Coherent Corp. (COHR) Earnings Call Transcript & Summary

Welcome, everybody. I will start with disclosures while everybody gets settled. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. For everybody in the room, I'm Meta Marshall. I cover networking here. I'm sure you've seen me around. We're delighted to have Coherent here with us today, Jim Anderson, CEO; Sherri Luther, CFO.

Obviously, big news yesterday with your NVIDIA announcement. So I just wanted to kind of kick it off to you guys to maybe just give a little bit of context for all the investors in the room, just kind of about that agreement.

Yes. Thank you, Meta, and thanks for having us. Definitely really excited about the announcement. So first of all, NVIDIA has been a great customer and a great partner of ours for over 2 decades through their Mellanox acquisition. And they really are a wonderful customer. We learn a lot from them. We think NVIDIA makes us a better company as we work with them. And so a great partner. And this new agreement is really a significant expansion in our partnership, and we're really excited about that. It's all around using photonics and optics to continue to innovate and advance data center architecture, especially around driving better power efficiency in data center architecture. And so we're certainly really excited about that. It kind of has 2 main components. There's an equity portion where they're investing $2 billion in Coherent. So they're now an investor in Coherent. We love that. Having a 20-year customer as an investor is great. And then there's also an R&D and supply chain piece of the agreement where we've agreed to continue to innovate together on new technology. And then also, there's a supply chain agreement that's multiple -- multibillion dollar. It covers multiple different product lines. It stretches out quite a few years, and we're really excited about that as well. So that's something that's really significant for the company and a significant amount of revenue moving forward. So yes, really excited about it.

Okay. Lumentum, when they were here yesterday, said that they would kind of use part of those proceeds to maybe kind of purchase fabs or kind of expand fab capacity. Is there anything that you've kind of earmarked that we should be kind of paying attention to for them?

Yes. Maybe that's a good question for our CFO. I never saw the money. It went immediately to Sherri. Sherri keeps a tight leash on all of us.

Definitely, your first priority is expanding capacity for capital. That's the first priority. And frankly, that's the #1 priority from a capital allocation perspective that we have for our company anyway, leave aside the $2 billion infusion, but really focusing on increasing capacity. This agreement is for CPO solutions, so expanding capacity in our Sherman, Texas facility in particular. But that's the main focus on CapEx.

Okay. Got it. I'm sure we'll kind of -- or people might ask questions about it as we go throughout. But I want to just kind of start, we sat here a year ago, you just completed portfolio review after coming to the company in the second half of '24. Here we are a year later with the seeming mountain of demand. Just how do some of the decisions out of the portfolio review position you best for today? And how have you needed to change course?

Yes. I think -- so first of all, what was the purpose of the portfolio review? It was really to make sure that we've got all the investment concentrated and lined up on the areas of biggest growth and profit opportunity for the company long term. And so that had two parts. There were places in the company where we dramatically increased investment. And then there were places in the company where we shut down investment or where we sold off businesses, right? And so we did both of those in parallel. And so places where we significantly increased investment where we thought we weren't investing enough were in data center communications, things like our OCS product, we dramatically ramped up investment in that. And then places where we thought these really aren't strategically aligned to where we want the company to be long term. They're really not going to move the needle for the company long term. In a lot of cases, they were lower gross margin than the company average. In a lot of cases, they were unprofitable. We either shut those product lines down or we sold them. We sold -- there were 2 product lines that we actually sold and divested. And so a lot of that work has been done. But I think both Sherri and I have agreed that we'll continue to do this on an annual basis because I think it's a good practice to have -- to every year look at every product line and make sure that on behalf of investors that we're putting all the dollars of investment, whether that's CapEx or OpEx, that we're putting all the dollars in the best place for the company long term.

Got it. I mean, Sherri, are there any places where you felt like you needed to pivot during the year?

Nothing that I would really say it required a pivot. But what I would say is I'm really, really pleased that with the focus that we had on reducing debt. And so when we sold off some of the divestitures that we've done, we really used that money and focus that on paying down debt so that we can focus on investing for the long term of the company, not only the reallocation that Jim talked about in terms of R&D spend and capital investment, but just really incremental investments that we've needed to make in the business. And I think that's been really good.

