Good day, ladies and gentlemen and welcome to the II-VI Incorporated FY17 First Quarter Conference Call. At this time all participants are in a listen-only mode. [Operator Instructions] I would now like to turn the call over to Ms. Mary Jane Raymond, Chief Financial Officer. Ma'am you may begin..

Thank you, Chelsea and good morning. I'm Mary Jane Raymond, the Chief Financial Officer here at II-VI Incorporated. Welcome to our first quarter earnings call for fiscal year 2017. With me today on the call is Dr.

Chuck Mattera, our President and Chief Executive Officer; Gary Kapusta, our COO of six months, whom we warmly welcome and our finance leaders. As a reminder, this call is recorded on Tuesday, October 25, 2016. Any forward-looking statements we may make today are made 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 Dr. Chuck Mattera.

Chuck?.

Thank you, Mary Jane and thank you everyone for joining us. We are off to a very good start this year. We continue to experience strong demand from a growing list of customers in our two major end markets, communications and industrial materials processing. These two substantially drove the results this quarter across all three segments.

Strong bookings from the communications market led to a book-to-bill ratio of 1.1. This is consistent with Q4 FY16, while the revenue increased nearly 40% year-over-year excluding the effect of acquisitions.

The bookings were over $100 million for the third quarter in a row, and orders for delivery more than six months out are the highest levels we have seen since II-VI leveraged its competencies into the communications market.

The foundations of that position include our organic investments as well as our strategic acquisitions in China, the US and in Europe. II-VI has emerged as a market leading and strategic partner to most of the world’s largest communications components makers, integrators and network equipment suppliers.

At one level of integration or another our products are enabling the growth of every major communications market segment. These include the growth of the China optical and wireless infrastructure, the global data center market, the 100G metro and cable TV markets in the US, and the global undersea fiber-optic network infrastructure.

Because we continue to employ our vertical integration operating model we are delivering on the expected value creation by manufacturing most of the critical materials and components internally.

As a result, we can bring our leading innovations to the market quickly and then scale the output by swift additions of capacity and operators to deliver to our customers time to market and time to volume advantage. Market demand has been high across our product portfolio, including our new products launched in the last 18 months.

We are adding capacity to meet strong customer demand especially for pump lasers, compact amplifiers for 200G and 400G transmission, optical channel and performance monitors, miniaturized WDM modules, 25G VCSELs [and photodials] and microoptics for waveone selector switches and tunable lasers.

Additionally, we are already seeing strong pull for our recently introduced 980nm uncooled pump laser with a built-in wave length stabilizer for CFT 2 and CFT 4 ACL and DCL applications.

While we are pleased by the current market conditions and our ability to enable our customers to win by having II-VI at critical points in their supply chain, we are increasing our executive contacts throughout the chain to have the best understanding of the progress of this cycle.

However, with all of the indications we have today we now believe that this strong demand could last into the second half of calendar year 2017.

Turning now to the industrial markets, especially those that focus on materials processing we had $71 million of revenue in the quarter, down sequentially 11% due to the seasonally slower summer period, and which was very similar to the first quarter of FY16.

Aside from the seasonal decline, we continued to see strong CO2 laser optics demand from China, where shipments were driven by both demand for low power optics and increased aftermarket penetration for high power optics. Demand for our 1 micron lasers and laser optic components was also strong.

For example, we had our second-highest quarter of sales for high-powered beam delivery components in Q1 with the main drivers being a combination of market penetration and market growth in Korea and in China.

This growth is evidence that our strategy to move towards an integrated marketing and sales structure and an increase in the number of our application engineers close to customers is working. Our sales into the other end markets of military, semiconductors, life sciences and consumer electronics in the aggregate grew 10% compared to Q1 FY16.

During this quarter, we expanded our presence in industry-leading silicon carbide substrates for wideband gap electronics for wireless communication networks.

