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Coherent, Inc. (NASDAQ:COHR)

Deutsche Bank Technology Conference Call

September 10, 2013 11:50 AM ET

Executives

John R. Ambroseo – President and Chief Executive Officer

Analysts

Kip Clifton – Deutsche Bank Securities, Inc.

Kip Clifton – Deutsche Bank Securities, Inc.

Good morning. I’m Kip Clifton. I’m on Deutsche Bank’s Wireless Equipment Research Team. And I’m accompanied by John Ambroseo, the CEO of Coherent. And he’ll start out by doing a presentation and then we’re going to follow that up with some Q&A, and I’ve got some questions. But if you have some questions that you don’t want to ask and you better ask the – this yorn saying that we have up, you can access that at yorn.com/db and select Find My Session and then you go to Coherent and then you can ask a question that way, and then I’ll post that to John. So that’s what I do. I’ll go ahead and pass the call over to John.

John R. Ambroseo

Good morning, everyone. I’d like to thank Deutsche Bank for having us here. I’m going to spend 20 or 25 minutes going through the deck, and then do some Q&A. If you have a question during the presentation, please don’t hesitate to ask. This deck is available on our Investor Relations tab on the website. It does include a Safe Harbor statement; you’re always encouraged to review that.

Let me tell you a little bit about Coherent. in case, you’re not familiar with us, we are longstanding name in Silicon Valley founded in 1966. We are part of the Photonics industry. And photonics is the merger of three disciplines: lasers, electronics and optics that it configured in a variety of different ways to satisfy essentially two different customer sets. The commercial customer set, which represents well over 80% of our revenue are predominantly OEM integrators who take our product varied into theirs, and then sell it to an end-user for a variety of different applications. And then the Scientific Research market, which is typically one-on-one sales to researchers around the world, usually college professors, but also researchers at private institutions, national laboratories et cetera.

There are a couple of pie charts on the right hand side of the page that I want to refer to. The first shows our revenue mix by markets and you can see that we are heavily skewed towards Microelectronics. And I will tell you that Microelectronics is far more encompassing in simply semiconductors. We have four sub businesses there.

There is flat panel display manufacturing, which is the largest portion of that business, advanced packaging and interconnects, which is around electronics packaging, semiconductor capital equipment, lasers, which represents less than 10% of total company revenue and then an emerging area and something called micro-materials processing, which I’ll spend a few moments on in the next slide.

The other markets that we are in our materials processing, our OEM components, the instrumentation and then the Scientific Research business. And then if you look at the geographic sales distribution, it actually closely mirrors the concentration in Microelectronics in Asia-Pacific. I will tell you that there are two things about that Asia-Pacific number; it’s not all Microelectronics that is actually quite a bit of Materials Processing and Scientific in it as well. But the real story is that the number of lasers that we sell that end up in Asia-Pacific is considerably higher than 50%. And that’s because many of the systems that we sell to integrators in the U.S. and Europe are exported to Asia for final use.

The sales distribution of 24% U.S. and 76% international is also unusual for our industry; typically companies in our space do a lot more business in their home countries, but we have over the years of developed businesses and acquired businesses all around the world and it’s now reflected in the sales numbers.

So let me now focus on the markets and as I mentioned, we have four of them and there are a variety of submarkets. So flat panel display manufacturing, the largest part of our business currently, the process that has driven the majority of that growth is something called Excimer Laser Annealing and this is used to make the transistor grids that’s going to high-definition displays whether their LCD or OLED.

So if you forgive me on the overly simplistic explanation, if you take a typical flat panel display and peel it in half, you have a front part that is where the image is created and that can be LCD or OLED. And then you have a back piece that is the transistor grid where the signals come from the image processor, they go through the grid and that tells the individual pixels on the front plane, what to do and when to do it, right. And the goal in making these very high-definition displays is, to put the pixels very close together, which means you have to have very uniform size transistors and they have to be well insulated from one another. And it turns out that Excimer Laser Annealing is an excellent way to do that.

So the standard amorphous silicon panel has passed through a laser beam. There is a process that takes place that reorganizes the size of the grains and the orientation of the grains and you end up with these very uniform, very electrically efficient transistors, and to give you a sort of a figure-of-merit.

An amorphous backplane, which you find in displays like the laptop in front of me have an electrical efficiencies about one unit, that’s an arbitrary unit. An LTPS backplane that you would find in advanced smartphone has figure-of-merit of about 100. So it’s 100 times more electrically efficient. And for battery power device and for size pixel density, all those things are incredibly important.