Yes. That portfolio change allowed us to dramatically increase CapEx for -- as you said, for indium phosphide capacity, et cetera. So I think it was really healthy for the company.

Got it. I mean where do you look today? You have a lot of customers calling you. Where do you kind of prioritize incremental investment? And what projects or time lines versus the customers who say, I have $1 billion order today versus those who say, like, hey, I would like you to do this so that I can have $1 billion in 2 years.

Well, $1 billion today, we would have to prioritize. But yes, there's always -- it's always a balance and a trade-off, and I'm sure Sherri will want to give her thoughts on this as well. But the way we're looking at it is, first of all, we want to identify what are the biggest potential growth drivers for the company in the short term, but especially in the long term. We're always trying to build shareholder value for the long term for the company. And so if there's investments that we can make today that will drive tremendous growth for the company in the future, we're absolutely willing to do that. And we definitely are doing that today. So certainly, data center, tremendous area of growth. We still believe pluggable transceivers is a big area of growth for the company. CPO is a tremendous opportunity for the company. We believe that in the data center, the remaining part of the network that's still electrical scale up will absolutely convert to optical over the coming years. It will happen in stages, but we'll see that conversion of electrical to optical to the point where we believe the end state is almost every connection in the data center is fully optical. Now that will take time, and it will happen in steps, but it's -- physics is pushing that, right? The physics demands that we switch to optical. And so we're making the investments today to enable that. And so yes, I think that's really the way we think about the big areas of growth. There's other areas of growth in our industrial business, et cetera. But those are a couple of examples of bigger areas. Sherri, would you add?

I would just add on that, that given the strength of our balance sheet and the fact that our debt leverage is 1.7 in our last quarter, which is well below 2, the target that we put out at our Investor Day last year, we're very well positioned to make those incremental investments and prioritize for the long-term growth of our company. And so good strong cash generation, but with a strong balance sheet, we can easily make those CapEx investments and focus on the long-term growth.

And Jim, are you focused on -- there are some very big TAM with more competitors. There are -- like are you looking for areas where you can have the most share? Or are you looking for areas where you can kind of differentiate more when you think about that?

I think there's always a series of factors that you take into account, right? It's never a digital one or another, right? But certainly, we look at the size of the market opportunity and the ability and the competitive field, right, and our ability to compete. We also look really carefully at gross margin dollars, right? We have had a big focus in the company of expanding our gross margin. And we made significant progress over the last 18-plus months. We've expanded gross margin by...

470 basis points to almost 500.

Almost 500 basis points, but we have more work to do, right? Our goal is to be over 42% gross margin. So gross margin and ability to get to those targets, that's a big factor as well. So there's definitely a number of different factors.

Got it. I mean then just on that, maybe back to this NVIDIA announcement, are there any like ways in which we should think about kind of the what the opportunity set is different for you versus Lumentum kind of as part of that agreement?

Well, I think Lumentum is a good partner. We like those guys. They're a customer of ours. They're a supplier of ours. But we do have a broader product line than they do. We're a bigger company. We have a broader product line. They're -- our agreement with -- I think you're asking about the NVIDIA agreement, it covers multiple product lines, one of which is the high-power CW laser that will be used for CPO. But there are other product lines that we have that are also included in that deal. So it covered multiple product lines all around CPO. So I think we have a pretty broad offering. If you look in the photonics industry, and you just kind of look objectively at the technology portfolio, there's really no other company in the photonics industry with the breadth and depth of the technology portfolio that we have. But combined with the second thing, which is manufacturing scale, right? Our manufacturing scale is incredible, right? And you got to have both. You have to have both the technology, but the ability to ramp these things to very high levels of volume at very high levels of quality. And that's something that I think is pretty unique and sets us apart. By the way, the other thing related to manufacturing is an incredibly strong U.S. manufacturing footprint, right? We were founded as a U.S. manufacturing company. We have over 20 U.S. manufacturing sites in 13 different states. And one of our most advanced facilities where we're ramping the world's most advanced indium phosphide production is Sherman, Texas, right? There's nobody else in the industry that's in production on 6-inch indium phosphide. We started production last year. So we're way ahead of the rest of the industry on 6-inch indium phosphide production. And so we're certainly -- we're a global manufacturing company, but we're certainly very focused on continuing to invest in our U.S. manufacturing footprint as well.

