Coherent Corp. (COHR) Earnings Call Transcript & Summary

All right, perfect. Let's get started here. For all of those who don't know me, I'm Meta Marshall. I cover the Networking Equipment space here at Morgan Stanley. We are very pleased today to have Mary Jane Raymond, CFO of Coherent Corp. with us, formerly known as II-VI, the artist formerly known II-VI.

All right. So Coherent, or the now renamed Coherent, has traditionally been a very acquisitive company, with over 20 acquisitions in these many years. These acquisitions have typically or more traditionally have been tuck-ins in differentiated and attractive markets. How does that remain the strategy of the company? And how has that evolved with some of the larger acquisitions we've seen over the last 5 years?

Yes. So the company's acquired 27 acquisitions in the last 25 years, and Meta is right. It's probably been about, out of that number of acquisitions, 20% of them have been what we would call transformative platform acquisitions, and the rest have been tuck-ins. So tuck-ins remain with us. And in fact, as recently as maybe 18 months ago, we bought 24 engineers in a very little company in Sweden, who happened to be experts at silicon carbide epi. But the platform acquisitions do step functions for us, either acquiring a new material or, in the case of ANADIGICS which we bought in 2016, acquiring a manufacturing site that has a platform that's on a certain diameter or type of manufacturing that we happen to want. So while Coherent, the former Coherent Inc. increased our revenue by 50% from our starting point, Finisar increased it by 100%. But back in 2010, the Photop acquisition increased our revenue by almost 40% at the time. So periodically, we do these platform acquisitions to either enter a market, get a new type of manufacturing platform or acquire a new material.

Got it. So we had momentum here yesterday. You guys had quite a protracted bidding war for the Coherent asset. Understanding that there's $250 million of expense synergies over the next 3 years, and -- but just how did you look at that opportunity? How do you look at the revenue synergy opportunities? And what made that the most attractive asset for you guys?

So we had a very clear view about what we thought Coherent was worth. And as many of you probably figured out, but maybe not, Lumentum had announced its merger agreement around, call it, January 15 or so of '20. Actually, they had been initially selected back at the day after Christmas because the day before Thanksgiving, most of us or the 3 of us, at least, were talking to Coherent at the time. We knew when we were talking to them before Christmas, that they had multiple parties. And I imagine that their thinking was that they pick one, and all the others would kind of go away. But we've been looking at Coherent for a very long time. And as I say, we had a strong view about what we thought their value was. And as a fundamental materials company, a diversified platform for us is actually pretty important because the goal is to be able to sell those materials into more than one end-market, with the industrial laser end-market being a very key market for us, and it always has been. So we wanted to get our earnings out. And then lo and behold, before we even did that, then [ MKSI ] bid, so it started to tell us who the landscape was. You also may have forgotten that we actually stood down before the last round of bidding and said this is where we're going to park. And we're a little bit, at least I was, surprised to wake up the next day to the headline that we had been selected. So I hadn't thought that would happen. We didn't think we were going in with the highest bid. I don't think we actually did, but we were still selected because we tend to be a good cultivation house for most of the technology we hire, we buy. Including all the people, right. We're usually a very, very good home for both the technology and the people who develop it. So at this point, we have the synergies. We're looking forward to the revenue synergies, which we're in the process of identifying now. And also the cooperation between the 2 sides, if you will, the former Coherent Inc. and the former old II-VI to really be able to become an even stronger presence in the market.

Got it. So, I mean, what central principles kind of drive managing such a diverse company at this point? And how do you assure kind of the best practices, optimization that have always kind of characterized you guys take place across this larger footprint?

