II-VI's (IIVI) CEO Fran Kramer on Q2 2016 Results - Earnings Call Transcript

| About: II-VI Incorporated (IIVI)

II-VI Inc. (NASDAQ:IIVI)

Q2 2016 Earnings Conference Call

January 26, 2016, 09:00 ET

Executives

Mary Jane Raymond - CFO

Fran Kramer - Chairman & CEO

Chuck Mattera - President

Analysts

Ted Moreau - Barrington Research

Jim Ricchiuti - Needham & Company

Dave Kang - B. Riley

Mark Miller - The Benchmark Company

Operator

Welcome to the II-VI Incorporated Fiscal Year 2016 Second Quarter Conference Call. [Operator Instructions]. I’d like to turn the conference over to Mary Jane Raymond, Chief Financial Officer of II-VI Incorporated. Please go ahead.

Mary Jane Raymond

Thank you, Candice and good morning. I'm Mary Jane Raymond, the Chief Financial Officer here at II-VI. Welcome to our second quarter earnings call for fiscal year 2016. With me today on the is Francis Kramer, our Chairman and Chief Executive Officer; and Dr. Chuck Mattera, our President and Chief Operating Officer.

As a reminder, this call is recorded on Tuesday, January 26, 2016. Any forward-looking statements we may make during this teleconference are given in the context of today only. We do not undertake any obligation to update these statements to reflect events subsequent to today.

With that, let me turn it over to Fran Kramer, our Chairman and CEO. Fran?

Fran Kramer

Thank you, Mary Jane and thank you everyone for joining us. Our second quarter delivered revenue and EPS was at the high end of our range. In fact EPS was above the top end. Our optical communications business remained strong this quarter both in revenue and bookings. Our industrial markets growth was affected by China being slower but absent that the division serving that industrial market particularly in the Laser Solution segment remained strong earnings contributors.

We announced earlier in January our intention to acquire two companies to expand our capacity in VCSEL. Neither of these transactions is closed yet so we will limit what we say other than we are excited be able to invest ahead of the curve for what we believe will be a significant growth market. The talent and capacity we acquired have the potential to serve multiple II-VI segments something we look forward to in our acquisitions. This is the first time in quite a while that II-VI has had a gap between signing and closing and acquisition. We are completing a number of important legal steps for closing as well as the integration assessment and the purchase price accounting. We intend to include greater details on the financial effects of these transactions at closing and with our third quarter earnings announcement. For now as we've been reporting on our last two earnings release as we expect our existing operations to deliver a good improvement in FY ‘16 over FY ‘15.

Let now turn it over to Chuck to comment on our global businesses.

Chuck Mattera

Thanks, Fran. The composition of sales into our top three end market were 36% into industrial, 36% into communications and 13% into military. Our two smaller and emerging markets of semiconductor capital equipment and life sciences were 15% combined. On a regional basis the distribution of our revenues for the quarter was 48% from North America, 22% from Europe, 17% from China, 7% from Japan and 6% from the rest of the world.

Now I will discuss some highlights across our three segments, extending the momentum from last quarter our Photonic segment continued to see strong demand particularly for its optical communications products. Due to revenue in Photonics was up 22% over the same quarter a year ago. Bookings for the quarter were especially strong up nearly 50% from the same quarter last year. While the bookings growth was driven by an increase of market demand, share gains and new product introductions a good portion appears to be related to larger and additional long term orders from customers becoming concerned about supply chain constraints.

The Broadband China program is continuing to drive orders across our portfolio including for 980 nanometer pumps optical channel monitors and passive components where we have significant share. To meet the combined and anticipated and sustained demand for our industrial and submarine 980 pumps we are expanding our global 980 pump capacity as we see this demand continuing into next year. The onset of new metro build in the U.S. is creating significant pull for our recently released OTDR modules as well as our amplification and passive components products.

Moreover deployments of 100G, 200G and 400G services for data center interconnects as well as the general transport markets are also driving demand for our suite of ultra-compact optical components and amplification solutions for coherent transceivers. Even though the optical communications market is still subject to cyclical swings, based on the increases in our bookings, our increasing penetration into the high reliability submarine pump market and the steadily growing data center interconnect markets we anticipate sustaining strong revenues through our FY ‘16.

