We're still remaining kind of attentive to that. But generally speaking, I'd say things are progressing the way we thought they might.

Great. We'll dive back into China a little bit later, but I think we just kind of wanted to reiterate upfront kind of COVID impact. I think we had a recent discussion where you noted that II-VI's core competency was directing, correcting and perfecting the laser beam, which, I thought for a company with so many divisions, was a great way of kind of summarizing II-VI. Can you explain to some who are new to the II-VI story some of the different businesses and applications that have allowed you to kind of enter in and perhaps why it's such a growth area?

So let me just start with -- II-VI is fundamentally a materials company, right. And because the growth of materials is a very, very capital-intensive process and it takes quite a lot of time to perfect the growth of the material, it's not really, in some ways, worth it. You can't really earn a return if you grow that material and you only sell it into one end market. And keep in mind that the company was founded in '71. We were starting to sell it into end markets that had -- and we only had $10 million of sales when we went public in '87. So early on in the company's history, we said the market's got to be big enough for us to make it worthwhile to go into it. So over time, we developed materials that could go into more than one end market. So the original material of the company, zinc selenide, there's a variant of that, zinc sulfide, that goes into military applications. The acquisition of -- the Photop acquisition in 2010 gave us access to certain materials that were used in lasers that were not CO2, that were other forms of laser power, and those materials are also -- and there -- particularly, that coating technology is also used in telecom. When we bought the assets from Oclaro, the gallium arsenide-based laser diodes, they were actually in our company at the time originally bought to be used in fiber lasers, right? But they also have a high level of applicability in optical communications. Silicon carbide, we first developed that for the wireless market, the RF market, and we always thought that it would probably be adopted in some form of power. It was more -- it was interesting to ask that the first place it was adopted is in electric vehicles. But we also think that eventually there will be a study written inside the next 2 or 3 years where silicon carbide is adopted in large electric motors. So those are some of the examples of -- the diode product which is used in AUV is actually a tremendous heat spreader. We would expect to see smaller versions of the diamond products used in other applications. But that's really the goal. And over time, we've really tended to find ourselves mostly focused on laser beam applications. So that keeps us from -- first of all, the material's inorganic. We don't do organic. We're not trying to figure out the next pesticide or something like that. It's all really about better utilization of laser light to do some work.

Got it. And I think that that helps summarize it. How can kind of your new reporting structure where you talked about photonic solutions versus compound semiconductors, how should we think of the different growth attributes, differently? Or are they the same kind of for those 2 reporting structures?

Well, today, with the closure of the Finisar transaction, we have the Finisar portion as part of Photonics now. I would say -- so we're trying to still perfecting exactly how we think the transceiver cyclicality will go over time. But generally speaking, I would have said that we probably have more sustainable growth on the compound semi side because it's also where we make most of the materials. Compound semi is the team captain from almost all the materials we grow. They're also the team captain of laser diodes. They have the ability to sell the laser diodes into applications where we're not making the entire component. So they tend to have less margin pressure, more sustained growth cycles. But if we contrast that to Photonics, Photonics tends to be more cyclical, more subject to margin pressure but when they are in a growth cycle, it's very big, right. So it might be 30% to the year and in the next year it might be 20% and it might actually decline. In II-VI's time, we did have declines in basically the optic communications space in the kind of 14 year, the beginning of the 15 year. And since then, we actually haven't seen that in II-VI. But the Finisar components have. So generally speaking, Photonics, probably over the long cycle, they have about the same growth. The Photonics cycle can be steeper growth but also would be subject to a cyclical downturn at some point. So those are probably the main ways to think about it. I'd also say it's subject to more margin pressure, because there's also more -- even in the old traditional II-VI, more assembly products. So the amplifier, for example, is not really a pure grown or laser diode component.

Got it. And so you started alluding to your acquisition of Finisar there. You have a long, very successful history of acquisitions throughout the history of II-VI, which you're trying to execute on a much larger scale as the Finisar. Can you explain how you've traditionally looked at acquisitions and what you saw in Finisar that made you think you could kind of replicate what you had done before?