So the -- probably the main core guiding principle, if you will, for the company is innovation achieved in profitable revenue growth. So by that, I mean, if you think about the kind of people that tend to be in our company, sitting here as the CFO, so I'm kind of the poet of the group, right, our guys could probably figure out how to make anything, but we don't. We don't make every material we could make. We don't even make every material in the industry, because we tend to pick the spots well because there's -- what we're really looking for is the innovation of the material or device platform usable in multiple end markets, right? So the main thing we're trying to do when you're a materials growth house, right, you have a lot of installed CapEx, you want to be sure that you can really leverage that. And so the goal to be able to use the foundation in more than one end market is actually really key. And then we focus on the profitable revenue growth, and what that means is it's got to be driven by mega trends. So if the market were dominated by a single customer, if the market were only a few years long, we might take a decision not to invest in that market or go after that particular slice of an end market because it doesn't have the longevity that we're really looking for. So those are the main things. And then once we have that, we try and have the processes of the fundamental platform, all of the same. And I'd say increasingly, in a set of continuous improvement on process flow, as -- now that the company is near over $5 billion in revenue, we're looking at ways we can kind of commonize our manufacturing practices, commonize the quality practices. Because I think as we've gotten bigger and the operations have become more intertwined, we can really see that things that everybody thought were different just look different. They're actually fundamentally the same. And so we keep driving that. That's why, Chuck, several years ago, put in a CTO. It's why we'll probably always have a CTO. We have a centralized purchasing function which we didn't have 5 years ago. All of those things are all part of driving us, as Meta asks, common processes to drive a diversified company.

Got it. So maybe one of those materials and opportunities that falls into many megatrends of silicon carbide, it's been a key investment area for you guys. How do you see this opportunity developing over the next couple of years? And just what assets do you have or are you investing in to capitalize on that opportunity?

With respect to silicon carbide?

Yes.

Yes. So first of all, the market for silicon carbide-based devices is about $15 billion by the year 2030. And silicon carbide, if you never knew it, at least in power devices, it's applications, say, in electric vehicles, is it allows the DC to AC conversion of electricity much more efficiently. So the upshot of that in an electric vehicle is that the car itself will go farther on a single charge, say anywhere from 10% to 15% farther. So if you think about that, not only is it using the same charge more efficiently, and also from the consumer point of view, it allows them not to have to charge the cars often. So we began looking at silicon carbide almost 25 years ago when we looked at the efficiency of electricity just coming through CO2 lasers, and realized that if the world moves more into laser processing from a manufacturing point of view, we need a lot more power to do it. And that the world was not actually converting the electricity it was generating very efficiently. So what we saw then maybe around 2017 or so, that sort of time frame, was that here in Europe, several countries starting, I think probably with Germany, began to have dates where they would actually no longer allow combustion engines to be made. We have some countries, whether it be -- probably even soon the United States, and I just saw this at Heathrow. But in China, for example, where there are fines or drop-off fees for driving combustion engine cars in major cities, not only from a traffic point of view but an air quality point of view. The wonderful aspect of those 2 things is that it added kind of a macro drive for cleaner power beyond just the consumer desire to have a cleaner vehicle. So that's really what's driving silicon carbide, and that's all of a sudden, if it felt this way to you maybe in the last 3 or 4 or 5 years, that's what's driving all of a sudden silicon carbide to now be correctly pronounced and spelled by everybody in the world. So we have always made silicon carbide because we looked at this as what we thought could be actually probably the first 100-year material for us, compound material. We are -- we have been investing in substrates all of that time. For those of you who question whether we make devices or not, we are beginning to make devices. We are still fundamentally a material supplier. We make devices for RF, and we will begin to make them for power probably over the next 18 months. The power section of silicon carbide versus RF as in wireless, power will always be multiples of RF. It's anywhere from 3x bigger to 4x. It's a very big market. If you think about that, not only electric vehicles but really, all large electric motors that could lead to like the electrification of transportation. It could be used in stationary electric motors, but as those are typically in buildings and whatnot, those tend to have a longer changeover. But when they change over, they're there for a long time, and it becomes a standard technology. So those -- that's the reason that we're really focused on silicon carbide and beginning to invest more rapidly. As we see car companies around the world beginning to set plans for when they think they will begin to convert their car lines, that starts to be the beginning of the real demand. Our company is really interested in the long-term development of this market, and are working to have our investments in at the right time.

Perfect. Maybe turning back to kind of another market that has had a lot of enthusiasm over time is the 3D sensing market. You guys have seen strong share gains this year. Can you just speak to what has been the key driver for these share gains? And just -- how do we think about kind of the movement of share between generations? And then just how do we think about some of the time-to-market advantages that you guys have in terms of as we think about in developing outside of -- the 3D sensing developing outside of the smartphone market?