Turning now to the industrial laser material processing markets that dominate the Laser Solution segment, our revenues in that segment increased 4% compared to last year despite the effects of the strong dollar. For the high power CO2 laser optics business worldwide we now see new laser bills at a ratio of 60% fiber to 40% CO2. Our high power bar infrared optics sales were flat to down in our major markets for the quarter as were our fiber laser cutting and welding heads for automotive manufacturing plants. This is due we believe the seasonal factors as well as the overall economic slowdown in China, even though the material processing market in China continues to be a growth area for us as we continue to find and grow new opportunities there. Our aggressive strategy and low power CO2 laser optics has also helped us maintain a leadership position in that growing segment of the market.

Semiconductor laser diode shipments grew 9% compared to the prior year. We expect that continued focus on productivity and managing operating costs including completing our first move to a lower cost manufacturing location in the Philippines will strengthen our competitive position. Our one micron and related product revenues for the industrial materials processing markets grew over 20% compared to last year. We have added compacting in the U.S. and in Asia to improve our customer service including expanding our training of sales and application engineers to support our broad and growing portfolio of one micron products.

In the Performance Product segment despite a decline in bookings both sequentially and for the second quarter of last year we are seeing several good trends, we see renewed orders from our military customers from ISR [ph] applications and see growing strength in components for semiconductor capital equipment where bookings for this quarter return to the highest level we have seen in the last six quarters. Demand for silicon carbide substrate for RF base stations is also strengthening after an inventory correction that affected our shipments in the first quarter. Revenues for this segment increased overall 3% sequentially and were down 2% compared to last year.

Before I turn it over to Mary Jane to walk us through a review of our overall financial performance, I would like to acknowledge our 9000 fully engaged employees worldwide for embarking on a quality transformation across the company and for their continued dedication to building new and sustainable growth engines for II-VI. Again this quarter we saw the combined benefits of our triple play in R&D investments, vertical integration and M&A strategy implement over the last two years continue to accrue. Those benefits along with the relentless drive for operational excellence and our unyielding determination to continue to deliver exceptional business results can be felt in every corner of the company. Mary Jane?

Mary Jane Raymond

Thank you, Chuck and Fran. So margins this quarter remained pretty steady with the gross margin at 37.3%, the EBITDA margin at 19.1% and operating margin at 11.3%. These improved a 160, 150 and 200 basis points respectively compared to last year. The Photonics 10% operating margin, the strongest we have seen since 2013 is very much influenced by higher volumes of new products. However about 200 basis points to this improvement are from our work on operational improvements. Our book to bill ratio was 1.08, the backlog today is $256 million up $60 million from Q1 of FY ‘16 and is $66 million in Laser Solutions, $85 million in Photonics and a $105 million in performance products.

EPS of $0.30 for this quarter was above the $0.26 top end of our range, three pennies of this were due to the full year effect of catching up the R&D tax credit which was extended in December for the calendar year in 2015. This compares to $0.24 a share same time last year which also included that same R&D tax credit annual catch up, that tax credit as you know has now been made permanent. This $0.24 of last year includes the $0.11 benefit of the indemnification settlement that we had again in the second quarter of last year. Year-to-date our cash flow from operations was $62.3 million a record for II-VI for the first half. We reduced debt $16 million bringing our debt level to 146 million. Our interest expense was about $600,000 for this quarter. We purchased no stock in the quarter and we’ve purchased about $19 million of our 50 million authorized program. We invested 9.8 million in capital equipment this quarter and expect to spend $50 million to $55 million for this year. For fiscal year 2016 we expect equity based compensation to range from $12 million to $13 million. The expense this quarter was 3.7 million higher than the quarterly average due to some accelerated investing.

The tax rate for the quarter was 14.4% and for the full year of FY ‘16 the tax rate should range from 18% to 20%. Our outlook as we noted in our press release does not include any effects of our any acquisitions. We will provide new guidance for the quarter when both the transactions close. The outlook for core operations for the third fiscal quarter ending March 31, 2016 is revenue of 185 million to 195 million and earnings per share of $0.25 to $0.29. This is all a prevailing exchange rates and all earnings per share comments refer to diluted shares. Comparable results for the quarter ended March 31, 2015 were revenues of 182.7 million and earnings per share of $0.23. The earnings release date is slated for Tuesday, April 26, 2016.

So with that operator you can open the line for question.

Question-and-Answer Session

Operator

[Operator Instructions]. And our first question comes from Ted Moreau of Barrington Research. Your line is now open.

Ted Moreau

So yesterday we heard from Anadigics that they have received a higher offer from one of the other parties that was originally interested in the company and so I'm just curious as to you know what are you thinking as far as continuing to pursue Anadigics as an acquisition opportunity and how are you thinking about how much you're willing to pay for a potential transaction here?