Right. You want to do it?

Yes. Sure. So Finisar brought us material systems that we didn't have in the area of pump and semiconductor materials. We had gallium arsenide. We had silicon carbide, but indium phosphide is a platform that Finisar had perfected over many decades, if you will. So that platform goes across markets, for sure, optical communications, 5G. Every front haul transceiver is going to have a laser that's going to be in the phosphide base. But it's also other markets like LiDAR and consumer electronics because of -- indium phosphide, the platform, allows you to put more light. It's less -- the die safety requirements are much lower for phosphide. So you can put a lot more power, so more applications. So that's a platform we didn't have, and of course, the transceiver business. I think we -- in addition to the fundamental building block, which is engineering materials and compound semiconductor technology, this technology is not easily replicated. It takes decades of perfection. You can't flip your -- do that and develop a factory for silicon carbide or gallium arsenide. So I think that's where our interest were.

I would say, generally, in looking at acquisitions, we tend to like material space companies unless they already work in the material and it's a capacity acquisition. High barriers to entry, it has -- they have to be making the stuff that's hard, right? So some of you I know refer from investors over the last year. Everything that Finisar makes today, some of it might be subject to being replicated from an assembly point of view. But the key technology, the high port count switch, the indium phosphide laser diodes, they're very difficult to make. And then we also -- believe it or not, we look at whether or not the people are good fit for our company, because it is our goal to retain them. We are really looking to add not only to the engineering bench. We're actually looking to add to the leadership bench. So those are the main factors when we look at acquisitions.

Got it. And understanding you have an analyst kind of investor event at OFC next week, which is much -- a bridge to OFC.

You're all welcome.

Yes. Exactly. There's plenty of seats available. But what have you learned about Finisar kind of in the last 3 to 4 months that you've owned it for maybe what you initially kind of thought about it when you made an offer a year ago?

Well, I'd say for those of you who listen to the reporting that we did on November 10 for the 12 -- the, sorry the 9/30 quarter, the status of the 3D Sending qualification was a little bit of a surprise. We knew they weren't shipping, because we can tell that in some of their results. But what we -- we were a little bit surprised that there was a technical issue to resolve. So that was a little bit new. I'd say that we -- they do have throughout the company -- for example, on how their financial system is designed, the deployment of their IT system, it's very, very well done. They have a lot of very, very good processes. I'd say certainly had a lot of very, very good people. Probably, the main thing we will try and kind of move them a little bit more toward is at least giving some thought to being profitable at GAAP, right? So sometimes, this can be true at any company, non-GAAP can kind of become a lifestyle. We're going to non-GAAP it out, so we're not paying attention to it. I don't mean to suggest that that's exactly what they did, but it is important that we look at numbers all up, all in. And we tend to look -- we look with them and they knew this that kind of what does it make sense to make, right? So I suppose when you're the inventor of a product, you might make a lot of it. You might make every variation. But if the market moves on, you need to think about what does it make sense to actually make. But generally, I think we found a tremendous amount of talent, some very, very good facilities, and we're really looking forward to delivering on the promise of this.

And so you've called out kind of $150 million potential synergies from this transaction. Where do you see that greatest opportunity to achieve those synergies over the 3-year period?

Right. So the main one is actually in the supply chain. So if we talk -- we just talked a little bit about good processes in Finisar. They have a completely integrated and centralized buying team, their supply chain team. It's been very decentralized in II-VI. We might have 4 people at 4 different divisions that buy diamond flurry. And up until 2 years ago, they probably all were individually buying diamond flurry. So the ability to really build on that and drive greater supply chain synergies is really, really important. And I think especially because we talked about the Photonics business being more cyclical, it's going to be very important to really look at what we're buying on the input material. So supply chain's probably the largest one. So when you look at the $85 million that's in the cost of sales, $65 million in OpEx, most people thought that that was closing factories. There is a little bit of that, but there's not a lot of that. It's really all in the supply chain. I would also say on some things where the margins might be very, very low, the other synergy would be determining whether or not it made more sense to sell components. And we do have a stated strategy of selling some of their key components to the external market the same way we do it in II-VI.

