Coherent Corp. (COHR) Earnings Call Transcript & Summary

Good morning, everyone. Welcome to Deutsche Bank's Technology Conference. I am Sidney Ho. I cover semiconductor, semi-cap equipment and IT hardware here at Deutsche Bank. Our first company today is II-VI. II-VI a global leader in the development, design and manufacturing of engineered materials and optoelectronic components and products for diversified applications in industrial, optical communications, military, semiconductor, medical and life science applications. Today, we're thrilled to be joined by II-VI CEO, Chuck Mattera; and CFO, Mary Jane Raymond. Welcome, Chuck and Mary Jane. So before we start, for those investors who are listening on the webcast, if you want to ask a question, there is a box on the screen where you can type in your questions. I will try to ask those questions as we go through our discussion. And before we get to Q&A, I know you -- Chuck, you would like to make a few quick overview. So please go ahead.

Thank you very much, Sidney, and thank you to Deutsche Bank for hosting us this morning. Thanks for your interest in II-VI. My quick summary is that we're coming off of a record fiscal year '21, where we saw strength in all of our markets. We're expecting another strong year in FY '22. We've sustained our strategic investments across the company, including in compound semiconductors. We announced a long-term investment strategy with underpinning a huge opportunity in silicon carbide-based materials and devices. We continue to manage the operations to serve our customers, manage our costs, including navigating through the supply chain and the challenges associated with COVID-19. And we're really excited about having moved into the planning phase for the acquisition of Coherent, which we now expect to happen in the March quarter. We have lots of opportunities in the near term, and the long term is even more exciting than we ever imagined, especially as we get closer to the Coherent team, which we have been doing. So Sidney, with that, I think we're ready to go into the questions and then take the Q&A from investors as we roll along. Thanks a lot.

Okay. Great. Thanks, Chuck for the quick intro. Well, maybe I'll just start off with some near-term questions on the core business itself, and we'll get to the Coherent deal in a minute. So on the demand side, you are seeing a very healthy demand environment with your revenue growing 30% in fiscal '21, and you got to a record backlog. Can you give us an update on what you're seeing in the market since maybe earnings? And how do you think about the sustainability of this strong demand environment?

Well, first of all, I'll just echo what Chuck just said, we ended fiscal year '21 with all markets strong at the same time. We do expect strong growth across the board, though keep in mind, our 30% growth in fiscal year '21 is about 18 on a -- if we don't Finisar for the whole year. So it's probably in the high teens that we could be thinking, so I don't think it will grow 30%. But generally speaking, you can see the demand environment developing across the board whether it's industrial, communications, semi cap, and that is actually the primary underlying driver of the supply chain shortages. So that's pretty interesting. But why don't I stop there and see if Chuck wants to add anything.

That's great, Mary Jane. I think that's fantastic. I think we can keep moving.

All right. So maybe drilling into the communications market. Last earnings call, you had big strength in datacom, 200G, 400G, those kind of things, driven by hyperscale data upgrades, and you call it super cycle. So can you give us a sense as to where we are in this super cycle?

Okay. Thanks a lot, Sidney. The -- our business was strong, both in telecom, datacom and access and even the cable TV market. Lots of people have termed this a super cycle because of the deployment of 5G, in particular, is expected to happen over multi-years. We started this service of this demand about 12 to 18 months ago, and it's really strong as it continues to be underway. On the data center side, even though we have products that are out in the marketplace, including being designed in and servicing customers for 800G, 400G, 200G, 100G will continue to be a large portion of the market for several years to come. We continue to be a market leader, the market leader in the transceiver market, and we're investing to be able to keep that market position. Overall, the demand environment continues to be very strong.

Great. Within communications market, do you have any concerns of inventory build at some of these hyperscale customers? The reason I ask is that there seems to be some concern of overbuild in some components like memory and hard drives. But on maybe the 200G, 400G products are so new that it's not possible to overbuild at this point?