Right. So first of all, just -- in case you never knew it, sometimes we're asked the question, how does our VCSEL array vary from someone else's VCSEL array? Why is it better or not? In fact, by the time you have 2 or 3 select suppliers in a given device, interoperability is very important. So if you look at the actual physical device, it's probably the same. What distinguishes a company is the quality and the ability to deliver at the right quality, at the right volume day in, day out. That is actually the distinguishing factor. So the control in the manufacturing process is really what ends up winning the day. That's why our company has tended to lean towards vertical integration. Now, we've said many times that as the company gets larger, we may make the decision to have a mix in our model of how we make things. But nonetheless, that's where we are with 3D sensing. It has another advantage, which is it allows us to become the design and partner of choice. If someone wants a very, very forward-looking brand-new design and they were to come to us, well, we just tell ourselves, right? We just work on it. If you go to someone who has everything that's outsourced, you have to tell all your outsourced partners while they try and make it for you just to get -- for the prototypes. So in any event, I think both of those things have driven our share gain over time. As for how it moves, however, in every -- probably everything that's made in the world honestly, but for sure in consumer devices, the fight is always for size, weight and power. The constant battle every day is to optimize size, weight and power. And in some ways, it's funny that, that's the order because power probably is the bigger one. The device is constantly, I underscore constantly from the first generation, I don't think we're making any single VCSEL array we were making all the way in the first year anymore. It's constantly being redesigned to liberate battery power. So as the phones go from just doing facial recognition, say, to doing augmented reality, you add multiple lasers to that, they draw the battery, so you need to be able to liberate that power. Therefore, to Meta's question about how do things move generation to generation, they could move all over the place depending on who makes what thing. But I don't know that, that's a fundamental share shift. I think if you just -- it's important to look at it kind of as line of best fit, right? And I think it does change over time. We were just talking about silicon carbide and how national directives helped develop that market. 3D sensing is different. 3D sensing is still entirely driven just by the consumer desire for a new type of experience or a new type of functionality in a handheld device, and that's an important starting point. So augmented reality. It's -- those are important learning curves, doing it in the device in order for people to learn how to adopt it in a car, right? But ultimately, the augmented reality functionality is actually what's key to being able to move to any form of LiDAR because if the car -- if you're moving, say, to autonomous driving, which is the larger deployment of devices, the car is actually looking outside of itself. It's looking around it, right, to figure out where to go, what to avoid, what directions to take. There is a fairly decent amount of in-cabin monitoring detecting if the driver is falling asleep, detecting if you're looking out the window when the light changes, right, to stay ready to drive, as I just had to figure out from my car. So all of those things are coming. Automotive does tend to take longer because since it has high insurance applications, meaning if features are in there, it can cause rates to be able to go down. But companies are very unlikely to do that until it's been proven to be fare thee well, right? So there's a lot of testing and a lot of certification required. But generally, we do think that those markets will continue to develop. It's certainly taking longer than most people thought, and even longer than we thought. We never thought it was quite as fast as all of a sudden, every phone will be 3D sensing in 6 months. But it has taken longer than we think, and I think it's still going to be an exciting market for us.

Got it. Maybe a question just on the acquired Coherent business. That is perhaps a more -- or you guys have described, it's a slightly more macro-sensitive business than kind of the legacy II-VI business, which had been maybe more diversified and less macro sensitive. Can you just touch on kind of how we should think about the overall macro sensitivity of the business, particularly as maybe the Coherent business outperformed last quarter on a weaker macro quarter?