Fran Kramer

Yes we did get that -- the Anadigics Company got an offer from Party B and as we see these [Technical Difficulty] from that one group we assess that each time that happens and try to decide which way we're going. Certainly we’re very interested in this business so that could give you some indication that we're realizing that this Party B apparently has an offer that has some clause to it let's say, and the company selling that business has a decision of what they want to do. We’re interested to win the business but at the same time we should pay the right amount of money for it. So we’re feeling we're going to stay right on top of it and watch it every step. That's about as far as I can go.

Ted Moreau

Okay. And then if I have it right it's all about adding the VCSEL capacity potentially for just a recognition in consumer electronics and whatnot. What's giving you the confidence that of the VCSEL will be utilized in these consumer devices and what do you see as the timeframe of that potentially happening?

Chuck Mattera

Ted, a couple of things number one we have ongoing product developments for VCSEL for these applications that are happening today in our laser and enterprise division and so we are engaged in a strategic marketing effort, a technology and product development effort and our channel checks combined with industry analyst who are forecasting that these applications will grow substantially and between now and 2020. I think at least one recent market survey suggests that the market might be as large as $2 billion for these applications. So it's an exciting enabling technology and we’re very confident in the technology capability and the interest and the timing in the market in many ways depends on some measure on the capability of the supply chain. So we see this as a chance for us to expand and have it scalable expansion capacity to address in those markets seem to be ready ahead as opposed to trying to catch up. Okay?

Ted Moreau

So just a follow-up here on, can you just -- VCSEL product offering is that similar to how we think about like a finished out [ph] product offering or an Avago [ph] VCSEL product offering? I mean is it -- or are you just providing certain pieces for the entire solution?

Fran Kramer

We make VCSEL for different applications including optical communications, including for sensing as you know for the MoS [ph] VCSEL and including for next generation applications including some of the ones that we just spoke about.

Q - Ted Moreau

Okay. But you're more intrigued with the consumer electronics opportunity than you are the data center opportunity?

Fran Kramer

We see a very strong interest and a strong demand and pull for our continued expansion or capacity for optical communications as well and that's here now.

Operator

Our next question comes from Jim Ricchiuti of Needham & Company. Your line is now open.

Jim Ricchiuti

Chuck, maybe this one's for you, you suggested when you were talking about the strength in the photonics business you cited few things, share gains, new products, some customers placing larger orders I guess reflecting concerns about possible supply chain constraints. Is there a way for you to maybe give us a little bit more granularity on that, what is one bigger or was one of bigger factor than the other?

Chuck Mattera

I would say that roughly -- I would put 35% to 50% weighted toward the supply chain one time supply chain events and those one time supply chain events include a customer moving off of the vendor management inventory and to regular commercial buying. Number two, they want some of our new products seem to be attracting the attention and need or desired by some customers for building some of the safety stock. And also just overall I can tell you that we feel it as well. There are certain elements of the supply chain that are in short supply. And so I would put 35% to 50% roughly as supply chain management issues.

Fran Kramer

Jim another maybe the last one which is over and above what Chuck has said, but it's in there is this return to us compared to when we took over. We were clear we knew the business, some of those have now returned and certainly in this summary communications business that's one of them.

Jim Ricchiuti

With respect to the revenue guidance for the March quarter. If I look at the vertical market breakdown that you provided but for the Q1 and Q2 it looks like you showed good growth in each of your verticals with the exception of the industrial which looks like it was kind of flattish for the quarter sequentially and so I'm wondering as we think about the guidance you’re giving for the March quarter is there anything we should be mindful of in some of these verticals in the quarter coming -- that were in right now in terms of where we might see a little bit of sequentially down revenues?

Fran Kramer

Jim, I will give you a start to an answer there, certainly in the second half of the year Q3 and Q4 we usually see an uptick in our laser solutions business and we see most of those possibilities exist this year and the CO2 business which is the one that takes off more in the third and fourth quarter has been modest over the last six, seven quarters compared to what we've had in the past. So we check on that using surveys that we do with our aftermarket customers and we see the aftermarket life just a little slower driven mostly by the worldwide economy. So it's on a pattern to do better in the second half. However if this continued slow economy it gets worse. We might not get the uptick we're thinking but I think we feel pretty good we will. That would be for that segment. I think Chuck gave pretty good update on Photonics for where we are with that build out and so on and so the third business is supposed to comment and it's performance products. We have some opportunities, we said the trends are good certainly the trends are good and will translate into orders and deliveries in the second half. We’ve factored them into our best judgment.

