Is This A Chance To Pick Up II-VI For The Rebound?

| About: II-VI Incorporated (IIVI)
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Sometimes one of the best things an investor can do is pick up shares of a quality company on a temporary problem in the industry. For instance, investors who bought Lincoln Electric (NASDAQ:LECO) below $40 are probably pretty happy that they did so. While the shares of laser optics and components maker II-VI (NASDAQ:IIVI) have been volatile, they historically haven't stayed very cheap for very long. The question for investors now, though, is whether this is another buying opportunity or whether II-VI's addressable markets have changed in fundamental ways that will make this a disappointing stock from now on.

A Disappointing Quarter Is Bad Enough...

Investors hoping that II-VI would echo the message of large industrials like General Electric (NYSE:GE) that the worst seems to be over were disappointed on Tuesday. II-VI reported that revenue fell 1%, missing the average Wall Street guess by nearly 10%.

While the company's results got some boosting from acquisitions, infrared product revenue fell 3%, while near-infrared revenue rose 14%. Military-related product sales fell 30%, while sales in the advanced products category rose 31%.

Margins and profit performance were mixed. Gross margin improved almost three points on an adjusted basis, or nearly two points after adjusting for inventory write-downs tied to falling tellurium and selenium prices. Segment earnings increased 5% on a reported basis, with a major improvement in near-infrared profits (tied to better volumes and recoveries in Thailand), but adjusted profits grew just 1%.

But Downward Guidance Just Makes It Worse

Forget a V-shaped recovery for II-VI. Although bookings were up a reported 9%, a sizable chunk of that came from the company's three acquisitions [including the deals for some of Oclaro's (NASDAQ:OCLR) assets and the M Cubed deal], and net backlog barely rose at all. With that, management took down the next quarter's revenue target by about 7% relative to prior sell-side expectations, and took down the full-year number by about 6%. As I said, management is not looking for a quick or dramatic turnaround in the business.

Will The Perfect Storm Pass, Or Is There Climate Change?

To a certain extent, it looks and feels like II-VI is just in the wrong place at the wrong time. Industrial customers in markets like off-highway vehicles, autos, healthcare and automation have seen business taper off significantly, meaning that OEMs like Caterpillar (NYSE:CAT) have less need for replacement parts and components and laser system OEMs like Rofin-Sinar (NASDAQ:RSTI) are seeing less demand.

At the same time, the chip industry (and chip equipment industry) is in the doldrums, and major telecom equipment providers like Finisar (NASDAQ:FNSR), Ciena (NASDAQ:CIEN) and Juniper (NYSE:JNPR) are still waiting for major orders from Verizon (NYSE:VZ) and AT&T (NYSE:T) to resume. Last and by no means least, while it's true that military spending cuts are likely to center on personnel reductions, the reality is that less advanced weapons systems are being ordered/reordered as the U.S. winds down its active engagements.

All of this could well pass - Johnson Controls (NYSE:JCI) was recently cautiously optimistic about auto production activity, for instance, and many investors are itching to call the bottom in Caterpillar. Moreover, there has been another round of "this is the year" calls for rebounds in chip production and fab equipment orders.

That said, I still think there are grounds for caution. In particular, I'm concerned about the advances made by fiber laser manufacturers like IPG Phontonics (NASDAQ:IPGP) and Coherent (NASDAQ:COHR). Cost and utility used to be limiting factors for fiber lasers, but they are now often cheaper than YAG and CO2 lasers, are as much as three times more efficient, and are cheaper to operate - particularly in cutting/welding operations.

That puts companies like II-VI in a tough position, particularly with respect to maintaining margins. Simply put, I don't think Caterpillar or Volkswagen cares much at all what kind of lasers they use, so long as they get the job done and do so in the most cost-effective manner possible. Where fiber lasers are now maybe 15% of the $4 billion worldwide laser market, that could double in as little as three years.

For 2012, for instance, it looks like the fiber laser market grew in the mid-teens, while the industrial laser market grew in the mid-single digits (better than II-VI's organic growth). The damage is likely to be most severe in high-power apps like welding/cutting and oil/gas for now, but I wouldn't assume that lower-power markets like telecom, medical, semiconductors/panels, and solar are safe for the long term.

I don't want to suggest that II-VI cannot adapt and roll out additional products for the fiber laser market, but it's a different world - one where IPG Photonics has substantial share today and a vertically integrated model. So, it seems fairly critical to me for the company to work closely with customers like Rofin-Sinar and Trumpf to see that they all play in the emerging fiber laser market. At a minimum, it seems like deals like the one for M Cubed that brought in additional advanced ceramics and control products are going to continue to be a significant use of cash and shareholder capital.

Harder To Argue For The Bullish Growth Scenario

II-VI has a strong growth record, using organic growth and deals to grow revenue at a rate of more than 17% over the past year. Unfortunately, past is not necessarily prologue. I do believe that markets like semiconductors and telecom are due for a rebound, and that the company could see double-digit revenue growth next year (fiscal 2014 vs. '13) and perhaps beyond. Unfortunately, I can't really go much past an 8% long-term compound revenue growth forecast.

At the same time, the company needs to prove that it can drive margin leverage from both an end-market rebound, further integration of acquisitions, and generally corporate "blocking and tackling." The company has a trailing average free cash flow margin of 10%, with more than a few years of low- to mid-teens performance. I do believe that, as markets improve and the company gets past issues like the rare earth price declines, gross margins can move back into the 40%s and operating margins can move back into the high teens. Should that happen, the company has a good chance of 12%-13% compound free cash flow growth.

The Bottom Line

While 12%-13% future free cash flow sounds pretty good, and stacks up well against an EV/EBITDA ratio of about 10, it's hard for me to be strongly bullish on these shares. Even with a slightly advantaged discount rate, that low-teens free cash flow growth only leads to a $20 fair value for these shares. That's not compelling upside given that the growth is predicated on solid rebounds in the medical, semi, PV and telecom markets and that fiber laser penetration could take away even more of the high-power welding and cutting market from YAG and CO2 lasers.

I'm not a major student of technical analysis, but I also cannot ignore the downward stairstep pattern that these shares have been making for a little while now. Consequently, while I appreciate the virtues of picking up the shares of good companies when they stumble, and I think II-VI is a good company within its industry, I struggle to see enough value to balance out the risks of slower-than-expected rebounds and increasing technological competition.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.