I would say that, first of all, in communications kind of across the board, inventory build is always a risk, always a possibility and definitely not a perfect science. I'd say that in II-VI, the ways we try and monitor indicators to try and have the best position to understand whether we're detecting inventory build or not is all bookings are required to have a firm ship date. If they don't have a firm ship date, we obviously put them in the -- we record that the customer would like something, but it does not become a booking until it has a firm ship date. We monitor changes in the dates that are in the bookings, especially if they push outward. Sometimes they're pulled in, but they are sometimes pushed outward. We monitor those. We especially monitor what we would call a debooking, someone actually deletes a piece of the demand that had a firm ship date. And because we report bookings every week, those land on Chuck's desk every week. They get a lot of attention in II-VI, a pushout or a debooking. And then we monitor our inventory at the customer site. So both the level of it, the condition of it, how it's moving. So that's usually in something in enclosed area that sometimes referred to as a cage, we monitor the cage. And then we require long-term agreements from customers before we expand capacity for them, especially in communications because it's a known cyclic market. Now all the things I just said may not be a perfect science and may not keep us from having a customer that does an inventory build. But at the end of the day, if I compare it my time here at II-VI to 2018, the last period of significant customer inventory consumption, it didn't affect us at all in that period, and our company still grew 9% that year.

Wonderful. Maybe let's switch over to talk about industrial side of things. You noted on your last earnings call that industrial lasers business saw the largest fiscal Q4 in history -- in your history and had a record backlog. What is driving the strong demand? Is it being driven by recovery in industrial market as more of global economy opens? Or are there more secular drivers -- forces driving this kind of growth?

Okay. Thank you, Sidney. I think actually, you hit on both of them. First of all, in the second half of our fiscal year and in particular in our fourth quarter, we experienced what we believe was a strong recovery and resurgence in the industrial economies in U.S., Europe and in Asia. And in combination with that post-COVID stabilization or post the last surge recovery, the demand for industrial lasers and industrial laser components shot up. And we had a record quarter, even in our infrared optics business in the June quarter of last year. We think some of that was due to a snapback, maybe a little bit associated with inventory restocking of some things, some components for some of our customers. But by and large, the overall recovery of the economy, the sense that the industrial base is going to experience -- continue to experience an investment in both the Western world and in Asia. That's the first part of it. The second part of it has been underpinning the growth in this technology over a long period of time. And that is that lasers are finding new applications beyond just cutting and welding and joining. But in particular, associated with the electric vehicle manufacturing and for battery welding specifically. There's yet another driver that's coming on to the baseline. So manufacturing steps are going to continue. Wherever there's an opportunity for the laser to provide a differentiated advantage either in cost or performance or in quality, the laser is going to continue to be adopted. I think those are the 2 drivers.

Great. Great. Thanks for the update. Maybe switch over to supply chain, Mary Jane, you talked about earlier. The supply chain constraints still remains an issue throughout the industry, but it appears that you guys did a pretty good job managing that through the June quarter. Can you give us an update on what you are seeing now in the supply chain? And any thoughts on how you think about the pace of the recovery in the supply chain?

Well, supply chain constraints are in our company, especially in communications, not solely in communications, but especially there, look at least to be intensifying. I mean, in the beginning, while parts were challenging to obtain, there were a few sources to try and get them, and we pretty much had a, as Chuck would call, an all hands on deck every day in the trenches getting parts. And as they become more scarce, that could become more challenging. We do expect that to continue for at least a year. As we look at demand in our semi cap business and in other places, expansion in the semiconductor capacity will help really alleviate that. That is underway. And I'm not sure that, that necessarily creates a glut of supply because there really is a very strong demand environment. It's certainly in our industries. But if you think about it, I don't know if any of our investors out there have tried to redo their kitchen during COVID period here, but I personally have been waiting on getting a new refrigerator for 8 months because as goods, including consumer goods, whether they'd be white goods or handheld goods become more complicated and have more functionality, they need integrated circuits and things like that, and they become more difficult to get right now. So I think once the capacity is in place, we'll see that begin to alleviate, but it could take as long as a year, if not maybe even a little longer. Chuck, what would you like to add?