Jim Ricchiuti

Just one final question if I may be, the industrial, were you seeing a little maybe slower sequential improvement thinking about second half. Is that more focused in China? It sounds like other parts, Europe, North America remain fairly healthy? Is that fair to say?

Fran Kramer

I think we've said all along over these last few quarters and maybe it's been four, five or six quarters. Yes, they're healthy, they're just not robust that's what we -- you know if that’s not robust in the first and second quarter, turn a little bit down because of something we can't predict that would cause us not to get to this numbers but I think we feel pretty good. I think all the down risk of economy getting worse relative to laser solutions business have factored into our forecast year.

Operator

And our next question comes from Dave Kang of B. Riley. Your line is now open.

Dave Kang

First of all Mary Jane I was looking to get a number, you said Photonics backlog was 85 million in the fiscal second quarter, I was wondering what that number was in fiscal first quarter and also a year ago period? Do you have that number?

Mary Jane Raymond

Shortly, ask your second question.

Dave Kang

Then maybe out for Chuck, so can you just talk about which products are very strong, which products are tight, can you talk about capacity situation? Because I know some of your competitors have said that they're pretty tight in capacity and maybe even on the allocation.

Chuck Mattera

We're feeling the effects of continued strong demand in China and from China Broadband and across the board, I mean as you know or as we talked about in the past. We are a significant supplier of amplifier components into that market. And so pumps and passives are experiencing quite a strong demand for that pumps and passives in general for that part of the market. The ongoing demands and the baseline demands in North America combined with both the anticipated, metro build outs in North America and also the gradual adoption of 400G in North America and in Europe, we're driving demand for across the board for everything starting with amplifiers.

Dave Kang

What about the OCMs? I know that's a key component for iridium blade, I would say that will also be a good indicator for metro build out to?

Chuck Mattera

I was about to say, amplifiers, optical channel monikers are a new optical time domain reflectometers and tunable optical filters. So the suite of those components that will be deployed are being deployed alongside amplifiers and in-line with the transponders. We are experiencing significant demand across the board.

And then finally since you asked me, regarding earlier Fran made the comment regarding 980 pounds, and that is for the OEM market, for our own internal amplifiers but also for the submarine market which is growing in response to the large increase in data center interconnect traffic as you know. So regarding our capacity we are managing our capacity very closely, very tightly. We have expanded and authorized increased capital investments this year above what we had budgeted. We have turned on our new laser chip on carrier line in the Philippines, they are offering us expanded capacity as well as a path for lower cost and we do have some constraints that we’re managing ourselves but also we're managing our own supply chain constraints as part of that and our I think the team are doing a great job at it as well, Dave.

Mary Jane Raymond

Dave, with respect to your question about the backlog, the backlog in the sequential quarter and the first quarter was $61 million compared to last quarter's backlog available with us and it was $54 million in the second quarter of last year.

Dave Kang

And Chuck so just couple more on the optical side, can you just talk about -- you just went through the annual pricing adjustment, how that was compared to recent years? And can you just talk about the lead times what was it before and what is it now?

Chuck Mattera

I'm not sure Dave, can you clarify your question regarding lead time?

Dave Kang

Yes. Lead times, I mean typically it's in the past it's been like what four, maybe six weeks has that been kind of stretched out to maybe eight weeks or maybe even longer?

Chuck Mattera

I think across the board, across our entire supply chain Dave, lead times are extremely important to our customers, we stay focused on that. In cases where we are surprised by sudden demand or by shortages in the supply chain and where we have done everything we possibly can in that case we may have to extend lead times. But we are absolutely focused on serving the customer, making sure that we’ve done everything we can for that. Regarding pricing, I would say in general despite the demands of the pricing environment continues to be competitive. And we had some success in slowing down the price erosion in some cases we have actually increased the prices and in other parts of the portfolio where there are multiple sources that we’re competing with we have stayed on our typical track of 2% to 3% reduction in the quarter.

Dave Kang

And just lastly, so your bookings were up almost 50% sequentially -- but sales were up only -- I'm talking about optical or photonics, up 50% sequentially bookings but revenue was up only 3% sequentially. Is that because of -- were you capacity constrained or can you go with the disconnect between bookings and sales or bookings I guess there for multiple quarters?

