Coherent Corp. (COHR) Earnings Call Transcript & Summary

Good morning, Paul Silverstein Senior Analyst, Cowen Networking and Communications Equipment. And it's my pleasure to have with us II-VI, there CEO Chuck Mattera, and CFO Mary Jane Raymond. Many of you or some of you may know, it's one of the most unique special companies I've come across in my 26 years covering this sector, and I really do mean that. And I want to thank Chuck and Mary Jane for joining us. I've got a ton of questions. I will try to leave at least a minute or 2 at the end for anybody who's got an urgent question, but hopefully, I'll cover the waterfront. Again, thanks for joining.

And I want to start off with a big picture question. You've got this confident that you have all these big ticket opportunities for both magnitude and duration both in card by 3D sensing, we go through the whole list, what are you most excited about?

Okay. First of all, thank you very much, Paul, to you and to Cowen to invite us here today. We have a number of growth drivers in the company, we've been talking about with investors for quite some time. I'll name a handful of them. I'm excited about them all. Let's start out with our communications and computing and our sensing business in the consumer market. All 3 of them go hand in hand. The overall drivers for the 3 of them are all relate. And yet, it's a great place for innovation. Higher speeds are required in the data centers. AR/VR is coming, is a major application. The fifth generation of wireless is here. The sixth generation is underdevelopment. And before we know it, I believe that we begin to hear about it, all of them are all related and as we move, the Internet of Things and sensing moves further and further to the edge of the network, it's just driving more demand for all 3 of those. That's one element of it. The electrification of transportation that incentives around that involves our silicon carbide platforms is really exciting. It's not a 1-year opportunity. It's not a one decade opportunity in our minds, it's really going to be a major bull market for our business over the next decades to come as the world evolves to address major problems with achieving net 0 on a sustainable basis. And regulation comes, digital passports come and at the end of the day, there's going to be a place for a leading supplier of high-quality silicon carbide materials and devices. So then let's move on quickly and into our industrial market that includes semi-cap equipment. We are a leading supplier of both optics, diamond windows and engineered structural ceramics into the EUV and DUV markets, and those markets are in the process of just simply exploring. The customers are concentrated, but their attention to us and their dependence on us is maybe even more concentrated. So that's really exciting as the world builds out all these fabs. Here comes other opportunities in the industrial materials processing market, which crosses over with electric vehicles in terms of battery, battery welding. A business that we and Coherent are addressing independently, but with the integration of our customers as they involve the development of a new fiber laser technology, which is among the technology platforms that we'll get when the deal with the Coherent closes. And finally, our aerospace and defense business continues to be a real great opportunity for us for the long term. It's a sticky business, and it involves competencies in electro optics, special materials and it's about to revolve -- it is evolving into a business that's dependent on laser technology. And so we see that as another great opportunity.

Okay. I think we should have asked you what you weren't excited about.

Okay.

No, seriously. I think we were curious to know, and I apologize for the question because it's long struck that you all are more long-term oriented. And I mean this is a positive sense. We know the company I've ever covered. That said, and I'm sure you appreciate, a lot of investors are concerned about supply chain, especially now in the wake of Cisco's comments about the China lockdowns, and the incremental challenge, not just a matter at today, the lockdowns are officially coming off, but the risk of significant congestion imports both air and shipping and how that impacts companies throughout the industry. Anything you and Mary Jane care to share?

I'll go first and Mary Jane can comment on it. We have a large footprint in China. We've been quite successful in operating there. We remarked on our previous earnings call in May that the impacts that had been widely reported, at least as far as logistics go and production go by many of the people in our space, we simply did not -- we were not affected the same way. So supply chain, yes, supply chain affects everyone, but we've done really a great job in my mind of managing through this particular time especially with regard to semiconductors. And as it relates to logistics and constraints in the ports, when you have a footprint like we have in China that is well operated, they have demonstrated their ability to get around and navigate the constraints much better than a Western company who's trying to manage things either remotely or with a small presence in China which we simply -- we don't have those problems.

Bottom line in other words is China lockdown still present an incremental -- tighter incremental situation?

They're not the problem.