Now over the last few years, we’ve been populating the market with these tools. The most common one is, for Gen 5, Gen 6 glass, which is a pretty large piece of glass and that can be – then be harvested into a variety of different sizes. Of the tools that go into that are about $3.5 million, the lasers and optics centers are about $3.5 million each and they have at least one service event per year that’s currently $250,000.

depending on the duty cycle, obviously, they could have more than one event per year. And then the most advanced one that we’re currently manufacturing is for Gen 8 glass and the laser and optics there are north of $7 million each. And the service events are about 200 – are about $500,000 per service event.

So we’ve been building this installed base, as well as building a service annuity under it, as you might imagine the service business has higher margins than the original equipment business. And as a consequence, we’re building a long-term model that’s pretty attractive. So the push for growth is going to come from increased penetration of smartphones, which currently is about 20% of the total installed base at least using these screens, penetration into the laptop market, as well as potential upside opportunity from all the television, which is just getting underway and at least one of the manufacturers that’s offering OLED TVs is currently using LTPS backplanes.

The other thing that can have an impact is our screen size has actually become larger and thinking about smartphones; smartphones are becoming to a point where there are semi-tablets or tablet sizes. If you move from 4-inch diagonal to 5-inch diagonal, as a 25% increase in size, which corresponds to a need for 25% more production capacity.

So there are multiple drivers on this business. In terms of competitive threats, we really don’t see any other laser-based processes that can be the displacing technology, because we have almost every laser technology in our portfolio and customers have tried virtually, all of them and none of them produced the quality, the speed or the consistency that the excimer laser-based process does.

The only emerging technology that has some potential is metal oxide. They’ve not been able to achieve the densities that LTPS can achieve and nor can they get the – apparently, the operating lifetimes or the electrical efficiency. So as an alternative technology, it has had limited impact today, and it does appear to be a fundamental materials problem rather than a process issue that’s holding it back, but we gauge that as best we can, and again, we see a pretty long line on the future business for LTPS.

The second part of this market advanced packaging and interconnects is predominately around circuit board technology, again, from older devices. this would be any-layer HDI boards. And lasers are used in two important ways: one is, to create the grid pattern on each layer that drives the functionality of the board and the second is to manufacture the microviewers that connect the various levels of the board and actually complete the circuit design. So just to give you a sense of the number of holes that we’re talking about here in a 4G/LTE phone, there are probably 400,000 microviewers in the board that’s in your pocket right now. And there’s typically, 10 to 12 layers, each one that has to be written.

Now you might be wondering why you would use a laser to write these patterns rather than something inexpensive like a glass mask and not lose the traditional technology, but what manufacturers have learned is that the laser-based technique gives them better registration, so they can save on material, and the digital process, so there are no masks involved, which means they can now operate the floor in a pool system rather than having it go into an inventory position, building up all these layers at once, because it’s more economically efficient to do that. Now they can populate the factory floor on a demand basis.

And then the semiconductor capital equipment market as I mentioned is one that we’ve been active in for a long time, predominantly around inspection and metrology. There’s some chip-scale packaging as well. When you look at that market, if you look at the utilization rate at any node, it gives you a pretty good indication of two things. What the capacity expansion demands are going to look like and also what the service needs are going to look like, because these lasers typically have to go through routine maintenance. You never want to be the long haul in the tent. You don’t want to have down event outside of preventive maintenance cycle.

So the consequence they’re going through regular servicing. and that along with the FPD business contributes a large portion of the 25% of the company’s revenue that’s tied to service business or recurring revenue. It says, so long here as the fourth market and we hold the hope that at some point, the solar market is going to spring back, but what has taken its place is something called micro-materials processing.

In general, when you use the laser for materials processing, you can think about using a bazooka or a blow torch. You are using a lot of energy to remove lots of material in a short period of time.

As you go to more delicate structures and finer features that approach really doesn’t work, because you have something called the heat-affected zone, which is simply the residual heat that doesn’t go into the process, heats up the bulk material around it, which causes all kinds of problems. but moving to a certain type of laser in this case a short pulse laser, the energy is only present for a very short period of time, you can think about picoseconds, which is a millionth of a millionth of a second or femtoseconds, which are the millionth of a billionth of a second. The energy goes into making the whole or a feature and it doesn’t go into the surrounding both material.

