Coherent Corp. (COHR) Earnings Call Transcript & Summary

[Audio Gap] that in itself is exciting, and it's nice to see you guys. We've got with us from Coherent, the formerly known as II-VI. We're going to stick with that for a little bit to get adjusted.

Yes, exactly.

And we've got with us the company's CFO, Mary Jane Raymond; and the CTO, Chris Koeppen. So Chris was, I guess, a lead addition, so sort of the bonus guest we'll say.

Thanks for having me.

So we've got essentially an outline of questions for this fireside chat. But if folks have questions, wave, and we'll try to take from the audience. But essentially, the way I thought we'd structure is, we'll start with some of the macro discussion, and we'll talk about some of the different business units to really try to get current and see how you're thinking about the future. But why don't we just sort of set view of your place, Coherent's place, in this macro environment where there's this increased uncertainty, inflation? How are you thinking about the effects of the macro on your company?

Well, if you think about Coherent Corp., as you know, the II-VI completed its acquisition of Coherent Inc. in the beginning of July, and then in September, announced the rebranding to Coherent Corp. We now have an even more diversified profile than we had before back to what we would have called a balanced portfolio with communications at about 44% and industrial at about in the mid-30s, and then electronics about 13% and devices about -- sorry, instrumentation about 11% or so. The macro has the potential to affect any company, including ours. But the balance of the portfolio, I think, allows us to withstand that a little bit. When we think about issues, say, for example, that could affect GDP, the industrial end market can be driven by GDP. But it depends on how it manifests itself in the world. If 1 economy is down, it doesn't mean the whole world is, and it also oftentimes has a positive effect on the service and aftermarket business. Because what that would mean is, that while companies may put new machine sales on hold or push them out, they would use the installed base more, which would drive then the aftermarket and service business. It also can sometimes have a very positive effect on the communications business, right? So we saw that when the economies were down at the beginning of COVID, communications went through the ceiling because of how people chose to work. And if people on a response to a macro environment were to say, well, let's try and reduce our real estate footprint and still have kind of hybrid working arrangements, that continues to drive a strong demand on the communication side. So I think that the way you want to think about it, at least for us at Coherent Corp. is that we have the ability to adapt, and we start focusing on adapting pretty early. I would say our company really focuses on, if we hear dynamics that could be out there, we start to plan what we would do about them if they came almost immediately. And that allows us, I think, to be prepared. That's probably one of the single biggest traits in the company's DNA.

And I guess one of the other topics we've talked to many of our companies about is the implications from a strong U.S. dollar. And I think part of what I want to dig into a little bit is, I think the investment community focuses too much or too exclusively on the revenue side of it, ignoring the hedges that come about. And then you're a globally based company, so you've got employees all over the world. Can you talk about sort of the puts and takes of that strong U.S. dollar on your financial statements?

Sure. I mean, first of all, I do not think that's something people should, at least in our case, be necessarily overly worried about. I mean, as you know, everybody in this room, it's just basically economics. The U.S. interest rates are going up at a time that the other countries have not necessarily yet followed suit and may not, right? So that makes the U.S. dollar stronger. That does have -- for our non-U.S. denominated revenue, it can have a dampening effect and did in the quarter. But we have quite a bit of U.S.-denominated revenue, probably easily half of the company, so -- if not more. It also, though, has the opposite effect on the cost, right? When the U.S. dollar is strong, that if you -- a lot of the cost of the non-U.S. locations would naturally be largely in the local currency. When that translates across to the U.S. dollar, it's translating at a lower number, which means the cost is coming down at a lower number. And so it ends up, we had about a $16 million depression on the revenue and a $6 million increase on the gross margin, right? So it has benefits on the income. And then aside from that, if you think about how that's moving the balance sheet, we have quite a bit of that hedge. So the effect on our FX from a hedging point of view is very, very moderated. That as an aside, even though Simon didn't ask this, has the same effect on the interest rate insofar as that's affecting our debt. So I think any time a company has a pretty balanced portfolio around the world of where it's operating, even if you see a diminishment on the top line, if you do see that, chances are you're going to see a pickup in the income.

And then I want to specifically dig into China a little bit in that. For you, historically, it's been a big market for revenue, but it's also a big region for your factories, your plant. And so China has been in the news a lot lately, between the macro economy slowing in China as well as the lockdown, and perhaps today, the unlockdowns. So what's your view on how essentially activity in China is affecting your business?