I spoke to our team this morning because I was excited about the news as far as the lockdowns. So Shanghai has opened up. And I think it's possible to overstate the caution that we have to have, and we do. We have that. But I think that the lockdown that we've seen in this last phase, I think we're going to put it past us. And I'm actually hopeful. I mean, there's no news about it, but I'm hopeful that with the reports of our projections for GDP for most economies, I'm hopeful that the Chinese may consider a stimulus to be able to stimulate the demand. But there's no news about that.

Before we drill down into the different big ticket drivers. I want to ask 2 other big picture questions. And again, I'm going to apologize as I know this will turn the ground, not the first time you discussed it. But Coherent, it struck me from the get-go that much like Finisar and perhaps like many deals you've done because the situation that you've had a clear mode to your acquisitions versus some of your install R&D where you identify assets that address multiple end markets that offer significant growth and bottom line opportunity over appreciable period of time and if there's near-term dilution, so be it. But each time they're controversial because you also identify assets that are either mismanaged or undermanaged by the current management teams that you think you can improve and where there's presumably a transitory market dislocation. Coherent essentially checked all those boxes. When you announced the deal, the market was not healthy, Coherent above and beyond the health of the market, not executing particularly well. And if you look at the numbers over the last 5, 6 quarters, it's been dramatically improved along the macro, both revenue growth and bottom line. What would you care to share with the audience either reiterating or above and beyond what you've already said in terms of the virtues of the deal?

Okay. We'll do that in 2 parts. Mary Jane -- we'll give Mary Jane a shot to go first and I'll add on it.

So in terms of macro drivers overall?

Well, what is Coherent? Why do this deal?

So one of the things the company said at the time of the [indiscernible] transaction was Chuck had a fabulous phrase at the time, which is growth is quantized, so it has not been the company's established goal to overweight into communications. But in growing at some point because it's quantized you do temporarily, right? So we weighed heavily into communications, and it was the company's stated goal of rebalance the company back to where we were because the balance of the portfolio is really essential, both to the company's stability and the ability to deliver profitable earnings through a whole variety of economic variations. So that's one phrase -- one reason. But that actually wasn't the main reason. The main reason as we see the world increasingly adopting laser power in multiple forms of some type of processing, whether it's materials processing, cutting, welding, brazing or enabling pictures or enabling illumination, lasers become more and more important and Coherent is really the gold standard. Coherent came into popularity with perhaps some of you during the time they were selling the Expo laser into OLED or perhaps during the deal discussions that were rather public. But coherent is a 50-year-old company that -- this is for you to realize it's a endurance, not that it's old and that is that pretty much every Ph.D. candidate whoever did any work in photonics as part of a physics, chemistry or photonics PH.D. did their work on a coherent laser including Chuck. That quality and the sustainability of the delivery of that laser power, it has been very, very instrumental in the introduction of laser processing into manufacturing in the world. We happen to make the optics, right, but they actually made the machines. So we see that continuing to advance the vast majority of the world's power. Welding is still done with the torch. And we're seeing advances in welding. And I think as we begin to see variations, for example, and car production, not just the resumption of car production, but different types of car production, whether that be electric vehicles, et cetera, it ends up having different types of cutting and welding type of applications that were not necessarily present during, say, past periods of prior generations of products. So both of those things are really, really essential to us, and then Chuck can take it from here.