Chuck Mattera

It's a great question Dave, and you answered it with a great answer. And coming back to my comment earlier and my response to Jim Ricchiuti, 35% to 50% in that range the bookings really laid out for us over a longer time horizon than we generally get. So we’re delighted to have it and it will help us improve our planning for the next one or two quarters and do our best to be able to break the constraints and increase our output to keep up with the demand and I would say we always need to have some headroom because we've been very, very aggressive about positioning both the performance and the ability of our teams to scale to meet market demands and to win business and to take share. So we’ve been very aggressive about that we will continue to be.

Dave Kang

And lastly, I promise this is last question is that I always get asked from accounts that about sustainability. Can you just go over, I'm assuming North America we’re just getting started as far as the metro so I think that's you know quite sustained. What about China? It seems like that's the sort of on/off, on/off?

Chuck Mattera

Right now it's on. And we're expecting based on our checks, our discussions with our key customers we’re expecting that the momentum that we currently are quite up in creating should continue at least through this fiscal year. We will have to update you on again on April 26, Dave and that’s our best view today.

Operator

[Operator Instructions]. And our next question comes from Mark Miller of The Benchmark Company. Your line is now open.

Mark Miller

From what Mary Jane just said about the Photonics backlog sequential improvement, it seems like the other areas went down. I was just wondering in terms of the drawdown in the other areas where there is a significant in terms of which area was drawn down more significantly?

Mary Jane Raymond

I think in terms of whether or not there's a very, very significant movement from the first quarter. Not really particularly in laser solutions, as we said our book to bill has been in the 99, 100 or a 101 time range for long time and to move some large amount of points on the whole quarter on this 10 points on the whole quarter. We’re really talking about the degree of movement that we ended up seeing in performance products. So I don't know that we're saying a really hugely big difference. I think performance products however you know which has our main markets to serve the semiconductor capital equipment market and the military market, those bookings as a factual matter are very, very lumpy. So in fact we just spent some time talking about the sequential growth in those just in revenue in those markets because some of those bookings we’ve had say six months ago.

So it's tough to say we had big, big differences in performance products when the bookings are lumpy anyway.

Mark Miller

Okay, you mentioned the cutting head market was flat, auto has been strong, is that a seasonal effect or do you expect that to pick back up?

Fran Kramer

I do think we think it has a little to do with the economy and how the use of lasers as it goes up and down as the economy does well and people slowdown on their capital procurement in the cutting had markets, one of them we think has that. Also a little bit of seasonality but will come into the better part of the curve on that here in the first or the second or the third and fourth quarter. So yes, seasonality a little economy driven, quite a bit.

Mark Miller

Your proposed acquisitions, I'm just wondering how that will -- will that have a significant impact on margins as you go from 3 inch wafers to 6 inch wafers? I'm wondering what the impact? I assume that’s going to be the principal impact during these acquisitions? Better margins, I'm just wondering how big an effect that will be?

Mary Jane Raymond

We’re not giving really any forward looking numbers on really any of the parameters for the acquisitions at this point in time. I think one it's preliminary and -- but you know do we think there is an advantage across a few dimensions whether they're economic or technical on the 6 inch, then yes, but I think in terms of its exact or even it's ballpark movement on the margins we're not commenting on that really at this point.

Mark Miller

And finally, your R&D spending went down sequentially. I'm just wondering what the trend is for the rest of the year?

Mary Jane Raymond

I don't think that you should expect as a conceptual matter that the R&D spending is declining. Sometimes there are slightly seasonal factors of when various things happen or are delivered particularly among prototypes but generally speaking our R&D spending is fairly steady.

Chuck Mattera

I could add just to what, Mark, what Mary Jane said, our team is more and more in this environment especially in an environment which is demanding new products and it's coming at our customers a little faster than what they expected. We typically will ask for NRE in certain cases and our teams are more and more are refining that they can be successful in that regard as an offset to the R&D expense. So when you see that it's not necessarily a slowdown of the activity but in some cases the treatment of how we pay for it basically.

Operator

Thank you. And I'm showing no further questions at this time. I would like to turn the conference back over to Mary Jane Raymond Mary for closing remarks.

Mary Jane Raymond

Thank you, Candice. Well first of all thank you all very much for joining us this morning. If there is follow-up, anything on what we've already talked about we would be pleased talk to you later. Fran is there anything you would like to conclude with?

Fran Kramer

Just to tell everybody who has been following, stay tuned for how we proceed on with these acquisitions and we’re upbeat about the third and fourth quarter of our base business. Thanks for attending.

Mary Jane Raymond

All right. Have a good day. Thanks. Bye, bye.

Operator

Ladies and gentlemen thank you for participating in today's conferences. This does conclude the program. You may all disconnect. Have a great day everyone.

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