I think that's great, Mary Jane. Thank you for your summary.

Okay. That's helpful. So maybe we'll switch over to talk about the Coherent deal. I think a lot of people are interested on that subject. Maybe first off, you won the deal very in the public -- very public way, bidding war. What gave you the confidence to continue to raise the bid throughout the process? And looking back a few months, has there been anything you've learned since the deal was announced that makes you more excited about this opportunity?

Okay. Sidney -- thanks, Sidney. It was a great process. It was an exciting process. It started -- in our shop, it started quite a few years ago. We have been looking and assessing both the market for lasers and laser systems for years. And we have developed a strong view over that time period that both the technology and the company and the footprint were of tremendous value to us as we look forward. So as the deal went on or as the bidding went on and we gained access to a little more information by way of this process that Coherent ran, it gave us greater confidence to be able to take the bid up that we could generate long-term shareholder value commensurate with that bid. And so as we got more information, we got more comfortable. We got access to the team, we got more comfortable. And in fact, since that time, we've had a chance now to engage with the Coherent management team as we began our planning. And in my case, I have met now more than 50 of the leaders of Coherent, both in the U.S. and in Europe. And after a 2-week tour closing out 2 weeks ago, of the operations in Europe and the teams in Europe, I'm even more excited than I was before. And seeing what their capabilities are, what the tempo is, what the mindset is and their enthusiasm and excitement about the combination is really fantastic to see. So all systems are go.

Great. Chuck, you talk about creating value. Obviously, we'll talk about cost synergy in a second. But I understand you probably don't want to quantify this, but how do you think about the potential revenue synergies by combining the 2 companies? Are there areas that you are particularly excited about? Maybe you can talk about the customers' response so far? And on the flip side, are there areas that you're concerned that there could be dissynergies?

Okay. There's 3 or 4 questions in one, Sidney. So good job on that. Well, let me -- I'm not sure which order, but let me take them. Let me say first off that our model did not anticipate any revenue synergies. So we didn't have that factored in. However, that's the game plan that we had with Finisar as well. And I can assure you that on day 1, right out of the starting block, that's among the first things that we will do in terms of opportunities for us to be able to gain revenue synergies that were not in the baseline. So that's number one. Number two, we do expect to be successful at gaining meaningful revenue synergies. We think that it will come at the cost of some revenue dissynergy. That's bound to happen in a transaction of this size. However, based on my discussions with customers, key customers so far, I'm confident that we'll be able to mitigate the impact of revenue dissynergies. Now as a result of the overall constraints of a process like this, we're not able to do anything more than plan. And so we have a limited contact with customers except or unless they happen to be also II-VI customers. And I would say that the partnership that II-VI and Coherent announced last fall around their ARM laser, their fiber laser along with our welding heads for the EV market, I think that's really a great stand-alone example of the kind of opportunity that we have. It's going extremely well as a partnership, and I'm expecting that we will find and be able to define more examples like that as we go forward. And I think that's probably where I would stop, Sid.

Okay. That's helpful. I understand that you can't do much with the customer side. Maybe move over to cost synergies for a second. Mary Jane, you've given us the cost synergies target of $250 million over 36 months. And I have full confidence that you guys can get that. But how should we think about linearity of these cost synergies, both from the standpoint of cost of goods sold as well as operating expenses?

Yes, it probably goes something like 25% in the first year and then like 37.5%, 37.5%. So not to be like too hyper precise about it, but maybe 25%, 35% and then the balance of 40% at the end. I think we will enact all the synergies right from the start, but certain ones take longer. I mean just to give you a very small example in finance, depending on when it closes, we may not look to enact many of the finance synergies other than the combination of the Board of Directors before the year-end, for year-end close, so that we be sure we have everybody in the same job, doing the same thing to close the year-end. So if that closes sometime in the first quarter, we're going to close the first calendar quarter or year-end is the end of the second calendar quarter. So it's not such a long time. But in some cases, you could have an example like that, where everybody knows what's going to happen and you just have a delayed enaction date. But that's the basic rough way we think we would deliver them. And it's fast and terrific.