Yes. Thank you, Mary Jane. Well, thanks for your question. We laid out the elements of our strategy. We just reminded people that diversification is one of them. And with our success -- on the heels of are successful with [ Verizon ] we not only scale the company. We not only develop a footprint into a marketplace and a foothold into a marketplace in the communications space that we simply did not have before nor could we have gotten without that. And it is going to pay dividends for us for years to come. But beyond that, we need to bear in mind beyond the diversification, beyond their technology, beyond their footprint in the marketplace, beyond their market leadership, beyond their customer intimacy, beyond their iconic brand. They've been operating for 55 years. And they add to an endowment -- technology endowment that we have created through the previous acquisitions that we've done and that environment of technology and people is like no other on the planet. And then I call it to mine this -- all these discussions today about the great resignation and the war for talent and how you grow talent. I submit to you that the acquisition of Coherent combined with II-VI will bring together in one place, the largest concentration of people in these technologies on the planet. And I think that's going to pay us tremendous dividends as well as our customers. I submit to you that we've been focused on selecting markets because markets -- picking the right markets with the right growth drivers and the right characteristics is what will allow us to have the confidence in our capital allocation, both the R&D and the manufacturing capacity and our ability to make money. That's the second piece of it. We have the endowment of the technology and the people, the selection of the markets. And then overall, the moves that we've been willing to make, all moves not only around productivity and setting very aggressive targets for productivity improvement for cost control. And for those things that you need to do in the short term, to assure the discipline and a healthy growth of the culture. We've been focused on that. But I want to remind you, finally, there were 2 other CEOs and their boards who saw a tremendous value in the diversification and in the footprint and in the technology and in the customer set that was reflected by Coherent. Two other CEOs participated in a gold process. And only one of them was selected that I remind people that as we were selected, we were not the highest bid. But I couldn't tell you how excited I am about the planning that we've done with the team. We are ready to go. Should the deal be finished and consummated tomorrow, we're ready to go on day 1. And we'll have some extra work to be done for sure. As always, the planning is never perfect, but I think that the planning is also going to avail itself some opportunities that we have underestimated. Finally, the regional footprint of Coherent with a large number of these employees in Europe and very few employees in China, a large footprint in Korea and their success in geographies where we have not been as strong over the last 50 years. And places where we have been strong, including in China, we're expecting that there's going to be some magic as part of our synergies and delivering on the $250 million that will come right at the crack of the bat and then we'll be busy with them.

And I assume there's no change or recently reiterated statement that you expected to close before the end of June.

No change on that.

No change. Just given that it's more of apologies, I'm going to ask you one of your other questions. Again, I appreciate that you all have demonstrated long-term strategic planning. So that said, did you all anticipate a degree of improvement over the last 4 or 5 quarters since you announced the deal? I mean the improvement has been dramatic of revenue growth and profitability, are you all expecting that degree of improvement this quickly?

They have a great team. We've been studying them and watching them and for sure, we expected them to be able to improve their performance. We're hopeful that it would happen, and they have executed in my mind, executed extremely well. And we're thrilled that it's beginning to evolve the way in which we expect.

So the real question I want to ask you, but I'm trying to ask delicately. I don't expect you to change your guidance here now on the stage. But the thought arises, the degree of improvement, when you all gave the initial dilution, statements, maybe the scenario has changed.

Well, we're not going to update anything from the deal model at this point. But I would say that as a general matter, especially if any of you are tempted to ask us about their fourth quarter revenue, you -- the last reported quarter revenue, you really need to think about what they've done over the last year. Because if you think about that, to have a new CEO come in, in 18 months, and do that sort of an improvement, knowing the company is getting sold, I mean those guys could have kicked back. So they were very, very dedicated to demonstrating what they had to offer the market. They did a very, very good job on that. I think as we go forward here, we'll have an updated forecast from them once the deal closes, and then we'll tell you what we think but I think we did have a view from them that they could do it. The fact that they executed that well is always a really wonderful thing to see.

Okay. I'm sure you've gotten this directly from more than one investor. A lot of folks think Coherent OLED, you made a point historically that it's not about any one technology. It is about display as part of a larger picture. It's not about OLED per se, but I wanted to let you respond to that concern that the OLED market is over and Coherent going forward?

I'll say one thing, and then I'll let Chuck do. So Chuck was saying earlier about the wonderful endowment that Coherent brings us in terms of scale and competence and understanding about how to employ lasers. The excimer laser was not developed for OLED. The coherent team had the excimer laser, right? It's a very excellent technology and they had the mental creativity and foresight to realize it could be used in that market, right? So that's just a very, very good example of the application of their technology. I'll let Chuck pick it up after the next comment, which is when I think about OLED as a version, maybe an early version, not sure about that, but it's a version of the display market, really, but what they did was they crack lasers into the display market.

I think the only other thing we can say about it is if you look at the value proposition for OLED displays, in the places where they're deployed and the penetration into the marketplace today, then you can begin to realize for mobile applications, the handsets, for laptops or iPads. So those devices that we tend to hold fairly close to us and the distance between the display and our eyes mostly fixed. So those -- for that geometry, for the need for power consumption -- low power consumption to extend the battery life, there's a value proposition for OLED displays today. And our understanding of what fraction of the market those displays take up today compared to the LCD displays is relatively low. Now we think that it will grow in time. And we think that there's -- there are use cases that can be argued that will come later as a possibility that even large-format displays like TVs or walls. There might be a play for them. But that's one time coming. So if you think about the display so mentioned [indiscernible] of the core which is another place. I think the footprint is stronger. They obviously have a very, very strong position. And we're going to have to think about it past the ups and downs of these cycles including, for example, the 5G handset cycle, it seems to have some ups and downs related to the lockdown in China. We expect these are going to be short with and it's really a long-term opportunity for Coherent to participate in not only OLED displays, but in other formats.