Got it. I mean EMLs indium phosphide capacity has been very tight, I think, is a generous term. How are you scaling capacity? How are you reducing the need for third-party EMLs? Just how are you judging what type of kind of indium phosphide laser to bring online?

Yes, it's a good question. And definitely, the industry is constrained on indium phosphide capacity right now. And indium phosphide used for EMLs, as you mentioned, CW lasers, both lower power and higher power CW lasers. It's also made for photo -- or it's also used for photodetectors as well. So there's a lot of products that are made on indium phosphide. There's certainly -- we think the industry is constrained through this year, most likely constrained through next year. And I think given some of the demand that we're seeing for CPO-related technology and indium phosphide usage for CPO, it could be years that the industry is constrained on indium phosphide. So what are we doing about it? We're ramping our capacity as fast as we possibly can. We've already said that this year, we're doubling our capacity, right? So we're doubling our capacity. We're doing that with 6-inch indium phosphide. The reason we're using 6-inch is because compared to a 3-inch wafer, you get 4x as many devices at half the cost structure, right? So it's -- we can ramp capacity much faster, and we can do it at half the cost structure. So this year, we'll double capacity. You can bet that we're going to continue to increase capacity beyond that. We haven't yet talked about our capacity plans beyond this year, but we will continue to ramp indium phosphide capacity. We see the demand -- when you take into account the growth in both pluggable transceivers as well as the CPO growth ahead of us, we feel very confident in the demand, and we're ramping capacity accordingly.

Got it. Early demand at 1.6T has very much been biased towards EMLs, but CW is expected to have kind of more share over time at 1.6T. Just how do you see kind of that transition playing out? Or how are you balancing kind of all of the needs given that you can do any of those? And do you see more of a role for VCSEL-based transceivers in the high-speed markets?

Yes. So at the beginning of the 1.6T ramp, which is we're early in that ramp right now, it's really -- it's a mix of EML and silicon photonics. For us, because we make both EML and silicon photonics-based transceivers, we have both for 1.6T. We don't really care that much. We're just building whatever our customer prefers. So if they have a preference for EML or silicon photonics, we just build whatever they have the preference for. And we expect there to be strong demand on both. But the other transceiver that we're going to bring out is in the second half of this year, we're planning to bring out our 1.6T transceiver based on VCSEL technology. So that's based on gallium arsenide. And if we remember at last year's OFC, we were the only company in the industry that demonstrated 1.6T transceivers on all 3 types of laser technology, EML, CW and VCSEL. So we'll bring out that new VCSEL-based 1.6T transceiver we expect in the second half of this year. The reason that that's really good is because if indium phosphide is the constraint that runs on gallium arsenide technology. We have plenty of capacity on gallium arsenide. So that will help with some of the industry constraints around laser as well. Now it has different characteristics. That's usually better for short-reach applications, but I think it will help offload some of the demand that the industry has. So we're anxious to do -- to get that ramped into production.

Got it. Sherri, maybe back to you just in terms of -- you mentioned, I mean, a book-to-bill of over 4 in the quarter. Just how are you judging like I want this amount under LTA to make an investment, I'm willing to float this much. Just like how are you kind of looking at that calculus?

Yes. I think there's kind of 3 main elements when we look at LTAs that are kind of important. One is the commitment that we make for capacity or product, volume product for a customer. The second one is the commitment that they make to take that demand. And then there's a third part of it, which is kind of they've got skin in the game in terms of providing CapEx monies to us. In the case of NVIDIA, it was equity investment. But those are kind of the 3 main elements that when we look at an LTA. And the NVIDIA agreement definitely fits the bill for those 3 things. But not all LTAs are that magnitude that they would be disclosed, and they certainly don't all have equity involved in them. But I think when you have those 3 elements, then it's a really good partnership where there's something for each party. And I think those arrangements have been -- we have multiple arrangements like that, that we have entered into, and those have been very, very good for us. And I think when you look at the amount of CapEx and the requirements in some of those LTAs, you evaluate that what are the needs as compared to what the customer is agreeing to. in there. So I think those have been very good for us. And I think that certainly, the NVIDIA agreement is an example of that.

