Coherent Corp. (COHR) Earnings Call Transcript & Summary

Good morning, everybody. My name is Amanda Scarnati. I'm one of the semiconductor analysts here at Citi. We're joined this morning by Chuck Mattera, the CEO of II-VI; and Mary Jane Raymond, the CFO of II-VI. We're going to dive right into some prepared questions that I have. If you have any questions you would like to ask of Chuck or Mary, please feel free to either click the link to ask the question or send me an e-mail directly at [email protected], and I'll be happy to ask them a little bit later on throughout this call.

So let's dive right into the pending offer of Coherent. I think this is sort of the biggest topic. Let's get the elephant out of the room to start off with. During your last earnings call, you mentioned that the regulatory process is going maybe a little bit slower than you anticipated and you're expecting the deal to be pushed out a little bit more. Can you just talk about what you're seeing in that process and if you're still anticipating a close early next year?

Good morning, Amanda. Thank you very much. I'm happy to take it. Our view that the transaction will close in the March quarter is still the case. Recently, we announced that we had cleared the German regulatory approval. And so that milestone itself was an important milestone, but we're still sticking to the March quarter as our current view.

Can you just remind us about the opportunity that Coherent brings to the II-VI platform and the rationale behind the deal. Obviously, diversification is a huge part of what your strategy is today and bringing that in adds to sort of another layer of growth here. Can you just talk about what your expectations are once that deal does close?

Sure. Well, we have been growing this platform, both by organic investment and by acquisitions into those markets that we believe are not only growing today but have the ability to sustain growth as a driver of growth over the next 5 to 10 years. We've picked vertical integration as a strategy and element of that strategy and globalization. And we have seen the benefits of a very large acquisition in Finisar that scale and diversification bring. We envisioned that same kind of a benefit for the Coherent acquisition many, many years ago when we started thinking about the combination. And so in addition to technology and product diversification, the ability -- our ability to be able to go to the marketplace at a higher level of integration at the laser system level and to pull forward with it components, materials and the overall disruptive technology that we intend to continue to develop are among the many benefits that we see. Having a talented group of people that are unique on the planet in the industry, the collection of people that they have at Coherent who've been developing this technology, applying the technology, scaling the technology are unique in the industry. And the combination of their talent with the talent that II-VI have today, I believe, will have in one place, under one roof, the diversity of technology assets, innovation assets and intellectual property assets to be able to leverage not only those investments that have been made already, but the ones that we intend to make going forward.

Perfect. And then for you, Mary Jane, can you just remind us about how we should calculate the Bain investment? And what are the impacts that you expect on dilution and share count going forward?

II-VI is very happy to team up with Bain, and we're excited about their interest to invest in our company. We have received the first $750 million, but we will not receive the balance of the $2.15 billion until the transaction closes. When the transaction closes, the shares outstanding for Bain are about 25 million shares. And we will post today an update to our investor presentation that has the way to calculate the share count. Included in that there's some what are called key statistics for the deal. So as for the overall, we expect that the transaction will be slightly dilutive in the first year and then accretive thereafter. We are well on with beginning to identify in very, very deep detail the synergies, and we will not detail anything about the revenue synergies until after the close.

Let's switch over to the operating margins. Operating margins improved quite a bit about this time last year and then again accelerating in the December quarter, but then reverted back in March. It was flattish in the June quarter. Can you talk about what's driving these fluctuations in margins? Is it really this high mix of 3D sensing that -- from the Apple business that drove margins up? Should we expect some similar seasonality in margins excluding the potential of the Coherent deal next year?

I would say that without any regard to any specific product line, generally speaking, mix has a very big impact on the margin. So compound semiconductors products, which are laser diodes and [ ground ] materials tend to have margins that are above the corporate average. And a proportion of the compound semi contribution to the quarter was the highest in the 12/31 quarter. Generally speaking, however, the margins become -- are very, very important to us. They remain the focus of the company. As we've told our colleagues many times, that's where the money is really made. But we are carrying at this point between 1% and 2% of additional costs for COVID and supply chain. We non-GAAP-ed a very, very small portion of those. And for example, our COVID costs are probably running at the rate of almost $5 million, if not a little more a quarter. So -- and with the Delta variant becoming stronger around the world, I don't necessarily see us backing off on that. And in fact, we could find perhaps along with others that we have reason to increase that. So those are the major things that are driving the operating margin at the present moment.