A number of applications have emerged around us over the last few years and they range from everything from cataract treatment to black marking of plastics and aluminum to cutting a strengthened glass. So it’s a wide array of applications that all appear to be headed towards solutions using these very sophisticated lasers, and that generally is a good thing from our perspective.

We do have a strong growth projection in this market. We expect the CAGR to be 10% to 15% over the next five years, and that’s based on continued up tick in ELA, the growth will be short pulse applications and then sustained growth in API semi. We have a very strong number one stand [ph] position. I talked about some of the growth opportunities and you can see at least a representation of some of the competitors.

Switching over to the Materials Processing business, this is the largest market for lasers in the world and one that we have been under represented in for essentially our entire history. There are a variety of reasons for that, but a few years ago we decided to redirect some of our efforts and address the materials processing market.

If you look at the materials processing, again, a very simplistic view. There are basically three layers of strata, the bottom layer which are low power lasers, typically deal with consumer products. So marking and engraving, textile manufacturing, converting, this is making packaging, the speed at which those things have to happen is quite high. The energies that are used are very low and as a consequent used these were low power lasers. That represents about 25% of the market. In 2012, that was probably $500 million just in lasers and that was where we have the majority of our revenue in this market.

The second piece of the market, which is about half of the materials processing market, is cutting thin metals and thin metals, up to a couple of millimeter stick. So you could think about that as virtually every body panel on every car in the world as an example.

It’s a billion dollars in lasers in 2012 and one that looks like it’s going to continue to grow because of the cost and efficiency these lasers is allowing manufactures to operate in fundamentally different ways than they have in the past and they are much more flexible than the mechanical tools, but probably more importantly, they don’t wear out in the same way because with the laser, you can deliver the same energy each and every time for many, many thousands of hours and this could result in the first cut looking the same as the million of cut. And that again represents, fundamental change for the way materials processing operates.

And then the third strata of the market, is cutting and welding of very thick metals, this is aerospace manufacturing, ship building and automotive space frames. These are very high-powered lasers.

Typically, when you look at the ownership position, if you are on the bottom strata, you are an OEM component supplier. If you are in that top strata, you own a process. So it really gives rise to a very different way of managing customer and managing business.

Our play over the last few years is to develop the portfolio for the middle strata that includes fiber laser technology, direct diode technology and CO2 technology. The reason for all three is there are a variety of different processes that you want to be able to support, and that different materials respond to different colors of light, hence, the trio solutions. And we’ve had some very good owner success with those products.

We are carving out a small position in the fiber laser space, if any of you follow the photonics industry you know that’s been a very hot area over the last few areas, and we are optimistic that we’ll be able to double our business in the next few years and hence the growth projection of 10% to 15% CAGRs for the next five years.

Switching over to Components and Instrumentation, there are basically two major sub markets here, medical diagnostics and medical therapeutics. On the diagnostic side, the lasers used for things like drug discovery, D&A sequencing and blood analysis. This is predominately an insurance pay market and as a result, the model is to drive as many of these systems into the field because our customers who are actually the companies that make the reagent kits want to sell a lot of reagent kits at 80% gross margin and put the boxes out there at the lowest possible cost.

The other thing that’s happening is the technology is moving much closer to the point of care. And as a result of that, a physician, a treating physician will be able to administer a test, get a result and provide a diagnostics in a much shorter period of time. And if you think about that, just in terms of the U.S. where the affordable healthcare act is going to add 30 million people to our healthcare roles, you can’t possibly grow the number of health practitioners as fast enough, therefore, you have to make the existing practitioners not much more efficient.

On the medical therapeutic side, we do understand the processes or applications including aesthetic procedures, surgical procedures. but the area that we have the biggest practice is, in ophthalmic applications, treatment of the eye, not surprising since the eye is an optimal device.

The hot area right now is cataract treatment and this is based on our short pulse laser, where you can extract a cataract and prepare the both the eye to accept and interact over lens replacement. It’s a very fast and very efficient technique and because cataracts are an age related disease as the globe population continues to get older and older more and more people are going to need this treatment.

The growth in this market is actually lower than the first two and that’s because to grow the instrumentation market, we’re driving a new level of technology that has a lower ASP, but fortunately, a higher gross margin, so that’s going to offset some of the top line growth.