So revenue into China for our composite company is about 20%. So that's the first thing to say. Of what we make there, a lot of what we make in China actually stays in China, right? We do have things that are made in China or finished in China that come out and are sold around the world. It has a decent amount of our assembly-based operations. But the thing to keep in mind, even though there's more recently, say, in the last 4 years, a lot of conversations about restrictions in China. Many years ago, probably at least 10, if not 15, the 10% wage increase in China started to make China not exactly the least expensive place to make things in Asia, right? So we began to look at how we would build out the rest of our Asian manufacturing footprint. Just for that reason, just on economics, right? So we have a fairly large presence in Malaysia. We have a fairly large presence in Vietnam. We have operations in Singapore. We have operations in Taiwan. And we have a decently sized operation in the Philippines. So if you think about our whole kind of Asia region manufacturing, it's very diversified and it's not just in China. The lockdowns in China, as it's dealt with its 0 COVID policy, are a bit, as you've read, right, if 1 person or 2 or 3 people in a site or a home, apartment building have COVID, they do put the little fences up around the building. And we have had that. I mean, we had that in Vietnam as well. I mean, we had it in the Philippines. And some of that wasn't so much that they locked it down as much as it was just too far for the people to go home. And we just dealt with it, right? So as Chris was saying earlier in some of our earlier meetings, one of the things we've also thought about is we thought about where our customers are and how we deal with anything from tariffs to just the length of the supply chain. We started to look at multiple places that we would make things, I wouldn't say 10, but maybe 2 at least, so that we can really manage our supply chain really from any part of the globe. That's not universal for every product we make, but it also is something we've worked on probably for the last 5 or more years.

So mentioning supply chain, I think the investment community has sort of gotten supply chain fatigue...

Yes, totally.

But I do want to check in, in terms of what you're seeing in terms of progress in the supply chain and what you're expecting for the timeline of a recovery.

Right. I would have said that we felt that the recovery on the supply chain was probably anywhere from the beginning of this calendar year to the middle of it -- sorry, sorry, '23, right? Now, we think it could be more towards the end of '23. In our case, it's largely in integrated circuits. It started almost exclusively on the ROADM side. That is easing a little bit. And I think the phrase we used in the earnings call was moderated. I would describe it as, if you manage the turnpike, having all the lanes blocked, it's like the shoulder opening. So it's not all the lanes are open now. It's just -- it's an easing. And that is very helpful, and that's been instrumental in the margins in the last 2 quarters because ROADMs carry a nice margin. We are seeing a reduction in the integrated circuits being in short part supply for transceivers. So we're working on that. But we've also had a year or 15 months to work on alternative designs that we've worked with customers directly on, and in some cases, the suppliers themselves to try and have alternative designs to figure out how we more proactively break those chains. I do think that during the COVID period where there was perhaps less capacity going in and perhaps not as great a recognition of how fast that was accelerating the communications demand curve, I think we just got very, very behind really in the supply. But that is what we're beginning to see easing up.

And so you closed the acquisition of Coherent and you've laid out, I guess, a plan for $250 million of synergies. Could you help us understand where those are coming from and the timeline to implement that?

So the synergies on the $250 million are 60% in the COGS and 40% in the OpEx. And the timeline sort of goes like 65, 90 and in the dollar wise and then the balance in the last year. Normally, we estimate that those last year synergies are the ones that tend to come from contract harmonization that sometimes you have to wait the contracts out to the expiration. Leases that might run out and then we combine sites and if we have 2 offices in the same location. We bought CoAdna, for example, that was true in Taiwan, where there's no impact necessarily on the headcount, but we do go down to 1 site. In the beginning, in the first year, largely what we see is really in the OpEx area. For example, the 1 that was achieved here in the first quarter, the 9/30 quarter, which was the retirement of the relevant C-suite people as we combine the 2 C-suites of the company -- the 2 companies. That's now complete. I think because you're probably going to ask me this next, whether or not we're going to increase the number of the synergies. The company will shorten the time to achieve the synergies before we increase the number. And if you remember, that's what we did with Finisar. We said the $150 million over 3 years became $150 million over 2 years. And then as we had that close to being delivered, we increased it to $200 million. So I'm not saying we're necessarily increasing it, but what I'm saying is we would have shortened the time before we increase the number. And so that's really what you should listen for.

So I want to ask next about your priorities for use of cash, and I want to set a little bit of context because I sort of feel like this is a very tricky question because it seems like there's no way you make everybody happy, at least probably a problem where one side of it is you can use cash to delever following the acquisition of Coherent, the other is you can invest in growth and spend more on R&D and spend more on CapEx. In particular, the question we've been getting is, will they delever or will they invest in silicon carbide, and that seems to be heating up quite a bit. How have you been answering or addressing those questions?