Jumping back over to supply constraints, which you just briefly mentioned. On the June quarter call, you mentioned that there was about $40 million in supply chain constraints on revenue. Are you seeing -- starting to see any of that reverse? Getting better? Getting worse? Or are those supply constraints still impacting the top line as well as the margins?

The supply constraints are certainly not getting better. And I think as we have said for a couple of quarters now, we expect that these could go on for as long as a year, if not even longer. We are seeing shortages, particularly in integrated circuits, across not only our products that need them, but I'm sure that some of you who have done kitchen renovations are still waiting for refrigerators, at least I know I am. So we are seeing fundamentally the driver of supply chain shortages being fundamentally demand. And we do think that, that demand is very strong and real. We are in the beginning of saying 5G really come into full force and will continue for some time. But at the present moment, the supply chain shortages are certainly not getting any easier. Chuck, would you like to add to that?

Yes. For sure, it's a little bit like hand-to-hand combat. It's a 24/7 job. The biggest single challenge I think is that the supply constraints and COVID-19 are all wrapped up in one ball of wax in some cases. And the market, it has some spots that are irrational. And the surprise is associated with some of our suppliers rescheduling almost at the end of the promise date, is an example of the kind of challenge that we have to deal with every day. It's a little bit like whack-a-mole. And we're doing the very best job that we can do. But as Mary Jane said, it's -- there's no way to characterize it as getting better. I think we're running on a treadmill.

All right. Fair enough. Those are quite a few analogies there, whack-a-mole, running on a treadmill. I guess that's par for the course here these days. Let's just talk a little bit about the 3D sensing business. We talked about it briefly a minute ago. Obviously, driving a significant amount of revenue. We saw strong revenue about this time last year. Can you talk a little bit more about some incremental design wins that you're getting outside of purely that Apple business, which drove a lot of revenue last year? Could we start to expect to see revenue in other parts of the market, maybe offsetting some of that seasonality that you typically get with the Apple business? And what is the progression there?

Okay. Well, we will talk about our -- we'll answer one question with regard to our primary 3D sensing customer. And we've been asked whether or not we're designed into the latest and all of the sockets that are available. So let me answer the question on that one, the answer is yes, simply. So we believe that any of the products that are in demand or forecasted in the near term, that we have been designed in and they're in the process of ramping. So that's step one. Step two, as it relates to the rest of the fragmented market, we have a number of design wins for 3D sensing applications. And if you ask me whether or not I expect those to contribute meaningfully to revenue, the answer is, yes, I do. But I do think it's going to be a FY '22 and FY '23 event. Does that answer your question?

It does. Is the opportunity solely in smartphones? I know we've talked to Giovanni in the past and he's mentioned some other opportunities perhaps in notebook computers and things like that, where you might see some opportunities for 3D sensing perhaps in some other businesses as well. Is the opportunity that you're seeing today for fiscal '22, '23 still really in the handset? Or are there other opportunities opening up?

I think the FY '22, FY '23 comment is FY '22, more design wins and staging for production and with an aim toward our FY '23 production. I believe that some of those opportunities are beyond mobile handsets. And I'm not going to comment any further. At least in 2 cases I'm aware of it, it would be beyond mobile handsets.

Perfect. Yes, I don't need you to give out any specific customers.

Yes. No, I'm not going to. Yes, thanks. Sure. I won't be able to.

Can you just talk about what you would expect to see as sort of a reasonable growth rate for this business? You've talked about maybe 10% to 15% growth in the short term. What would -- is that still a reasonable growth rate? Or do you anticipate something different?