Demand is surging for these materials not only for RF applications, but also for power electronic device applications and so we are working to add capacity as we are in a nearly sold-out position. We are expanding silicon carbide substrate capacity with the addition of new equipment and manufacturing space in the second half of this fiscal year.

We are seeing more growth opportunities in the power electronics market with the adoption of high-power devices that will enable the electrification of the car. In RF, demand is being driven by of a number of factors including the growth in wireless base stations that we believe is initially being driven by the China broadband initiative.

We also believe that longer-term that demand will eventually expand into new markets in India, Asia, Europe and South America.

With respect to our major new platform investment for FY17 to expand into the 3D sensing market as we debuted late last year, we expect 3D sensing to be deployed in more applications and we expect to be in a leading position to provide optical components and semiconductor lasers, particularly VCSELs that enable 3D sensing functionality.

Examples of some applications include virtual and augmented reality, [Indiscernible], gesture recognition and biometric sensing. Our incremental investment in R&D and capital this year builds on our materials expertise, our two new acquisitions and our experience making VCSELs in high-volume for the [mass laser] over the past decade.

This further underpins a broader foundation from which the company can address the larger optoelectronic devices market. I will turn it over to Mary Jane now for the financial comments.

Mary Jane?.

Thanks Chuck. In Chuck’s comments today we focused on the market trends. I will turn your attention to page 3 of the press release table 2, where you can find the results by segment, including bookings, revenue, operating income and the operating margin.

Our bookings were $244.3 million, our revenue was $221.5 million, our reported EPS was $0.26 a share, and if we exclude the $0.09 per share of the investment that Chuck just discussed, the adjusted EPS was $0.35 a share.

Of the trends Chuck discussed, you will see the influence of the growth in the communications end market in the photonics and performance products bookings growing in total 60% and 12% respectively compared to Q1 of last year.

This is also evident in the photonics revenue, which grew 33% over the same quarter last year and attained a similar record-breaking level of revenue to that achieved in Q4 of FY16 just last quarter. Our organic growth in the quarter was nearly all in photonics.

3% of our year-over-year consolidated growth was due to acquisitions or just under $6 million and this was all in the laser solutions segment. During this quarter, the industrial market remained strong but changed in its percentage of our revenue to 32%, while the strength in the communications end market drove its share of our revenue to 43%.

10% was the military and 15% was in other end markets. Regionally, 45% of our sales were to North America, 19% were to China, 16% to the rest of Asia and 20% to Europe. Our gross margin of 39.5% advanced 110 basis points sequentially.

About 70 basis points of this was due to the receipt of insurance proceeds for last year’s Q1 FY16 flood in Fuzhou, China. Our book-to-bill ratio was 1.1 for Q1, our backlog was $311 million consisting of $76 million in laser solutions, $123 million in photonics, and $112 million in performance products. We have solid order for the upcoming quarter.

Our R&D spending this quarter was $21.8 million or 10% of revenue. While this is a similar dollar level to that achieved in the fourth quarter, it is a very different composition and it is considerably higher than a year ago or 15% higher all due to the VCSEL platform investment.

During the fourth quarter, we still had quite a bit of R&D and engineering that was associated with the RF products business that we sold in June. The R&D for the RF products also was either sold or reduced.

With that transaction complete in the first quarter of this year the company commenced its announced investment program for VCSELs for 3D sensing about $25 million pre-tax for FY17. The Q1 portion was $7.6 million, and just as a reminder VCSEL or V-C-S-E-L, stands for vertical cavity surface emitting lasers.

The SG&A expenses in the quarter for Q1 2017 were down 3% sequentially compared to Q4 2016, but were up 16% compared to Q1 2017.

While we are adding customer facing resources to drive the organic growth and we are continuing to evaluate select M&A opportunities, we are also investing in efforts to consolidate some of the SG&A spending around the world. During this period, we are carefully controlling additions to our expenses. The Q1 2017 tax rate was 31.7%.