Got it. And so maybe I jump to the next question, which is just -- Finisar had a large concentration in the datacom market, which can have high demand, kind of as you spoke about. That can also be highly competitive. But it did quite well in this quarter, Q2, and with a good portion of kind of the outperformance. So how do you think about this segment? And how do -- pursue a component strategy versus a module strategy? And...

Well, I think, first of all, over time and part of the reason that II-VI over the years has really made very, very specific and conscious decisions about what do we make, so to give you the best example that's not so related to communications, we probably make a decent part of the components, the critical components, to make a laser cutting system, right, an industrial laser system. And we don't make them today. And we made a decision that we didn't really think we were going to go into the laser machine business, because it's a valuable thing to make, the components, and we wanted to really focus on what is difficult to make, where can we add the most value. So I think as we approach what we are looking at, I think it's a certainty that we will move into components. I think we have had, I'll just put it out there, many investors saying to us when are you selling the module business. So first of all, if we are even going to think about divesting anything, anything, same thing for factory closures, we're not going to talk about them until we do them, right? We have people in those businesses, right? We have people on those factories. So I think that's less likely to be the case than it is to really look at which markets we're serving, to take a look at the profitability, to make sure that we have a good understanding of what customers about, what the value really is and then to deal with that accordingly. In the aggregate, between selling components and looking at how do we think about the rest of the module business going forward, I don't expect -- because people have asked us this as well, I don't expect that we would have revenue dis-synergies in the aggregate to be particularly material. But as I say, I think the real goal here is we want this business profitable. We need the margins back up, and we want to make sure that where we're putting our time and our capital is on things that are not easy to replicate. It doesn't make any sense to put a lot of capital into something someone else can easily copy.

Got it. And so maybe what brought a lot of people to the II-VI story or even the Finisar story is 3D Sensing. Prior to the acquisition of Finisar, you had your own facility for VCSEL, Finisar had their own 4-inch facility and then they also had this Sherman facility which people were very excited about. Can you just give us an update as to -- you noted kind of an issue they have had earlier in qualifications, but where that Sherman facility is and just how you think about kind of 3D Sensing revenue building throughout the year.

So first of all, the Sherman facility is really beautiful. And Finisar did a very good job, 700,000 square feet, really building out a portion of that facility for their clean room. And what they didn't do is put all the -- all those offices in the whole space. They don't need those yet. They can spend any money on the space they don't need yet. And I would say that it is not though a simple thing to move from 4 inch to 6. And for those of you who are monitoring us, when we moved from our 3-inch platform to 6 inch, we made a decision to start on 6 inch first and I would say that we announced that we were going to look at making the investment to move to 6-inch 3D Sensing VCSELs. I had people calling within 3 weeks saying, oh, we heard you broke a wafer. And I felt like saying, are you totally serious? I mean we're moving from 3 inch to 6. That is not trivial. I mean just -- if you think about how the epitaxial layer goes on, right, you want to perfect that epitaxial layer across that entire diameter. If you perfected that flow pattern on 3 inch and then you move it to 6, that's not some adjust-the-knob kind of thing. It's a big deal. So it's also a big deal for them. I'd say that they're probably making very good progress. As we said, we would expect to be able to finish that by the end of the quarter. But I think the people should continue to be excited about that facility. It was very, very well-capitalized. It's one of the largest plants. It's an important U.S. plant. And as for the 3D Sensing market in general -- I mean generally speaking, forget about what II-VI is shipping or what Finisar is shipping and just look at what the commentary has been on handheld devices from the major makers of handheld devices, I think the main thing that's actually happened in the 3D Sensing market is that the device has not -- we haven't seen the deployment of 3D Sensing to the extent we should. We were expecting it right? Back when analysts were estimating this, it's very clear why analysts asked us questions that they were expecting a device with 3D Sensing to basically have a world-facing view right from the start. And that's not what launched, right? What got launched was basically facial recognition. For there to be, I think, really a great deployment of it, it has to be able to do world-facing, too. That takes a lot of power. So there's a lot of work that had to go into the design of the device itself to be able to sustain a world-facing view, an augmented reality capability and not drain your battery in the next hour, right? So I think as we see that develop, I think that the world will see quite a lot of demand for the capacity that's in place now.