Well, I'll answer the cash question and maybe Chris can address kind of how we just look at investment priorities in general in the company. First of all, the first call on the capital of the company is always, I think, going to be CapEx because the growth in the profitable revenue is really essential, right? It's essential for the cash flow, it's essential for the company's growth, it's essential for a lot of things. And after that, it's paying down the debt. The company has a very keen interest and has told investors that it is important to us to pay the debt down, not just get to a lower leverage ratio by increasing the EBITDA. Having said that, I've now been at II-VI for -- sorry, at Coherent for -- I'm rapidly getting rid of my red, white and black clothes and moving them to blue. And so today, I didn't either. But anyway, I've been here for 8.5 years, and I've probably heard this question with respect to investments at least 4x. Why aren't you investing more in this faster? We watch the market very carefully, and I'll let Chris talk about that, so that we time the investments. It doesn't make a lot of sense to have an enormous factory that is then laying idle for the next 4 years, right? I would also say that our company has doubled the capacity of our silicon carbide base every 18 months for almost the last 10 years, right? So we've had no break in the investment that we've had, and we have never had any break in our conviction that silicon carbide is an important material of the future and likely to be 1 of the most ubiquitous materials in the world. I think we -- what we've announced that we're already investing $1 billion over the next 10 years, about $400 million of which will probably be invested in these first 2 years is not the only investment we'll ever make. And the company continues to look at what its options are for how we have a solid and impactful larger entry in this market. But let me just let Chris address kind of how we are continuously looking at how we look at the investments of the company in general.

Yes. Thanks, Mary Jane. I think you hit the nail on the head saying, we are investing a lot in key technologies like silicon carbide. So for us, Simon, it's around prioritization. So we'll use the capital as necessary because we don't want to be shortsighted in terms of not investing in something that's going to give us a multiyear payback and multiyear return on that investment. So we will invest in the capital because that will give us revenue generation in the near term and the long term. And then R&D, we do prioritize. It's part of our synergy planning, too, which is what are the most impactful R&D investments, including areas like silicon carbide, indium phosphide, compound semiconductors, and we'll make sure we invest in them at the right level for the market returns. So we're in constant communication with our customers. I mean if we speak about silicon carbide, in particular, we're the top supplier in some segments and in the top 2 in others for the silicon carbide substrates. We have -- all the customers are our customers. They tell us what their needs are. We plan our investments accordingly. We're not -- again, we're not going to be shortsighted in terms of not having the capacity to meet their needs and to get the return that our investors are expecting. So I think it's just -- it's a -- every quarter, we have the discussion. Is this the right level of investment? Do we need to accelerate? Or can we prioritize something else? I think we'll...

Is there any rule of thumb for those of us who have to analyze on the outside warning in your quarterly meetings to say, well, normally, it's this percent of revenue, even though on a given quarter, you may have puts and takes. Is there any sort of guideline you could give us of how to think about it?

For just on carbide capital?

No, for all CapEx.

It's about -- well, what we had said back in 2017 when we did our first Investor Day was that we expected CapEx to be between 10% and 12%. And then it wasn't for some years a little bit, we purposely moderated it down during 2020, for example, during COVID because the world also moderated its demand. So you would expect we would do that, right? But I think it's -- if you think about where we are now, I remember the first year, we said it would be $100 million. Everybody asked me when it was going back to $50 million, which is what it had been prevailing for a long time. But 10% to 12% is really where the company has been for many, many years, even like prior to 2012. So I think that's really where I think we will be looking at it. And then we'll just see how the markets move. And we -- if you think about the CapEx, this year is really for expansion capital because if it's not in the ground today, we're probably not making goods off it, right? So we need it in advance. And we think about what that timeline is. That's why the conversation is really refreshed every quarter. Investments today are really looking at what are we expecting in the next 2 years. And we want to make sure we're as current on that as we should be. But I think that you should think about CapEx really being in that 8% to 10% -- 8% to 12% range over time. And as the company grows, it might move to 7% to 9%. But generally speaking, it really does not rest to 5%.

I think we've got a question, Eric. And I'll repeat the question for the webcast.

I want to follow-up, which you said, Chris, about the silicon carbide, doing more of the substrate. I think a lot of people have wondered about CapEx and is there going to be a CapEx range, because some are doing modules or copper level assemblies. Why is substrate the right happening for you? What's the return on that market?

So just to repeat the question. So Coherent is thought to be focused on substrates, whereas competitors are doing substrates and modules and components. And so I think the question, as I understand it is, why do you choose a strategy you do?