The tax rate was affected this quarter by an increase in our FIN 48 reserve. The reported EPS in the quarter was $0.26 a share, and includes the investment for the VCSEL platform of $0.09 a share. Our cash on hand is $220 million and our net debt position is $28 million. We had $30 million of cash outflow for capital expenditures this quarter.

We still expect to commit a $100 million to $110 million in capital for FY17 driven by our new investments and capacity expansion, and we expect the cash flow in the year for capital to be a similar amount. We had $4.1 million in share-based compensation for the quarter.

For FY17 we expect the share-based comp to be between $13 million to $15 million, higher than our normal $12 million to $14 million due to two factors. One is the increase in share price and the other one is the first time investing in a three-year performance [risk]. We did not purchase any shares here in this first quarter of FY17.

We had $31 million remaining on our $50 million stock repurchase authorization. For fiscal year ’17 our excess cash is focused on funding our investment program and paying down our debt, though as always we will monitor our stock buyback opportunities.

Turning to the outlook, the outlook for the second fiscal quarter ending December 31, 2016 is revenue of $220 million to $230 million and diluted earnings per share of $0.24 to $0.29. The increased R&D platform investment will remain about $0.10 a share for this quarter.

This is all at prevailing exchange rates and all the earnings per share comments refer to diluted shares. Our diluted share count is now 63,590,000 shares, and the comparable results for the quarter ended December 31, 2015 with revenues of $191.4 million and diluted earnings per share of $0.30.

As discussed in more detail during our Q&A, our actual results may differ from these forecasts due to a variety of factors, including but not limited to product demand, customer forecast, competition and the general economic condition. This concludes our prepared remarks.

Before we open the line for questions, I will just let you know that our second quarter earnings release date is slated for Tuesday, January 24, 2017. So as a reminder, all the comments we make including the forward-looking statements are just based on our knowledge today. And with that Chelsea, you may open the line for questions..

Thank you. [Operator Instructions] And our first question comes from the line of Jim Ricchiuti with Needham & Company. Your line is now open..

Thank you. Good morning.

Got a couple of questions, just with respect to additions to capacity, it sounds like there are several areas that you are adding capacity, but maybe we could focus a little bit first on the optical side, Chuck, I believe you talked about capacity expansion of lasers and amplifiers, can you give any sense may be sequentially what kind of increases you are seeing there, and in terms of capacity and how quickly can you bring this capacity onto meet demand?.

Thanks Jim. Good morning. Thanks for your question. Yes, regarding the optical communications market, we have an intense program to improve our yields, reduce our cycle times, improve our overall efficiency as part of our overall yield and throughput increase program.

I would say that on the pump laser side, a reasonable estimate is just about 10% to 30%, I would say, in that range Jim, and we can add it quickly and we are adding it quickly. We are in a near sold-out position on many of the [poles], and a sold-out position on others.

We have a – on amplifiers, I would say just overall probably just about the same level, maybe 10% to 30%, and in order to fuel the amplifier business we also need a comparable increase in output for integrated passive components, which as you know, we make most ourselves..

Got it, and then Chuck you also talked a little bit about opportunities in power electronics, it sounds like you are seeing good demand in that market.

Is that an area you are also scaling fairly quickly?.

Yes, we are Jim. We have – our silicon carbide business that we have been investing in for many years basically has two major markets, and they both are quite hot today. One is the RF wireless base station market.

So we make substrates to those companies who make gallium nitride-based electronic devices for 4G and will for the future 5G wireless base stations.

In addition to that, the power electronics market and that is a market, which is enabling the electrification of the car for high switching speed components for power electronics for hybrid electric vehicles and the like, and we are seeing a very significant increase in interest and demand for our product portfolio, and we are sold out.

And so, we are quickly adding capacity. We design and manufacture all of the equipment ourselves, so we have full control – except for the supply chain we have full control over our ability to active passively and we are in the middle of an interesting and exciting program to do just that..