And so your value proposition and kind of Finisar's value proposition have not only been vertical integration as kind of an advantage. In the case of Finisar also you have new manufacturing. Large competitor in this space thinks that 3 years of kind of knowledge trumps vertical integration. Just how do you think about the competitive landscape kind of playing out over time?

Well, yes. I mean first of all, if people took what the total shipments are today and just called out the TAM for sake of discussion, that's actually a pretty small TAM, right? I don't think -- what anybody with any intelligence would do is kind of start price war over that size of a TAM, right? So this market really -- we expect it to grow. And we spend a little bit of time talking about handheld devices in -- it's the fundamental technology for LiDAR, right? It's also the fundamental technology to allow a factory that does mixed model scheduling, for example, to be able to be 24/7 lights out, right? Most 24/7 lights out factories today in the world make the exact same thing. So the machines don't have to distinguish between parts. It's a very, very big and important capability. I think there is no question we -- even me would say, experience is helpful. But we have been making VCSELs for a very, very long time, and we have made unpackaged VCSELs for a very, very long time. So has Finisar made VCSELs for a long time. I'm not sure as this market evolves given how probably the technology will evolve. But just because someone had a head start means that they're the only ones who will ever be in the market. But we love competitors. It always helps us do better. So I'm sure we'll continue to do well. But we absolutely, in the fullness of time, expect to have our fair share of this market, for sure.

Got it. And maybe turning to kind of the China market. Yourselves, Finisar both had kind of the exposure there. U.S.-China trade relations, Huawei bans, kind of all of these things have caused disruption over the last year. How do you think about kind of China as an opportunity? How do you think of it if they decide to insource more versus kind of the 5G expansion that they're currently kind of building out?

Right. I would say if we were only talking about made in China 2025, I would have said we have to be one of the best-positioned companies in the world in China. When we bought -- an acquisition we did in 2010 in China in Fuzhou, we did that to have access to the end market of China. It's the world's second largest economy. A lot of what they're doing uses laser power, whether it's the development of their network for communications or it's their desire to move to a knowledge-based economy, a more advanced manufacturing-type economy that will build on principles of Industry 4.0. Both of those things end up using laser power in one way or another. As we think about Huawei tariffs, all that sort of stuff, most people assume that if there was tariffs on your product, the company would just -- a customer would just go someplace else. That's not so easy. What actually happened is customers work with us on where we were shipping from, where else we made things. So we made a lot of accommodations to help manage the tariff situation, both for ourselves and for customers. And that's not we just shipped it from some other plant. You have to legitimately make it. You have to do it correctly. But we do make quite a lot of our Chinese products also in Vietnam. Why did we start that? Because the 10% wage increase every year in China started to make China expensive, right? So we already started thinking about that, and we had a pretty good way on about that. I would say the 25% U.S. content rule, all the rules around the Huawei on the entity status, we were probably -- we weren't the first company, but we were one of the first companies to come out and say we think this will have no effect. And it didn't really. 10% will probably have a little bit more of an effect, but I don't think that's hugely more material. Huawei being banned is a totally different story, right? I think that has major implications on the communications market because you have to assume if the U.S. bans Huawei, the Chinese will not only react. Our people will not react to that. The Chinese will also stop buying from U.S. equipment makers that they could have bought from otherwise. So it's just interesting that it's the DoD that said, "Wait, don't make that move yet." So I think as we look at what China might do -- because there's a lot, all this tension, right, would cost Chinese companies to say, wow, this is for the birds. I want my destiny in my own hands. I do think particularly on the key operative components, laser diodes in particular, they aren't made in China today. Laser diodes and gallium arsenide or indium phosphide are not made today. Silicon carbide is not made today. If I were betting I would have said left to our own devices, the world's own devices, the one material we're likely to see come out of China is silicon carbide. I mean it's a very ubiquitous material. I think it's likely that we will have competitors, but it's not easy. So the assumption we're going to have 100 competitors is ludicrous. Over time, because they learn to make laser diodes, yes of course. But at the same time, they are needed in so many things. I'm not sure that they can replicate the world's capacity and really make them at such a level that they could really completely disconnect from the U.S. market or any other world market.