And in the last market scientific research, it is a GDP kind of market. It’s been a GDP kind of market for almost its entire history. It remains an important one to us because we get to try new technologies, we get to develop relationships with customers that are going to give rise to new applications, it gives us first look and a lot of stuff, and here is the state-of-the-art is something called Artifact in physics, which is a pulse of light that’s a billionth of a billionth of a second long and people use it to take pictures of electrons moving. There’s a lot of reasons they want to do that, but it’s unbelievably cool and at some point, will lead to some fractal applications.

From income statement, bookings and revenues, you can see that 2011 was an absolutely terrific year for us. 2012 we had some pull back, and as a result of China and some of the other markets including a slowdown in stimulus spending in the U.S. and Europe, pro forma EBITDA still in a very healthy range, pro forma EPS also in a pretty healthy range. And then lastly, just a quick snapshot of the balance sheet, $200 million in cash, no debt. We have been very aggressive at buying back in-stock between 2008, 2012, just under $200 million of stock was repurchased that represented about a 33% take down in the number of shares, and we did do a special dividend at the end of last year of $1 a share, that was roughly $24 million, again, that was all done with cash on hand.

And at that point, I will turn the floor over to some Q&A.

Question-and-Answer Session

Kip Clifton – Deutsche Bank Securities, Inc.

Thank you, John. I’d just to like to remind you all, if you have any questions, feel free to submit those on your own or feel free to fashionably just raise your hand, I’ll go ahead and kick us off here. So John, if you could just talk a little bit about the competitive environment, because I see a lot of the same competitors and the different market segments that you operate in. What do you think is your competitor advantage over some of those other guys?

John R. Ambroseo

Well, the markets that we focus – we focused on in the long-term have really relied on a new combination of performance and reliability, and for many of these products, we’ve been able to generate multiple generations of technology that keep pace with what the customers need. We’ve done a very good job of understanding the applications and how they’re evolving and we’ve been able to hit the value points that have been important. So it’s not just the cost of acquisition, but the ability to service them to drive volume through their factories et cetera.

As we move into the materials processing space, which is a much more competitive environment, there we’ve tried to take the position that we wanted to be disruptive in some of the technology, because again, we understand that you have to drive a benefit for the customer, in order for the customer to do business with you and it’s through innovation, it is through a service model and it’s through a value proposition model that we really focus on. So we’ve just been able to do more consistently than I think, virtually any of our competitors.

Kip Clifton – Deutsche Bank Securities, Inc.

In the past, you mentioned ELA is kind of a lumpy segment and I think that you are expecting follow-on orders this year, how is the timing working for that?

John R. Ambroseo

So the ELA market tends to come, the orders tend to come in big blocks.

Kip Clifton – Deutsche Bank Securities, Inc.

Okay.

John R. Ambroseo

Typically, tens of millions of dollars at a time, the revenues are actually much smoother, because what happens is a customer placing order for an entire line, it will deliver that over an extended period of time. We are working on some follow-on orders right now, we do expect to have them sometime between now and the end of the year, some of them will come sooner, some of them will come later, but we’re really not concerned about the timing, because we’re deeply involved with the customer, we know what they want to do, and now it’s a matter of basically document and everything they want and figuring out exactly what the timeframe for delivery is.

But as we take new orders at this point, the factories flow through, I think at the end of March. So we don’t deliver anything until the third fiscal quarter of next year anyway, and that gives us an attractive cushion let’s say, and that should come out – come across as being, looks like favor of the business we’re not. But the most important thing for us is to make sure that the customers are going to get what they want and when they want it, and the timing is – the timing is what the timing is.

Kip Clifton – Deutsche Bank Securities, Inc.

So it tends like visibility right now is pretty good there, how is that in other segments?

John R. Ambroseo

The visibility I’d say across microelectronics, historically has been good even in a down cycle, it’s been at least six months, and it’s probably – it’s better than that now. Within materials processing, that’s more of a turns business, but given the fact that we’re starting to break into some new areas and the customers are having new longer-term conversations with us to make sure that we can deliver against their needs. So I’d say that we probably have, today, probably between three and six months of visibility and growing. On the instrumentation business, again, it tends to be a longer cycle, just given the fact that customers place bulk orders that have to be delivered over an extended period of time. So six to 12 months is probably not unusual, in the instrumentation space, and the scientific business is a turns business. So you put a lot of leads into the funnel and it’s just statistics that drive the business at the end of the day. So you may not get the mix perfectly correct, that you typically reasonably close on the revenue side.