I think it's a long game that we're playing. We have been at this long game now for a few years. We've been clear with investors that if you look back even 2 years ago to the -- our FY '22, we did anticipate that the market adoption would be much greater for a 3D sensing VCSEL arrays. It will be much greater than what it is today. And we've also been clear that we believe that we have, under roof, enough capacity to serve more than 100% of what we believe the demand is today and is forecasted to be in the next 1 to 2 years. That remains the same. So our target is to expand our product portfolio in applications beyond our largest customer, in applications that move beyond the mobile handset and which applications would also pull through other innovations that we have, both in optics and in integrated circuits. And so we will continue to invest and manage and grow in this business. And our goal is to provide our customers with a market-leading advantage. And so a lot of the market development and the market growth rates are going to depend, to first order, on the adoption rate of these products. And I think we leave it at that, Amanda. To the extent that the market grows at a significant double-digit growth rate, we intend to continue to invest in the R&D product portfolio. We have the scalable manufacturing capability and we're aiming at a party that we think will come and will be bigger than what we have today. But that's not a forecast for FY '22 or FY '23, it's a general direction. And I believe that the value proposition that we have is attractive to large system-like customers who are thinking about next-generation innovations. And in fact, all you need to do is go back at least to our large customer with their May press release. There, we're talking about future products. And that's what we're getting organized to do.

Perfect. Let's talk a little bit also then about the silicon carbide business, another piece of the compound semi side. Obviously, there's been a lot of talk lately in this market. Cree is adding capacity. Other customers like ON and Infineon are driving their own internal capacity as well as STM. You mentioned also that you're increasing capacity there and talked about numbers like 5 to 10x increase and investing a little bit more heavily as the market is sort of expanding. Can you talk about your competitive position here and how you see some of these newer companies bringing their own internal capacity, and how that could impact what you're planning on doing in the market?

Okay. All right. That's, as usual 4 or 5 questions in 1. So I know you like to get your money's worth. So let's start out and repeat for some potentially new investors. This technology is enabling and is going to provide a tremendous opportunity for people who are in the power electronics market for decades to come. We believe that the fully vertically integrated market that includes substrates, epitaxial wafers, devices, modules and even systems based on silicon carbide power electronics will be a $30 billion market in the next 10 years. Electrification of transportation is the primary driver, but it is not the only driver as the world seeks to improve the overall electrical efficiency and reduce the exposure to CO2 emissions. We have been investing in this materials technology for more than 2 decades. In 2010, we laid out a road map, and the road map pointed us to certain improvements in the quality of our substrates and certain indicators from the marketplace that adoption was being well planned. And at that time, we would begin to make and be able to justify investments based on the projected returns, make investments to be able to, in effect, vertically integrate on top of this foundational technology for low-dislocation density, low-defect density silicon carbide substrates that would be required for -- especially for high-end power electronic applications. The strategy has a number of elements to it. Number one is be among the best silicon carbide substrates so far that is in the marketplace, and offer both technology, scale, quality, resiliency and overall great customer service for those people who will buy substrates. We acquired a company that has differentiated technology for silicon carbide epitaxial wafers. We invested and then we acquired a company that has differentiated technology for high-temperature hot implantation of silicon carbide devices. We partnered with General Electric after their more than 2-decade investment in high-reliability, high-performance silicon carbide device fabrication. We partnered by way of licensing exclusively their patent portfolio and then also licensing their module portfolio. So we have a road map that we will continue to invest in scale, facilities, equipment, scale to serve the growing market at the substrate level, over the next 2 or 3 years, the epitaxial wafer level. And that same time period, that's growing and will continue to grow. And then also to be able to offer those customers in the marketplace who don't want to buy substrates, don't want to buy epitaxial, they'd like to be able to buy devices and team them, for example, with their silicon devices and make an offering -- a combined offering and so -- that includes silicon carbide power electronics. Those are the spots in the marketplace that we're aiming at. And with the leverage of the GE IP, we are well underway. But that investment is aimed at a large market that's in the process of forming and that will continue to grow for decades to come, we believe. And we think that the foundation of it is silicon carbide-based materials technology, and we're going to leverage the GE device technology and position ourselves in the marketplace as a provider at 3 levels of integration: substrates, epitaxial wafers and devices and modules. I hope I answered your question.