Wonderful. Here's the question that everybody is asking. I probably have 5 inbound questions on this one. On the regulatory approval side, can you give us an update on the process-related deal? And specifically, a number of questions are asking about China. And try to compare that to maybe the last deal that you guys did in Finisar, is there anything difference between that? Are you guys able to even travel to China to do some of these regulatory process? So if you guys can talk about the Chinese approval process, that will be great.

Sure. So overall, in regulatory just overall, we have filed our applications with all the required jurisdictions. So the U.S. was cleared as you know, the first early on, maybe as long as 2 months ago at this point. And then you probably saw the recent announcement in the last couple of weeks that we had clearance from Germany. And I'd say the Germany one was good because it was one of the larger jurisdictions. For example, we're also cleared in Spain, but Spain is not as big a market as Germany. China, for sure, as everyone is asking, has made it clear that their protocol is to go last. They wait until everyone else is done. So it will be the last one. It doesn't necessarily mean it would be necessarily a problem. But that is a way to think about it. So our acquisition with Finisar closed in 10 months and 2 weeks. And our -- if I look at the Oclaro acquisition with Lumentum, theirs closed in 9 months and 3.5 weeks. So I think we're very -- we announced this transaction, it was finalized on March 25. So at this point, we are just under the 6-month mark. At this point, I think it's going exactly as we thought. We do not expect any major issues in really any jurisdiction, but we do think that everyone will do a careful job. Now as for traveling to China and traveling anywhere for that matter, when we move the timing from the end of the calendar year to the beginning of the first quarter, March -- the March quarter, sometime during the March quarter, part of that was learning about people's COVID protocols. And whether they were even doing in-person meetings, whether people could travel, et cetera. That was the small adjustment of time that we thought it could take longer. In terms -- that same thing applies to China. It isn't clear they will wish or benefit from in-person meetings. But Chuck can probably speak for himself, but he's very, very, very conversant on the protocols for what will happen when he travels to China because, first and foremost, he misses all of our guys, so do we all. We would all love to go see our team soon, not haven't seen them for 18 months. We know what the protocol is, 2 weeks or 3 weeks quarantine there, 1 week quarantine coming back, if not a little more on this side. And I think most people are having to have their China visas renewed in order to go. So that process is all underway. But generally speaking, we have had a few Zoom calls with the [indiscernible] guys. And I'd say it's at least moving along. Chuck, what would you add?

Okay. Just by way of the process, thanks, Mary Jane, I'd like to say that I have great confidence in our ability to get through the process. That's number one. Number two, what's different about it is the directorate [ consent ] led the administrative process for the Finisar acquisition is different than the one that we're going through for the Coherent acquisition. The semiconductor directorate just approved the Analog Devices and Maxim transaction. That was a real strong indication in my mind. I have great confidence in our ability to get through it. I was on the phone last night with them, among our largest customers in China. We have a great legal team and a great technical and operations and management team in China. We're well known and I believe well regarded by customers in China. And as far as planning goes, I'm currently planning to be in China for the entire month of January. So I'm really looking forward to it. Our planning of the Coherent transaction is going on with great momentum over the next couple of months, and I'm planning to dedicate my time in China in January. And I'm expecting that we will be right on the schedule that we have in front of us in the March quarter.

Okay. Thanks for the update. So maybe just one last question on the deal itself. It's an open question. Do you think there are areas of deal that the investors may not be appreciating as much as you would like?

Go ahead, Chuck.