So I think we've had questions even before the acquisition closed about why was Coherent's revenue wherever it landed in a quarter, say, for 3/31 or 6/30 quarters. And it was always hard for us to answer, because we weren't ever allowed to talk to them about their revenue until the acquisition closed. But some of it was supply chain, I think, in their cases. Having said that, right, industrial end markets are the ones that are driven by GDP. For those of you who knew II-VI, 15 years ago, you will remember that our -- my first boss at II-VI, Fran Kramer, would talk about the growth rate being 2x to 3x GDP, because what would happen on industrial lasers is they would replace optics 2 or 3 times a year based on usage. They were used more -- it was more than that, right? So industrial -- the industrial end market is macro affected. And if you think about how the old Coherent Inc. is, it's largely in the industrial segment -- in the industrial end market. Having said that, short of a global equally-timed type of recession like we all saw in 2009 where literally, every market in the world was down, significant unemployment. Oftentimes what happens in a weaker macro is that the end -- the new machine tools could be slower. That's true. But oftentimes, what happens is the aftermarket and the service side of the business is much stronger. And that's about for the former Coherent Inc. It's about 30% of their business, so say $1.5 billion of our revenue, and it's about maybe 15% for the entire company. And the reason for that is people may slow down the purchase of new CapEx. But if they're still making things, they're not going to say, "oh gee, a recession is coming, let's stop." They're going to say, "okay, let's make the stuff on the machines we have and might push their shifts to be longer, might run on the weekend, might run more over time, and so they will actually use the assets more." When they do that, they tend to consume more aftermarket parts and need service more frequently. So that's pretty typical. The most recent case, I remember was 2015 when some of our other machine tool companies were talking about the market being down. Because the old II-VI was only in aftermarket parts, our business went up by 10%. So I think when you think about macro, don't overreact to it. First of all, think about where it is. In other words, is it really everywhere? Because if it isn't, you're probably not going to have a whole scale reduction with the company. And second of all, think about how deep it is, is it really driving huge unemployment? Because if not, the factories are probably still running. And if they are, the machine tools are being used and the service business is likely to be pretty strong, which, by the way, also tends to have a greater-than-average corporate margin -- gross margin.

Got it. Okay. Maybe speaking to -- we clearly talked to Lumentum yesterday, they're seeing some impact on the datacom and cloud CapEx side just due to some inventory digestion, something that you guys had said you weren't seeing last quarter. Is there anything to speak to about the divergence and commentary either because of share gains or just different portions of the market you're addressing?

First of all, there's probably 2. One, I do not believe, especially with some of our competitors, that we have the same customers to the same degree. And so customer mix can have a very big effect on what you're seeing. We don't necessarily sell all the customers. We even do have, in general, the same thing either. But I'd say the largest driver of the difference in the 9/30 quarter was we don't have the same customers to the same degree. I'd say the other thing was, when II-VI came into the datacom module or otherwise known as transceiver business, the assets that we acquired to do that had been fairly weakened 400G. They were very, very strong in 200G, but fairly weak in 400G. We've caught that up quite a lot, and also had some very nice initial sales in 800G. And so I think what we're also doing is gaining share by kind of regaining kind of our rightful seat at the table, if you will, and having a greater set of competitive products to be able to bring to market.

Got it. Another question that we get from investors is just the amount of inventory sitting on any of the companies we cover, balance sheet, and just whether as you guys work through your own supply chain and your customers work through their supply chain, how are you determining what true underlying demand is and where there could be kind of gaps in where you're getting information, or where there could be information gaps?

Sure. So first of all, probably to say -- I mean, I think customers if they really wanted to, if they really wanted to game it, they could. But it usually backfires on them, right, because if we have -- see huge cancellations in orders, then we're very, shall we say, disinclined to put those customers back in the backlog when they need help. So there's 3 things we do that at least in our experience, have proven to be very helpful. One is, so we have our backlog, right. For something to be in the bookings and make it to the backlog. So the bookings in the backlog are the same from the following. They have to have a firm ship date in the next 12 months. So there has to be a firm ship date. Therefore, we have a firm ship date to monitor, and we look at whether or not dates are moving, okay? That's the first thing. The second thing is we look at whether or not there's an outright elimination or cancellation of an order which we would call, in side II-VI, debookings. Those are reported to the CEO every day, so we don't have very many so we doesn't get these messages too often. But what I mean to say is there's a lot of visibility around them. What is this really about? Who is the customer? What happened? What do we know about this? Et cetera. We could have a customer that goes out of business, I mean, just saying in the main and the whole scheme of the world here. That would be a reason for debooking. But we really look at what it is. And if it were to be a customer to have reason to move it, we'd work with them a lot about what's really going on here and really preserve what they really need and try and get underneath. Is this temporary? Is this a timing issue? And to the extent we can, we might accommodate with a customer a movement of timing and then work with other customers to fill it in. And so I'd say there's a little bit of that goes on every single day. The final thing that we do other than really talk to the customers every day is many customers, especially in communications, have inventory on their site, right? It's actually our inventory. So in the normal parlance, you refer to it as consigned, right? That's in a special room. We refer to it as the cage. Our people monitor the cage. They're there, that's their whole job, is to monitor the cage. We watch that cage. We look at how it's turning. We look at what's going on. We look at if it's climbing, if it's not climbing. We look at how it's being consumed and how things are being actually shipped. And we use all of those, including moving timing, to say where is this ball of string going. What do we see here, and would that give us an indication something might be moving. And so we'll work with customers sometimes if they need to do that, and we might -- they might have a genuine need. We would usually negotiate for more share, in that case. So I would say that if a customer really had a need to move something, we do work very hard to work with them, but we also work very hard on preserving the value equation with them actually. And this is one of the reasons why back a year ago when people said, why aren't you just passing along all your supply chain cost increases? And we said, well, we look to optimize the value in that. This is one of them, right, that we might not pass that along in exchange for more committed, maybe just short of or all the way to take-or-pay type agreements. So we have been watching it. The closest example I can give you is 2017. You may remember, we had huge growth in communications in '17 then many people in the industry saw an actual falloff. In the II-VI case at the time, we had 34% growth in '17 and 9% growth in '18. So yes, the growth rate moderated that's true, but what it didn't do is decline all the way down. And I think those ways of trying to monitor that with customers helped a lot.