Yes, you did. Can you talk a little bit then on -- we've heard some arguments that II-VI is a little bit better at the 5G side of the silicon carbide equation versus the electric vehicle side of the equation, where Cree is sort of dominating the conversation. Do you find that as sort of an accurate description of where you fit in the market? Or do you think you have just as strong of an opportunity in electric vehicles as in the 5G side?

Well, First of all, from -- taken from the position that we we're in, in the marketplace today, we don't make electronic devices for sale, not yet. But we're coming. So what we make for sale today are silicon carbide substrates, and our power electronics business and our GaN-based silicon carbide substrate business are about equal in size. And so what we see is a huge opportunity in 5G and then also in 6G to come. But if you take a long-term view, that $30 billion market that we can see forming is going to be largely a silicon carbide power electronics market. We're intending to provide the best that money can buy in both segments or subsegments. That's what this multiyear R&D and capital investment is about.

Perfect. Let's jump over to the communications business. And just as a reminder, if any clients have questions, feel free to just click the button and send them over, and I'll be happy to ask what's happening there. Let's just jump over to the communications business. It's the largest segment. Obviously, it's about 65% of sales. Can you talk a little bit about the drivers of this segment and where you see the biggest growth opportunity, whether it be in telecom or datacom?

Mary Jane, you want to take this? I'll just take a break.

Well, first of all, I think we think the growth in both parts is very good. We have seen good growth across both telecom and datacom. And we believe that, particularly for 5G as the world converges applications for consumers computing and communications, that datacom and telecom service start to merge a little bit. But nonetheless, we see strong growth in all of them.

Okay. Can you talk a little bit about what you think the growth potential is in these markets if you size what that opportunity is?

Well, we see the communications end market growing at certainly multiples of digits. And I'll just check one thing here while I'm talking to you. But certainly, we would expect, particularly in the strong part of the cycle, to see the market growing in excess of 10%. In some years where we've had a very strong communication cycle, we've grown as much as 30%. I don't think it's easy to forecast growth rates in the communications market. It's a little bit of a cyclical market, but certainly, we would expect to see II-VI able to grow at certainly, probably 1.5x whatever the market growth is given the [ core of the nature ] of most of our components.

Perfect. What are the near-term dynamics that you're seeing in this business? Do you expect to see growth return within the next couple of quarters? Or do you continue to see a little bit more lumpiness?

Look -- go ahead, Mary Jane. Please go ahead. Sorry.

I was going to say, I'm not really sure that I follow your question, considering that we posted really fantastic growth in the 6/30 quarter. I don't know if perhaps others are not seeing growth at the present moment. But we certainly are, and posted that very well in the 6/30 quarter. And for the first time in our company's entire history, we have a guidance range that could be in the same neighborhood for first quarter as fourth quarter, which has never happened before. Bad supply chain shortages could change that quite a bit, of course. But at the end of the day, we are seeing good growth right now and have been for several quarters. Go ahead, Chuck.

Yes. Mary Jane, I was going to say exactly that. Point to the bookings, point to the backlog point to the enthusiasm that customers have and just come back to 2 things: executing and getting past the supply chain issues and executing to get the next generation of products out into our ROADMs and into the transceivers. Those are the 2 things we're focused on. We're focused on execution. The market is strong both in the core telecom, in the data center, and it's even strong in the passive optical network in the access market as well, at least in some parts of Asia. Market dynamic is favorable.

The next question I have here is, I mean you kind of highlighted at the beginning is your diverse platform, right? You've talked about seeing the benefits of the platform or maybe a somewhat conglomerate approach that you're aiming towards at this point with adding in Coherent, adding in Finisar, et cetera. How do you view -- what do you view is the key benefit of having this diverse conglomerate approach?