And last question just on the VCSEL side, can you give us an update on how that program is progressing in terms of scaling, and how we might think about the opportunities and also the competitive landscape, if you could spend a few moments on that?.

Yes, okay Jim. Thanks a lot for your question on the – our platform investment. I would say it is progressing right on plan.

And as we discussed in the last call, we will go through at least a three or four-quarter period to both add capacity that is adding tools, developing the processes, qualifying the processes and making the manufacturing line capable – qualified and capable of production.

We said last quarter that we would expect that that production opportunity would unfold in the second half of calendar year ’17, and we are still on that pace. So we have quite a bit of work to do – quite a bit of work done and quite a bit of more work to do. The global team is charged up. They are very, very excited working together extremely well.

And I would say that is – that we don't have any surprises that we didn't expect here along the way. This is running the course and running well. So that is on that front.

Let us see, what else did you ask us?.

Lastly on just the competitive landscape, are you seeing any changes in that area Chuck and then I will drop off, thank you?.

Yes. No, we are not Jim. There is always news – there seems to be always be news around this, but we tend to stay close to the marketplace, close to our potential customers, close to customers, keep our heads down and stick to the [community]. I don't have anything else to add about the competitive landscape..

Okay, thank you..

Yes, sure..

Thank you. [Operator Instructions] And our next question comes from the line of Dave Kang with B. Riley. Your line is now open..

Hi, Dave..

Good morning. Thank you.

Just a few follow-up questions regarding the optical comp side, so this segment declined 3% sequentially, can you elaborate which products declined sequentially, I'm wondering if that is more GPON related?.

Well, actually – first of all let me just give you the last five quarters of revenue for photonics just so we have an appreciation of the picture. Last Q1 it was $71.9 million, Q2 it was $74.3 million, Q3 it was $80.6 million and Q4 it was $99.1 million, so a $20 million lift Q3 to Q4.

So, here where we are at $95.8, we are still at a fairly seriously elevated level. Having said that, during the fourth quarter we had a little bit of remaining product that was an inventory that we were able to ship, and that probably wiped out the coffers pretty well.

Chuck just got finished explaining the capacity additions, but nonetheless we still continued to see a very, very good level of delivery this quarter; very, very excellent capacity utilization by our guys and frankly pretty decent [Indiscernible]..

Got it.

So basically it sounds like – well, so regarding the outlook for the second quarter, which segment will drive most of the sequential growth, is it going to be optical or laser or both?.

Well, we would expect to see sequential organic growth to some extent in all of them..

Okay, got it.

And then just going back to optical side, what is the split between China and US, and demand from both countries strong or is one particularly stronger than the other?.

Well, with respect to the – just in the whole of the photonics segment, in Q1 we had a fairly decent strength in China. I mean it was probably about – in the neighborhood of about 25% and that is not particularly different than what we have seen in other places. North America grew somewhat slightly. That is probably the best way to describe it..

Got it, and then on the laser side, can you just tell us how your fiber laser related products did?.

Well, we continue to see very good growth on the fiber laser products.

I mean obviously the industrial markets, which had been in the doldrums for quite a few quarters are not exactly going at anything close to the growth level of the communications cycle, but nonetheless we are beginning to see a bit of a pickup and they still contribute not only a substantial portion of the overall corporate income, but still reasonably good growth in the – sort of in the 20s..

Yes, I would add to that Dave.

In the quarter, we continue to see increased demand for our lasers, for our beam delivery components, for our optics components, for both the fiber laser and direct laser markets, and that includes not only from China but also from Korea, the US and from Europe?.

Got it, and then lastly on the VCSEL and 3D sensing, first of all my understanding is that you guys are working on the 6-inch platform. What's the status on that, first? That's my first question..

Okay, Dave. Yes. I answered this question a little bit earlier. I would just repeat that. We are in the process of adding precocity developing processes and in a program to ultimately finish by qualifying a manufacturing line or manufacturing large quantities of pixels for a number of markets involving Samsung.