Okay. Well, I guess I'll -- I'm not sure that I would have characterized it like that. We're focused on all levels. So substrates, devices and modules. And we're currently working with customers at all levels. The significant part of our current internal CapEx investments are in substrates. We are making CapEx investments in the other areas as well. We're also looking at leveraging external partners, for some of the CapEx in certain areas. I think everyone knows prior II-VI, now Coherent Corp., well, we love vertical integration, and we love to do -- we have our own fabs. And we will invest in all of our technology platforms significantly where we know we're going to have some differentiation. We can really leverage some other people's infrastructure in certain other areas. For example, we wouldn't invest in a silicon fab ourselves because it is going to be a well-served area. So we feel very comfortable that we're going to have a combination of both internal investments in areas where we know we have -- we might be 1 of only 2 companies in the world that can make the type of silicon carbide substrates that the market needs for both power and RF. But in areas where, for example, some of the fabrication manufacturing facilities, we may not need to do that investment just ourselves.

I would also just add one thing to what Chris said is, there's no -- I mean, just to help you out, there's no thought to be just in substrates. That is what we make today, right? As Chris said, we're making the other ones as well. But we are fundamentally a materials company. We started making substrates. So it would only stand to reason we'd keep making them, right? I mean, we believe that there will continue to be a merchant market for substrates. And then in fact, it's very difficult to make. The silicon carbide substrate is very difficult to make. So being a materials company, we would naturally make the material unless early on we decided that wasn't where we were going to focus. But in this case, we started investing in it 25 years ago because we did think, just based on, frankly, how much electricity it took to run a laser, which was the other area we started and we realized that there would have to be a way to convert DC to AC power more efficiently as the world got larger and things became either more dependent on laser power or just more electrified.

So one of the things I sort of get a little bit nuts about when we have Coherent conversations with investors is, we spent so much time talking about silicon carbide and 3D sensing, which combined or single-digit percent of revenue, datacom's the biggest chunk of business. So I want to take the conversation there, because it's -- I almost feel like it doesn't get proportionally enough attention. And so I'll try to be as blunt as I can without being too crazy, but you and your primary competitors seem to see the environment a little bit differently. They're talking about slowing. You guys seeing the datacom business is coming away, and there's a lot of debate in the investment community as to why you might see the world a little bit differently. So I'm not asking you to speak for somebody else, but what's your take on the datacom transceiver marketplace? And any thoughts on why somebody might see it differently than you do?

Sure. I mean, I guess I'd talk about customer exposure and product exposure. So in those 2 areas, we have a very broad product offerings, and we serve many customers. So from our perspective, we really see the continuing trends of bandwidth, bandwidth deployment and it really depends on the segment of the market and the data centers, in particular, while some of the end data center, hyperscalers may be cutting back some of their CapEx investment, others are not. So for us, we, again, at the broad stroke level, we're still seeing it up and to the right for us. And in particular, 200G, 400G and 800G, the high-speed transceivers, the demand is very strong for them right now. And we're 1 of the leaders in that area, and I think that speaks a little bit to our strength there.

And from an investment community perspective, we often start by looking at capital spending forecast, whether it's for telcos, whether it's for the hyperscalers. And those models are telling us that the hyperscalers spending growth decelerates massively in '23. So depending on how you define the group, it's still 5%, 6%, 7%, 8% growth coming off of teens growth off of 30% growth. How do you see the growth of your addressed market? So not looking at their CapEx, because they're doing -- building data centers and construction and real estate, so your part of the market, how do you see your TAM growing?

Do you want me to take that, Mary Jane?

Sure.

Yes, I would -- again, I would say, preferentially growing stronger again, because of the high-speed transceiver solutions that we have. You really have to be at the forefront of the data evolution, the data speed evolution. But if you don't have the 200, 400, 800G, you are going to trail a bit in terms of the deployments. If someone's cutting back on CapEx, it's usually not sort of the next-gen know that they need to have out there to support all of their data needs. Again, as you correctly said, their CapEx plans are encompassing. It's all the servers and everything else, the capital infrastructure, the facilities infrastructure, the datacom and the transceivers are just 1 part of it. So for the customers that we deal with the demand that they have for us, we still say -- I would say, above sort of market growth.

And you're in a market data center transceivers, so inside the data center that it's been tough for us to really handicap or understand the market share moves because of the diversity and the kinds of players that seem to be competing in it. Have you been a net share gainer in that environment? Is that why you've had the growth? Or has this been a rising tide float to all boats, but for -- we don't see the revenue of the Chinese players or what's buried inside the giant semiconductor companies and things like that?