Well, yes, I do think so. And I think so because the combination of engineered materials, lasers, optics, electronics and the problems that need to be resolved over the next 5 to 10 years, they are going to get even more substantial than they are today. The power of the combination from an innovation point of view, from a scale point of view, I think, are underestimated. And I'm looking forward to one heck of an opportunity to demonstrate that. Thank you.

Great. Thanks for that. We have a few minutes left. So I want to touch on 2 other topics those what I consider the growth areas. The first one is on silicon carbide. You guys like to invest $1 billion into that business over the next decade. And I know the business is still relatively small, but that may be one of the largest businesses in the future. It seems like you guys are going to be more vertically integrated. Can you talk about your strategy in the business? And how may that be different than in the past? And there are a couple of questions in -- from the audience asking about the size of this opportunity in terms of maybe just the market itself. So if you can talk about that, that would be great.

Okay. All right. Sidney, thanks a lot. Look, for relatively new investors, let me say that the foundation of this silicon carbide-based power electronics business and the GaN-on-silicon carbide RF business, the foundation is a silicon carbide substrate, a high-quality silicon carbide substrate for which II-VI have been investing in for more than 2 decades. So we just didn't start this overall process technology investment. It's been going on for 24 years. We decided about 3 or 4 years ago that once we met major milestones in the substrates, it would be the right time for us to begin to develop a vertically integrated strategy because we believe that the marketplace would require that in order to have both confidence in performance, cost, reliability and scalability, and that customers -- ultimately, the marketplace will grow to be so big to be as big as a $30 billion market in a decade that customers would want to have the agility, the flexibility, the certainty and the command and control over supply chain to avoid and to avert the kind of problem that people are facing today with the rest of the silicon semiconductor supply chain. Those companies who are building electric vehicles on the basis of this technology will not be able to stand the kind of disruption that they have in their own factories today with factories that are idle because they don't have access to key silicon components. The world is changing. And it's going to change a lot faster over the next 3 to 5 years, and we anticipated that. And so we took a number of bold steps over the last couple of years, and they include a license and a close cooperation with General Electric who have been a 2-decade long innovator in silicon carbide power electronics for high reliability, for high voltage, for high-performance applications that they have of their own and their aircraft business and their energy business and their wind mill business. This is a leader in industrial power systems that have invested for 2 decades in this device technology. We have an exclusive license to the GE device -- silicon carbide devices. And we have a license to their module technology. We are building a baseline of capability for the fabrication of devices and modules on the basis of that plus an acquisition that we did of a leader in silicon carbide, epitaxial growth technology. And then finally, we've also acquired a ion implantation company that has specific process technology for ion implantation and for fabrication of silicon carbide-based devices. Our multiyear investment is going to happen at 3 levels of integration: substrates, epitaxial wafers and devices and modules. And so we have a multiyear road map to be able to get qualified. We'll start out by -- we are working with an outsourced wafer fab partner along with General Electric to get our first generation of devices qualified. I'm still expecting that to happen by or before the end of the calendar year '22, at which point or before we'll be into the marketplace with models, prototypes and applications that we can be designed into. Customers, we're engaged deeply with customers today. In the meanwhile, we're expanding our facilities for expanding our crystal growth capacity, our epitaxial wafer capacity. And so we're having to add, expand our facilities and add capital, both for substrates and for silicon carbide epitaxy. And we are intending to go to the marketplace ultimately with a 200-millimeter wafer technology that will be designed in with a partner for our fabrication. And in the meanwhile, all systems are go. Things are going extremely well, and we have access to the things that we need, except now for the facilities and the equipment, which are part of our investment plan for 2022, and it will continue into '23 and '24, so that we have a scalable manufacturing capability that can keep up with the forecasted demands that will drive the growth that we see in this decade. Okay?

Great, Chuck. I would love to spend more time, but I think we do run out of time. So thank you very much for being with us, Mary Jane and Chuck, and enjoy the rest of the day.

Thank you, Sidney.

Thank you very much. Yes. Bye-bye.