Kip Clifton – Deutsche Bank Securities, Inc.

Smartphones are big end market for you, how does that work and as you look out six to 12 months?

John R. Ambroseo

So when we look at that market, we actually try to take a much longer view than six to 12 months, because we’re booked the deliveries for at least the next six. 12 months doesn’t really give us the right view and were – I think our view is simple and probably consistent with ones that are expressed by others that as you look at cloud computing, the impact that that’s had and you have a new win standard coming in and I think 2015, that’s going to move us from 300 megabits per second or 7 gigabits per second, everything is going mobile.

And as a consequence, we think that the screen sizes are going to continue to expand, so not only the smartphone devices continue to proliferate, but the screen size actually grows, and both of those things play very favorably into our business, because they’ll drive demand in terms of units and in total area, which is the way the panel manufacturers typically look at their production needs, they calculate how many square meters per month of material they need to make. So if you are making 25% larger screens, you will be making 25% fewer devices or you have to expand capacity.

Kip Clifton – Deutsche Bank Securities, Inc.

All right. Any questions from the audience? So let’s just switch over to the balance sheet, how much cash do you feel comfortable running the business on and then it seems like historically, you’ve used that as you just mentioned the buyback shares and then also for M&A tuck-in acquisitions, how do you see that going forward?

John R. Ambroseo

The market continues to be hurdle for tuck-in M&A, I’d say that the challenge of course, is finding the ones that you want that concrete, the right strategic opportunity. For us, it hasn’t been about acquiring revenue, it’s about fortifying market positions. In 2012, we did three acquisitions and we probably looked to get good look at 20 or 25. So M&A continues to be something that we will pursue and our preference has been to fund them with cash on hand. To answer your first question now, how much cash do we need?

There are two ways to answer that, and I think the first is probably more important, and that is where do we need the cash and the reality is, because our corporate structure is in the U.S., we probably have somewhat higher cash needs here than we do in Europe or Asia. The number that you can economically come to is 100 million comfortably, but with the distribution that slightly favors the U.S. versus Europe and Asia. Right now two-thirds of our cash is offshore predominately in Europe and a third is onshore. So the acquisitions for example that we did last year, we did under our European structure.

Kip Clifton – Deutsche Bank Securities, Inc.

Okay, talk about the opportunity with hardened glass for a second, if you would?

John R. Ambroseo

Sure. So as you talked to mobile device manufacturers, they all want to use hardened glass in their devices for obvious reasons. It turns out that the stuff is so durable that it’s difficult to cut using traditional techniques. So the choice that I think many of them have selected is that they actually cut the glass into individual pieces before its hardened, which is the reverse of what you should do. Right, you should process the bulk and then the last step is to cut it into the form factors that you want.

The laser-based processes that have been demonstrated thus far, show that you can cut various formulas of strengthened glass at very high speeds up to 300 millimeters per second and in some instances without any post processing.

The other thing of that, a laser based process is that you can cut corners literally, so you can cut rounded edges at speed, which means in a single step you end up with a finished product whereas, if you cut glass using the traditional technique you cut in straight lines and then you have to grind the rounded edges on it, which is the second process. So for those reasons the ability to cut all the formulations to cut at high speed, potentially no post processing. There is a pretty sizable opportunity for cutting tools and we’ve done a bottom tops down estimate and we put it somewhere between 1,000 and 2,000 tools depending on the configuration of the tools.

So obviously, if it’s a larger tool, it can cut more glass and cut larger panels, you need half as many of them, if you are cutting smaller panels you need twice as many of them. The dollar opportunity is probably similar from our standpoint because the lasers that would go into a big system are roughly twice the cost of the lasers that are going to a small system. But it’s – if you’ve ever seen one of these things on a run, it’s pretty impressive. They put in a big panel and then every once in awhile you see a little flicker of light, and these finished pieces are just dropping out of the bottom. It’s really pretty amazing for us.

Kip Clifton – Deutsche Bank Securities, Inc.

Any – one last chance any questions from the audience. John anything you like to add here?

John R. Ambroseo

I think we’ve touched on all. Again, I want to thank everybody for their time and again, thank DB for – to have us.

Kip Clifton – Deutsche Bank Securities, Inc.

Absolutely.

John R. Ambroseo

Thank you.

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