Got it. And even outside of Huawei, you're exceptionally strong within the China market, just with your industrial lasers business, enabling kind of a lot of local start-ups, kind of that idea where you can enable the competitor. This business saw some weakness kind of coming out of fiscal Q1 as China PMI came down. That PMI has kind of continued to have some weaker data points. How do you think about that opportunity over the next year or that market over the...

Well, if you would ask me coming -- when we were reporting out this quarter, so we saw a pickup including kind of in -- generally in Asia. We saw a pickup in the industrial market or at least a flattening of sequential movement in the industrial market that would tell us it looks like laser usage is starting to resume, because it's -- the thing that starts to affect our business a lot, that is, as Meta said, affected fiscal Q1 was lasers in the field not being used. Then the aftermarket components are not being consumed, and that's roughly a function of the GDP falling. When we saw that pickup, I would have said we could see a resumption of laser utilization. Now with corona, it's a little bit hard to tell whether we will, because it's disadvantaging a lot of people who would buy goods that are made with laser processing. So it's a little bit tough to tell. But I would say that the way we're likely to see this is that laser utilization will first pick up. That might be what happens over the next year. We don't make laser systems, the actual cutting machines themselves. So I'm not perfectly good at this. But I would imagine it's after that, we start to see sales of new machines.

Got it. I want to open it up. Are there any questions from the audience? Maybe -- sorry, back there.

[indiscernible] talked about getting it qualified in Q1, account in Q1? I guess what is kind of the next steps beyond the quality or, I guess, start to fill up that factory and get new customers beyond just getting the initial qual done?

Well, I think on the question of what would it take to get new customers, I mean it would help if the market picks up, right? So I think as the -- we have worked with a lot of other customers. And I think as we start to see the volumes come up, that will be helpful there. Finisar has a very good capability in modules. So in the Android space, particularly of makers of Huawei end phones, we see some of those customers preferring to buy a module, which is how AMS gets in this picture, right? They happen to have very good module capability. II-VI has never made modules. So while we may have developed that, I'm not really sure. We really have never done it. But Finisar has, and they have some modules and qualification as Giovanni talked about in the script. But keep in mind, it's a really very, very beautiful fab. And it's possible that over time, we could also use it as a multipurpose fab. So in the U.K. fab that we have, that is designed to be a multipurpose fab, gallium arsenide or indium phosphide.

Got it. [ Chris ], so did you have a question you want to...

Yes. No. It's just around the carbide.

Yes.

What's your understanding of the [indiscernible] given the [indiscernible]?

Well, so right -- so for II-VI, we make our wafers for -- sorry, substrates for both RF and for power. And so while power was certainly a little flatter this quarter, it was never all of our silicon carbide. Our view on silicon carbide is this is not going away. I don't see the world reembracing -- surely, we're just kidding. Let's go back and make all combustion engines, right? I don't see that really happening. Even if we see a little bit of a dip on the power side, I think we haven't even begun to see silicon carbide adopted into large electric motors. There's no question the power side is larger than the RF side. Like today, it's RF that's actually picking up, and that was a lot of the growth we saw in the most recent quarter. But I just do not see the world trend to be able to use electricity more efficiently going away. So from a capacity point of view, we have been doubling our capacity every 12 to 18 months for years right. And at some point, there will be probably a significant inflection when Honda, Nissan, GM, Ford have 5 or 6 lines of electric vehicles. And for most of our customers, we have an understanding of kind of what their road map really looks like to do that turn. So the market moving down a little bit from a vehicle point of view, I just think it's really a temporary blip. In the fullness of time, that's going to look like a yawn.