Yes. And I think that, that announcement yesterday certainly will catalyze more customers to go and do long-term agreements, right? Some have already done -- put them in place. It will certainly catalyze more long-term agreements. And for us, we think that's a win-win for us and the customer. Why would we not want to secure demand further out in time? That's just better visibility. It gives us more confidence to invest the capital. And as Sherri said, a lot of times, there's a financial -- upfront financial commitment from the customer, which means skin in the game.

Got it. OCS, you mentioned it earlier. It's been a big topic of conversation over the last year, seeing growing interest there. Your approach has liquid crystal, which hasn't necessarily been used by kind of the one vendor who deploys OCS today. You've noted that you're working with 10-plus customer -- or 10 customers on OCS. Just where do you feel like customers are both with kind of liquid crystal as an approach and then just kind of with OCS in terms of moving from maybe lab trials to deployments?

Yes. In terms of those 10 customers, it's over 10 that we've engaged with. There's multiple customers. It's not just one, there's multiple customers that have already deployed that in real data center applications, right? So I don't think there's any hesitation towards using liquid crystal. In fact, it's kind of the opposite. It's a more reliable technology that's nonmechanical. I think if you look at in a data center, if I have the choice between using a system that uses mechanical moving parts or using a system that doesn't, right, that's based on technology that has no moving parts, hey, you're always going to want to use the system that has no moving parts in the data center. It's going to be more reliable, right? Moving parts are not reliable. So better reliability, better long-term predictability, et cetera. So I think the reality is right now, the market is very strong. The demand is very strong. We are right now just supply manufacturing capacity limited. The market is bigger than what we thought a year ago. We are trying to ramp our manufacturing capacity as fast as we possibly can. I'm actually not worried about demand at all. There's plenty of demand. I'm meeting with the team on a weekly basis. And all we're talking about is how do we ramp capacity faster, right? So -- but I think over the long term, what will play out is, yes, I believe that the better technology is one that's nonmechanical technology.

Okay. And then, I mean, just maybe back to that for a second, just in terms of understanding demand is strong, but how are you determining, okay, this person is doing trials, this person is doing real deployments. Like how -- there's precious resources that know enough. There's only one Julie.

Well, Julie is pretty amazing. Well, I think right now -- so all of -- like those 10-plus customers, they're all in different stages. Some are in production, deploying them in data centers. Others are on the other end of the spectrum. Some are just starting their evaluations, right? I think we have enough resources to support those customers right now with wherever they are in those stages, except for the fact that our manufacturing capacity is below demand, right? The biggest problem we have now is just let's -- the demand is incredibly strong. We just need to ramp our manufacturing capacity faster. So every single quarter, we've been increasing manufacturing capacity. And that's really what we're 100% focused on right now.

Okay. Maybe the announcement with NVIDIA is clearly around CPO for scale-up, which I think has been kind of largely an additive market to you guys. But there's also been the CPO discussion for a long time about scale-out and just whether it is cannibalistic eventually. I think you talked about on the call that there's going to be a role that is predominantly transceivers for a long time. But just how are you kind of messaging that path? Or how are you determining what that path is of kind of gradual CPO adoption and scale?

Well, I mean, ultimately, we'll just -- we'll build what our customers need, right? And -- but what I can tell you based on our customers' forecast, the long-term forecast, what they're telling us is that pluggable transceivers will remain the dominant format in scale-out, scale across, DCI, right, through the rest of this decade, right? We'll see pluggable transceivers, we believe, continue to grow through the rest of this decade. Now we will see some adoption of CPO in the scale-out portion of the network. But we believe that, that will be relatively modest adoption. And that CPO is really the technology that enables the electrical network and scale up to be converted to optical, right? -- the biggest adoption of CPO will really be in the scale-up part of the network because that will really drive the conversion of all those electrical links to optical. So that's our view of the market. That's what we're seeing in terms of customer orders and our engagements with customers. But ultimately, we'll build -- we can -- obviously, we can build both CPO and transceivers, and we'll build both simultaneously, and we'll build whatever mix the customers want.

Okay. Finisar, maybe more traditionally or coherent hadn't always been known as having the biggest telco business. But you guys are doing quite a bit of business right now kind of on the scale across DCI side. You're participating in the ZR market. Just where is the DSP knowledge coming from in order to kind of produce the ZR? And just how do you feel like that opportunity is to take share on the telco side?