Let me go back to its proper, but you could also answer this in connection with Coherent. You're a foundational technology company. You cover a range of technologies or asset foundational for some in different end markets. A thought arises that from a year now perspective, the macroeconomic risk, it looks like macroeconomic conditions are going in the wrong direction. What's your exposure? You do a lot of things that strike me as not immune or largely insulated, but can you discuss pros and cons?

Can you elaborate, Paul?

Sure. So I think about silicon carbide, right that's going to happen. I would think not necessarily independently but largely independently of macroeconomic conditions. More and more automotive manufacturing is being pushed by government. Well, the only question being is adoption, but that's going to happen somewhat divorced from macroeconomic trends. On the other hand, there's concern about your communications business with enterprises, they're doing less well. They spend less money on IT. There's been less money with the Verizons of the world, et cetera, and they'll spend less money on their infrastructure rollouts that will impact your comms business. Any thoughts you can share from your perspective?

I'm thinking that there can always be those headwinds that come for a period of time. When I look back at the last 10 years, most of the time that those headwinds came, they were really intentional pauses by the users. We'll look at the balance of the CapEx and OpEx investments and especially look at the value proposition of the next-generation technology, decided they could operate their networks a little harder for a little longer and wait before deploying an existing generation to deploy the next generation. We watch it happen with 40G, but it went to 100G and for sure, it's happening 100G to 200G to 400G to 800G and people are talking to us, and we're developing the 1.6 terabyte [ receiver ] technology because we know it will come. When you look at the appetite for information is going to continue to happen in the value proposition, tele-density and the applications associated with it are generally connected to a healthy economy. And the drivers of everywhere around smart factory, smart cars, smart highways, smart hospitals, smart universities and is this overarching trend of work from home. We only see larger and larger deployments of infrastructure that we be enabling, for example, of this sensing out at the edge of the network. If there's a magical way to do it aside from the way in which the world is currently doing it, it's not -- I'm not aware of that. I think it's going to be more of the same. But I don't think anybody should say, oh, by the way, we'll never experience any slowdown.

So here and now, I trust there's been no signs, no metrics that would suggest in the attenuation strength of demand trends, whether communications across your markets?

That's reported in our May earnings call as reflected by our bookings or backlog and the overall tone and tenor of conversations from our customers, not in the here and now. And we're looking out longer than what we ever looked out before.

And just as a reminder to the audience and correct me if I'm wrong, but your momentum of the 2 dominant players in both ROADMs and 980-nanometer pumps, your ROADM business has been constrained. That's where you've been hit on the hardest supply chain. There's a lot of revenue that haven't been able to ship. I assume that, that will get better over time, that there's pent-up demand. It's not that just shifted to some other vendor.

Right, right. There's really, I think the supply chain is -- so we, the company, are not the constraint on ourselves. So we are not part of our own supply chain constraint. Of the integrated circuits that are the most short parts are largely affecting the ROADM business. There is simply no percentage in the customer double ordering, for example. I mean what are they supposed to get from that, right? We can't get the integrated circuit, they can't get it twice. There's no percentage in them moving to someone else because there are a few of us and that's a very, very universal and of course, largely the concern or the driver of the supply chain stores is demand, right? And I think to Paul's earlier question, short and absent a coordinated economic downturn, like 2009 which, at the end of the day, still in our company, only lasted 9 months. During COVID, while we did see a little bit lower industrial production, we saw massive communication increase as people work from home. And if you think about an economic downturn and how companies might react to that, they could say, okay, let's release the real estate footprint and hotel people, right? If they did that, then they're even more significantly providing the ability to work from home and enable the Internet, et cetera, et cetera.

Mary Jane, can you remind us of the margin opportunity over time. I'm not just talking about the next several quarters, but over the long term. You've been around 40% momentum, which has been the most direct comp, is it a fair deal higher, which I think is a good thing in terms of ingesting the opportunity for upside and not identical businesses, but there is a lot of overlap. Any thoughts you can share?