I'd probably want to add on the RF side, 5G is really driving. And there is a lot of speculation, et cetera, that the Chinese government is really going to -- in terms of stimulus after corona, to really put a lot of money into building that infrastructure.

[ Peter ]?

You put out press releases last week talking about your IC and laser component sales. How should we think about timing, magnitude and margin for that?

So I mean these are -- so Finisar has been vertically integrated for -- since the very beginning, ICs, lasers, detectors, not so much optics. II-VI brings the optics. And those discrete components are qualified and have been qualified into all the webscalers and OEMs, et cetera. So our -- on the II-VI, on the other hand, we've been -- we sell into all levels of the value chain. So we sell into the integrators. So the integrators are -- whom we are engaged with now on opening up essentially the entire portfolio of the Finisar components, I mean they know that they are qualified. Our transceivers and the building blocks that are in the transceivers are qualified to the end customer. So we don't think it's going to be a long drawn out qualification cycle. It's going to go quick. So I would say 6 to 12 months.

Market, what do you think about market [ to the ] opportunity?

Well, I'd say generally speaking, laser components tend to have a margin above the corporate average. But obviously, we don't disclose margins by product.

And ICs as well, right?

Right. That's fair.

Got it. Well, first of all, is my silicon carbide question. But I would like to -- a couple last questions that I have. Just on the ROADM opportunity within China and particularly maybe the -- there's been some kind of share shift that even your kind of major competitor has kind of spoken to. And so just how you view the ROADM opportunity and where you view the greatest opportunity as you exploit that opportunity kind of over the next couple of years?

So the ROADM opportunity is not just China, it's all over the world. And we sell legacy II-VI. We sell primarily into the small port comp, and those are getting really interesting for 5G for front haul, certain kind of wavelength management and the access networks. So that is going to be a big vector of growth. The high port count, the legacy II-VI business, also we have a high port count product and the keep separate business is also high port count. So there is enough opportunities on ROADM, both in China and in North America and in Europe, to drive that. And for us, a ROADM is not just a WSS, we build -- we integrate a lot of the other components that make up a ROADM, including amplifiers and monitors, OTDR and optical channel monitoring. So it's a higher level integration that we provide.

Got it. And then maybe for a last question, just on the military market. That's an opportunity that you've served for a number of years. It's a critical kind of piece of your business. So that's been a high-growth area. Just like how people think about what is it that you're selling into that market and why you've been able to kind of be as differentiated as you have been in there.

Right. So I'd say basically, the U.S. military is a very, very good codevelopment partner. They also have been, for many years, very forward thinking on the use of lasers. So actually, the absolute very first customer of the company's zinc selenide products and probably can't tell product back in 1971 was the U.S. Navy. So I think their foresight in understanding the value lasers can bring has been very beneficial. I think also they tend to think very far in advance, and they tend to share that in order to be sure that products can be developed to match what those needs are. So it's interesting as all of our customers go, they're probably the most knowledgeable about the fundamental value of the material as the limiting item. So unless you innovate the material, you're not going to hit certain limitations, right? So all that's been pretty helpful. I think we have tried to do our best sticking to our knitting. I don't think we've tried to ever become a prime. And I think we've really focused on the things that are difficult to make, so whether it's the sapphire panels that go in the Joint Strike Fighter or some of the critical components that are going into high energy laser systems. So I think those are part of it. But it's also a customer we've known and worked with for a long, long time, and they probably are the best example of why being a design-end partner is very valuable. I do think that while that's a great growth area for us over time, I don't know that military will ever be 40% of the company. I mean first of all, government accounting will take over the company, and I don't think we want that necessarily. And I think we want to try and maintain some balance. But I think that is going to be a market that of all the markets were probably the fastest start to get percentage points of its percentage of the company's total revenue.

Got it. I have no idea where we are on time, but I'm going to assume that we're good. So II-VI, thank you so much for joining us today.

Thank you for having us, and thanks for coming on this late time. See you.

Thank you.