That developing plan to both developing and qualify the platform will continue throughout this fiscal year '17..

Got it, got it.

Any design wins, can you talk about that or is it still kind of early at this point?.

Yes, we don’t have any design wins that we will be discussing today, Dave..

Okay, got it. Thank you..

Thank you..

And our next question comes from the line of Mark Miller with the Benchmark Company. Your line is now open..

Hi, Matt. Congratulations. Good hike and good report and an impressive strength in a lot of variants. Just one of these areas of the performance products was up in terms of the bookings double digit sequential and year-over-year. I'm just wondering if any more color there, did you get a large contract.

What gave that year-over-year in sequential improvement?.

Well, Chuck talked about a couple of different things. Let's just start with the -- from the communications market, kind of in aggregate, particularly the use of silicon carbide substrates and the or that's part of what drove the bookings in particular.

We also have continued to have some pretty decent rank in the military end market, though as, people have seen in general and also with us which tends to be a little bit longer to write them up. Those are probably the particular main drivers..

Okay..

Yes..

Excuse me..

Sorry Mark. Anyway, yes, please go ahead Mark..

Even with the insurance thing factor out here, your margins were at the high end of guidance. I was just wondering was this mix optical telcom what really drove the margins up to the high end of expectations..

Well, I think actually the main thing that is really driving it is positive volume variance. Across quite a few of the operations, communications for sure absolutely because it's so much volume.

But even on the silicon carbide side in the materials processing components, some of those guys not only have continued to improve the operating efficiencies in their factory that kind of let's just call them comfortable not at capacity levels which is a very good thing to do and very hard.

But on the optical side, particularly in Photonics where they are really starting to push the limits of the capacity and have them for a while. They start to get very nice, operating efficiencies off that. Then we added about 30% capacity for pumps and were last year and still continue to see those sort of efficiency gain.

So, that is really fundamentally the main driver. There's no question that makes this probably helping a lot. For example, Chuck talked about the undersea build out that has a particularly good effect on the mix but it's not a lot of revenue.

So, the main thing really comes down to just the efficiency of how our people around the world are running the operations they're in..

Yes. Mary Jane, I'll like to add Mark with regard to performance products. We did see a real strong pickup in our semiconductor bookings in the last during the quarter. So, that also contributed and in fact is interesting that we also saw our first EUV related order in some time. So, it's I think a very positive indicator..

Besides EUV, what specific areas semiconductors were picking up?.

Okay. So, Mark, we make materials for wafer stages, for wafer chucks in the frontend for a whole host of those components. And recently, we have been expanding into the backend of the line. And so, we have a suite of new products and I would say that both frontend and backend we are seeing a lot of interest as we expand into the marketplace.

It does feel like things are warming up..

In terms of the backend, there are several new things that are ramping such as wafer-level fan-out copper pillar or so can be, are you playing into that in terms of the 3d chips, the expansion of these type of features?.

In the backend, Mark, our segmentation of our carbide is around wafer chucks, heater blocks, and for both inspection tools and for wafer probing and wafer bonding tools..

Thank you..

Yes..

Thank you. [Operator Instructions]. One moment for questions..

Okay, well..

I'm showing no further questions at this time. I would now like to turn the call back to Dr. Chuck Mattera, President and Chief Executive Officer for closing remarks..

Okay, thank you Chelsea. To conclude our call today, I would like to say that our Q1FY17 results were enabled by the unyielding enthusiasm, sense of urgency and teamwork of our 9500 employees determined to contribute to this success of II-VI and our customers.

Your dedication, commitment, innovations and hard work makes it possible for us to meet customer expectations. They continue to pave the way for our future growth with the development and introduction of new products and by initiating new programs to improve our overall quality and operating efficiency.

As of today, we're four weeks into the quarter, it feels like we are on track to deliver another good quarter ending in December. Thank you for your interest in II-VI and for your questions today. Chelsea, this concludes today's call..

Thank you. Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day..