So I would say that for a few years now, my comment about the margins was that 3D sensing and silicon carbide were the 2 areas in the compound semiconductor segment that hadn't yet come into their own. They hadn't yet really begun to ramp and as we've seen 3D sensing ramp, you can see this in our press release in the segment table at the op margin, which is not a pretty decent proxy. And that is that we've seen those compound semiconductor margins well into the mid-20s after hanging around the high teens for a while. You also see Photonics a little bit reduced because ROADMs, which are their highest margin products are the ones that are the most short part. The return of industrial, which is actually the highest margin business in the company and in many ways, the most enduring. Also very strong right now. Semi-caps very strong right now, which is fully EUV, another growing area. So those are the main things that really start to move the company's margins upward. So 3D sensing starting EUV pretty strong, silicon carbide definitely growing on the substrate, but not yet to the point where we're shipping modules, which we think is probably in the mid-20s -- 2020. As a result of that, there's a lot of value in that value chain going from the devices and the modules. That will also help with those margins as there's really more of a return on the investment in those platforms. I think all of those start to help. I think as we continue to see growth in communications, increasing the complexity, higher data rate transceivers that require really a lot of engineering to integrate the laser -- the integrated circuit and the electronics. It moves -- that market starts to move away from players who are basically extremely good at assembly but very, very difficult to engineer but guts of it when it's not just a great assembly. So those are the sort of things that lift those margins in the company over time.

Let me ask one last question before I give a chance to the audience. Silicon carbon, you've got a $1 billion investment plan over the next 10 years, a lot of which will be done in the next 5 years. I think there's some debate to some extent. Is there too much capacity coming to the market? Is there not enough capacity? In your investment, correct me if wrong on both to scale up your substrate capacity where you've been maxed out year after year in outstanding your expansion of capacity historically. And you're investing to get through devices and modules to market in that mid-20s time frame. Any thoughts you can share from your perspective?

Yes, I'd like to clarify that our investment in our scalable materials technology starts with the capacity expansion for the substrate. It also starts with a diameter expansion because we're aiming to be the leading supplier of 200-millimeter silicon carbide substrates to high quality. But in addition to that, our business model today, as we look out over the next 3 to 5 years, depends on us also being able to produce some fraction of our own epitaxial wafers. So the capital investment that you're seeing last year, and we'll see for '23 includes both substrates and epitaxial growth. And we -- over the next 2 or 3 years, that's where our focus will be because we're using at the moment and outsource the wafer fab partner for producing the devices themselves. And we're going to continue to evaluate that. But at the moment, that's the approach that we're taking because the materials themselves, both the substrate and the epitaxial is the differentiator as it relates to the question about the demand, it's always possible that there'll be some overcapacity at some point in time. So I'm not going to say that couldn't happen. But I can say that if you have the highest quality materials and the highest-performing devices in a market that is going to grow for decades and is likely -- more likely in my mind, to have a chip crisis for supply than it is on the demand side. Because it's just difficult to make these devices to begin with. There could be some, but I think it's going to have to -- it will have to be under some circumstances that are really hard for me to fathom. It won't be a marketplace that just anybody can come and serve. And our 25-year head start on the materials that have given us a differentiation as a leading supplier for semi-insulating silicon carbide #1 on performance. And here comes to scale on conducting the power market. There are a fewer things that are this exciting.

We're already past [indiscernible] So 10 second question. In terms of commercial volume, 200-millimeter sick worry?

Our ability to produce it today is right on the track that we're on. We are turning customers away. We do not have enough capacity for 150 or 200 to serve.

I would say most companies that are buying assets right to -- their tools are still fixture for 150-millimeter. Right? So that's not a trivial thing for a company that's buying a substrate to refixture to 200. So there would have to be enough 200 available in the whole world to be able to refixture all their entire factory. So the demand is still at 150, as Chuck saying, and we're returning customers.

But technically you can do 200.

Oh certainly. We introduce 200 in 2014.

Let me say that the equipment set to produce the substrate, we design, we develop, we manufacture, we control it. And that equipment set is completely scalable, all the way to 200 millimeters. So we can grow 100, 150 or 200. We just need to invest in capacity.

We got another half to questions. I want to thank Chuck, Mary Jane and all of you, if I could give any help on II-VI or any other company, please let me know. It'd be my pleasure. Thank you everybody. Thank you.