Got it. . Another kind of priority has been the balance sheet. There was a fair amount of floating rate debt kind of taken on with the Coherent acquisition. Just can you refresh investors on this? How you're thinking about balance sheet, debt pay down, and just how to think about the impact of the Bain investment as well?

Sure. So with respect to the debt, right now, we have about $4 billion of floating rate debt. 40% of it is hedged. By June of '23 at the end of the fiscal year, 50% of it will be hedged, and then there is another hedge starts, and then there's a little more following that. So that's the first thing. The second thing is we -- you may remember in the 9/30 reporting, we had set our initial interest rate cost estimate at 2.74%, which was based on the forward curve going to 4.2%. When we got to reporting at September 30, the forward curve was sitting at about 5.3%. And so we said, well, this would normally affect us by about $14 million, and our goal is to limit it to 5%. And my treasurer might not like my telling you this, but his actual goal, which he signed up for himself, was to actually meet the original estimate. So now that we've heard some different commentary from Powell, which I do admit changes every day. But any scintillation that there might be interest rate movements in 2024 which we are moving into next year 2023, which we hadn't expected, right, we made the decision to try and pay the debt down sooner. We hadn't decided to pay any of it in the first year. We usually like to try and start the synergies, but we went through and we really scrubbed the synergy cost with a real fine tooth comb to figure out, well, actually of these costs, which ones are actually cash? So for example, the retirement of the C-suite executives at the former Coherent Inc. involved about $20 million of vested equity that isn't cash. It's value to them, but it isn't cash, right? So we looked at that, that's an example where, okay, we had $20 million that was assumed to be cash that really wasn't. And so we really looked at that and said this year, we really want to try and pay down some of this debt. So that's what we're working on right now, and we'll just continue to monitor it. Different things happen. I would also say from a macro point of view, if the world were going to go into a more protracted recession, first of all, the last 2 times it looked like that happened, whether it be the beginning of COVID in March of '20 or back in 2009, we do see Fed action in the other direction. That's the first thing. But the bigger thing is the CapEx moderates on its own, right? We're not investing CapEx today for product we're going to make tomorrow or even next quarter, right? We're investing it as expansion capital based on what the order book looks like and where we see demand. So that's what I mean about it naturally moderates. If people take demand more slowly or they expect their, say, their '24 curve flattens, that could change the direction in which -- or the rate at which we're investing capital. And you may have -- you may not remember this, but we actually did that in March of 2020 in the beginning of COVID. Our CapEx estimate was $200 million, and we spent $135 million. So that -- it does naturally moderate on its own. And even though this isn't a wonderful thing, the working capital moderates on its own too, right? So all of that would be available from a debt perspective too, should we be in a position to have to go that far. And then finally, we could always look at certain swap options. Some of which are not totally ideal, but do absolutely help on the interest rate.

Got it. Well, with that, we're basically out of time. And so I could sit and talk to you all day. But Mary Jane, thank you so much for being here today.

Yes. Thank you for joining us. See you soon. Thanks, Meta.