Very good. We've -- I mean, our telecom business, what we call communications business grew 44% year-over-year last quarter. So we're seeing very good growth. The fastest area of growth is DCI, as you mentioned. We're seeing very strong growth though in some of the more traditional transmission and transport markets as well. But in DCI, we feel very good about the growth that we're seeing. We have a full lineup of ZR/ZR+ transceivers at 800 gig, 1.6T, et cetera, right? So we feel very good about the future growth of that product line. And then you asked about DSP. Yes. We -- actually, as part of the portfolio review process, we decided that we should outsource our DSPs, right? So we don't have in-house DSP. And that's the same thing that we do on our datacom transceivers is there's perfectly good, multiple good solutions in the marketplace. We have great suppliers for DSPs in data center. And so we're using external DSPs for our ZR/ZR+ products as well, right? And that allows us to focus on what our differentiation is, which is all the optical technology, right? We're experts in photonics, right? Anything that's photonic related, that we have a solution. We've got great technology. And so that's where we want to concentrate all of our R&D dollars.

Okay. I have questions about non-datacom, but I want to be mindful.

What? You mean other than data center?

Exactly. Exactly. So I'm going to open it up to questions and see if there's questions from the audience before I move on to other categories. All right. Perfect. So just -- we spent a lot of time talking about datacom. There's certainly a very large materials laser business that serves other markets. You just highlighted some of the Photonics West. These markets have been relatively flat now for a while. But just where do you see the opportunities emerging here considering it's still a very profitable business?

Yes. We love this business even though nobody ever asks us anything about it, right? So it's about 30% of our revenue. It's very profitable. It's a high gross margin business, very sticky customers. So we think this is a great business to be in. And it does grow slower than data center and communications, right? But we're -- and it's been relatively stable over the last few quarters. But we're starting to see growth pick up near term. That's really about semi cap. A lot of our -- in industrial, what we make, a lot of it is like industrial lasers, so it's photonics, but in a bigger format, a bigger industrial laser. And semi cap uses -- semi cap equipment uses a lot of laser technology. So as you're seeing some of the semi cap vendors like ASML or KLA-Tencor or Applied Materials, you're seeing their -- them start seeing a pickup in demand. That gets reflected back on us as we're a supplier to some of those semi cap vendors. So we see that market start to pick up. So we expect our industrial business to start to grow over the coming quarters. The other really interesting -- and I hate mentioning this because we're taking it back to data center, but it's within our...

I gave you an out. I gave you an out.

Is in our industrial business, we've got some really amazing materials that actually -- that we've used for many years in things like semi cap equipment, but that actually have some pretty amazing applications in data center. So one of them is we make a technology -- it's a material called THERMADITE. It's a proprietary material, and it has amazing heat transfer characteristics. And so what we're engaged with a number of very large customers on is using our THERMADITE material as to replace copper heat exchanges in the data center. So think about instead of a copper heat sink, replacing that with THERMADITE and you're able to pull much, much more heat out at a much faster rate. And so that's something we're really excited about, and that could be a great application of that material and could have tremendous demand. There's another technology in our industrial business, which is a thermoelectric material, which can pull the heat, take the waste heat out of the data center and convert it back into electricity. So imagine right now, all that heat that's being generated by the data center is just getting picked up the air conditioner, right? Instead, imagine being able to take part of that heat, reclaim it and put it back into electricity and funnel that electricity right back into the data center. And even if you're able to do only a few percent of the heat and pull -- put that back into the electrical supply, I mean that's a massive win, right, especially when you think data centers today are primarily constrained by the power that goes into them. If we're able to reclaim some of that power, that's great. So that's another area that we're investigating within industrial. So there's a number of longer-term really good growth areas within the industrial business beyond just your typical markets as well.

Yes. Got it. Sherri, I want to spend a second with you. I could not find any person who had been able to get their convertible bondholders to forgo their dividend, which is something that you were able to do.

Sherri is just that good. Amazing CFO.

Yes. So just how are you thinking about capital allocation opportunities and just chances to optimize the balance sheet? You mentioned kind of getting leverage below kind of target levels.