Yes. I mean, I guess I would say, we have a very good share of customers in terms of gains or losses. I can only comment on what the demand signals we're getting from our customers, and those are very -- those are strong for us. But again, it comes down to being -- we have the component technology that enables 200, 400, 800G type of transceivers. And that's where we're seeing that strength. And so I'd say we're always at the front of our customers' mind share for their next-gen deployments, and that's what where we're seeing right now.

And do you have a way to maybe -- I hate the what inning are we in question, but sometimes it's the best way to kind of describe something vague. But where is the industry in particularly 200 and 400 gig because I assume 800 were batting practice?

Right, early innings. Yes, we're getting some singles still in that 800G area.

So where is the market in 200 and 400?

I mean, I would say it's robustly in the middle that's -- beginning to middle of the cycle for 200 and 400G. I mean, there's still a lot -- it's got a lot long legs for that cycle. I mean, the 100G is still strong, and that started close to a decade ago.

And I remember sitting in meetings maybe 5 years ago, before you acquired Finisar, debating that the world was going silicon photonics, and legacy architectures like yours were going away and wouldn't work. And I remember your colleague, Giovanni saying to us, "Listen, if the only tool you have is a hammer, everything looks like a nail. The only thing you do is silicon photonics, everything requires silicon photonics." So with the benefit of hindsight, we've proven that you don't need silicon photonics. Now I have to ask the question now, as we're looking at newer technologies, do we get to a point as an industry where you have to change architectures and you need to be in silicon photonics and have that for the future? What's sort of your view on where the technology needs to go next?

Yes, I would say it's going to be a little bit more of the same from Giovanni's perspective, his point of view. We have all the tools in the toolkit, including -- we've been doing silicon photonics for quite some time. We just evaluate for every single next offering for that specific product for those customers, what is the right solution? So whether it's a short-reach gallium arsenide VCSEL, long-reach indium phosphide, a silicon photonics modulator for some very compact form factors. We've deployed all 3 technologies in these high-speed transceivers. So we don't see any major paradigm shift, if that's what you're asking in terms of. Indium phosphide and gallium arsenide will certainly carry the day for an upcoming decade. Silicon photonics is an important tool in the toolkit as well. But there won't -- we don't see any game-changing architectural changes to the network that would require that it all shifts over to 1 type of technology or another. But it's good to have that as a tool. For us, it helps us to have the best solutions for our customers in the end. So we do deploy silicon photonics as well, but where we think it's important.

So before we run out of time, and this is just flown by, by the way. I want to make sure I touch on the telecom side of your product portfolio where you've got ROADMs and amplifiers. And I guess, part of the struggle is that 1 of the leading manufacturers, OEMs has run into some supply chain issues. It sounds like they're related to ICs, not to your product. But the worry is that if the industry slows down because of that golden screw, does that affect you? Do you see your businesses vulnerable to your customers being unable to get components you don't make?

Well, I mean, first of all, on the telecom side, we have had that. So that's the integrated circuit shortage with respect to ROADM system with longest running supply chain issue we have. So that's the one that is easing now. And we've worked with customers through that to try and satisfy not only other parts of their demand that we can supply, but also in redesigning some of those integrated circuits to allow them to get the products they need without necessarily waiting for the very original and great circuit. And I would say, we have found customers to be very, very collaborative with us on that. I mean, they could said, that cost be money, forget it. So that's the first thing. And the second thing is, from an absolute telecom point of view, we also are seeing good progress on our coherent transceivers, which is also a nice part of that.

So I wanted to ask a very specific question on the ZR part of that, so that's a pluggable 400-gig transceiver. It seems to me, as an industry observer that it's a pretty crowded space, but it sounds like you've had some success. How do you think about that particular opportunity for Coherent?

Sure. I would say we focused on differentiated solutions. As you said, there's a crowded space. We have a 400 ZR+, which is really an extended reach. As you know, a lot of the architectures have shifted over time in terms of data center to data center. It's not necessarily a campus environment anymore. These are long, long spans. So our customers in the end will use the tools they need to send the data from point A to point B over certain distances. So the classical metro or access or data center interconnect, they're all interrelated now with edge computing. So everyone wants to put lots of bandwidth over different distances. And so whether it's shorter distances using lower power consumption transceivers, like our 100G ZR transceiver that we're announcing, or the 400G ZR+, customers really can't get enough of those types of offerings that we have right now. The 400ZR specifically, we would sell more components into that specific space because it isn't an area that we had a differentiated solution on.

Well, that's great. Well, folks, I want to thank everybody for joining us. Chris, Mary Jane, thank you very much. It's been great, it went by quickly.

Al right. Thanks.

Thank you.