Okay. Well, let me try -- let me take a look back. When I joined this company as a Board member, the revenues were coming off of a $45 million year. That business today, if II-VI had not taken the approach that we have taken, that business today would be a roughly $200 million or so business and not with the growth prospects that we have. So what we've been able to do is to target markets. That's a key feature of our strategy, is being able to identify the key market drivers. That requires a deep understanding of technology. If you're one-dimensional in technology, chances are you're not going to provide value to these really large-scale adopters of this technology, and they're just not going to want to deal with somebody that has only one element of a solution to them, especially when that one element needs to be integrated like a laser, and optic and an electronic. So the selection of materials, devices, laser technology and now here comes Coherent, it's been really thoughtful about how they play together, how they enable each other to grow and how they enable us long term to drive the overall target operating model that we have and at the same time to get the benefit of diversification and scale. It's all a common theme, Amanda, markets, technology, diversification, scale. Markets, technology, diversification scale, all with a target of long-term shareholder value in mind. And you can look back and we'd be a lot different company today if we hadn't taken the path that we've taken. And we are going to be a different company 5 or 10 years from now as well.

On the flip side of that, do you see any risk of distraction by having so many different product areas still kind of working through some of the Finisar synergies and whatnot, now bringing in this extra company? Does that create any risk in that position?

What it creates is a demand for high performance, sustained demand for high performance, a stamina and a passion for what we do. I don't believe -- and that's one of the things I think about this management team, I don't believe just any other management team could do it. It would be a distraction for some because that's what it takes to be an Olympian. You have to work at it every day. And for those of us, starting with the CEO, who love it, it's not at all a distraction. It's a passion.

Perfect. I do have a client question here, jumping back over to the silicon carbide side. It's a multipart question, as you've seen from me many times.

Yes, yes, yes.

So the questions are, where do you think that the economic value accrues in silicon carbide? Is it up the wafer materials level? Do you think it's more at the devices module system level?

That's a static question. I'll answer it this way. Today, at least by way of what customers tell me, the value is in the silicon carbide substrate when they see the price they pay compared to the price they pay for a silicon substrate. And when they look to see the results of their yields and the reliability, especially at high end for demanding applications, they realize that the substrate imparts much of the value to their products. That may explain some of the things that you see in the marketplace. So the cost today, I think, is the substrate is an important part of the cost equation. I think if you look out 5 or 10 years from now, it's possible that, that will change. But it's going to take a much greater volume and a much greater capacity of innovation than what exists today. That's my thinking. And by the way, that's part of the spot that we intend to disrupt. So the fact that people -- supply chains are ordering in front of us, that shouldn't be any surprise to anybody. It's the largest semiconductor market in the making. Who could be surprised? The question is, how does it turn out? It's going to turn out for those people that are nimble and that can bring together substrates, epitaxy implantation, device design, reliability devices and modules. It's a pretty complicated situation, but we're going to make money at it step by step, and we're going to add value to it step by step in a smart way so that we can generate long-term shareholder value. And we don't mind being the underdog. It's okay. This is a long game. I hope I answered your question.

I think you did. And I do think there is value to being sort of an underdog. The other question here is, do you think that the silicon carbide industry needs to consolidate a bit more? Or do you think that the market is sustainable where it is today?

I think the market is small compared to the size it will be. And I do believe that there's more moves and rearrangements that will happen over time. I think that's bound to happen. And that's notwithstanding anything about either the regulatory environment that could change or the overall supply and demand calculus, especially in China.

Perfect. All right. I think that we are just about out of time here. Chuck, Mary Jane, did you have any final thoughts that you wanted to depart with?

Mary Jane, why don't you wrap it up?

Yes, I think Chuck did a wonderful job reviewing all of our major points. And as usual, Amanda, your questions were covering the broad, broad landscape of what we're all already hearing from investors. So thank you very much, and we thank you for including us in your conference. And we'll talk to you soon.

All right. Thank you so much. Enjoy the rest of your day.

Thank you, you too. Thank you. Bye-bye.