Yes, yes. Well, I mean, first of all, I would say that the dividends and preferred shares you're referring to are from the investment that Bain had in the company, and they've been a great investor. We really like them. They've been a great relationship and a great partner with the company. So we really appreciate that. But in terms of capital allocation, the first priority, as we've talked about all this capacity expansion and CapEx that's required, that's the #1 priority because that drives the long-term growth of the company. If we don't make those investments, then we don't get the top line growth. Top line growth and all of that is very, very important to the company and to all of you, all of the investors, which is what we want to drive. And so making sure that, that's the top priority is number one. We talked about the portfolio optimization, making sure that we were putting the money in the right highest ROI within the company. So that's part of that, too. But it's the #1 priority. And so how do we do that and make sure that we can do that effectively? It's making sure that the balance sheet is strong and clean. We refinanced our debt a quarter or so ago to get the lowest interest rate possible and so that we could best position ourselves to reduce the interest expense that's hitting the P&L but also reduce the debt -- the most costly debt that we've got. And so our debt has -- the leverage ratio I mentioned earlier is 1.7x, which is down from over -- when I started the company, I think it was well over 3, maybe even higher than that, but it's come down quite significantly. And that's a reasonable place to be. The leverage ratio that we had put out at our Investor Day last year was below 2. So we're going to continue focusing on debt, but the #1 priority is really investing for long-term growth. And with a comfortable leverage ratio that we have, that makes it even easier to be able to do that and focus on it. So I'm really pleased with the progress that we've made there.

I mean there's been an intense focus, maybe sticking with you, Sherri, just on gross margins, particularly as just ways to take advantage of some of the tightness in this market. How do you think that investors should be kind of judging you guys in terms of gross margin progression, both in terms of portfolio makeup, but just in terms of kind of taking advantage of this market?

So I think -- I mean, we talked a minute ago about how we've improved the gross margin by almost 500 basis points since the end of FY '24. So that's good. It's not good enough. Our target is over 42%. Our last quarter was 38.7%. We're certainly guiding sequentially up in our current quarter. And so we're focused on a daily basis on gross margin. I think when Jim joined the company, there was a complete change in the way that we're looking at managing the company in terms of gross margin. I think general managers had not really looked at gross margin before. They weren't really held -- that's what they told us anyway. They were not really held accountable to gross margin. And so boy, has that changed? They all know what they need to drive in terms of improving gross margin. And so that is a daily focus that we've really put in place. And our strategy is primarily twofold. One is cost reduction, which is the entire company and making sure that everybody is driving yield improvements and reductions in product input costs and improvements in the manufacturing process, for example, in all those areas. And that's everywhere in the company. There is a focus on that. The other part is pricing optimization, maybe a little bit to part of your question in terms of the market and opportunity. And certainly, where there's opportunity to price our products for the value they provide, that makes sense because our products help differentiate our customers. And so where we expect to get the larger magnitude of that is really in the industrial side of the business, mostly because those products are, in many cases, we're the only company that makes those products. But we have also been able to employ that in our communications business and also in our data center business. So it's a strategy that we have been very successful in to date. When you think about the benefits of cost reductions and pricing optimization, those two items, the way to think about which has more of an impact or the quantification of that is that typically the cost reduction is about 2/3 of the benefit. And then pricing optimization is about 1/3 of the benefit that we see there. So we've got a ways to go in terms of grading us. We're not where we need to be. I'm not satisfied with our gross margin. But I am really pleased with that we've made good progress and that there's the focus on gross margin, and we've got a strategy to drive that improvement.

Okay. And then, Jim, maybe just last question for you. Do you guys feel like you have all of the pieces to execute on what you need? Are there are you constantly looking at M&A for ways to kind of further expand capacity? Just how are you thinking about kind of that organic, inorganic calculation?

Yes, definitely. We're always looking at scanning the landscape for is there anything that we can inorganically add to the company that would accelerate our plan, right? So we're -- clearly, we're making big investments on the organic business. If there's anything that we can add either technology or a product that accelerates our organic plan, absolutely, we're open to that. We spend a lot of time on that. We haven't found anything really compelling yet that we've needed to add. But certainly, we continue to scan for that and look for that. Absolutely.

Okay. All right. Well, Jim, Sherri, congratulations on the last year and everything going forward.

Thanks, Meta.

Thank you.

Thank you.