Description

IIVI's FYE is June 30.

Background

Today, IIVI produces a wide range of optical components for diverse laser applications.  Over the last 15 years, the laser industry has grown significantly as lasers have displaced traditional tools used for cutting, drilling, punching, marking, welding, ablating, cladding, and heat treating.  In general, lasers are faster, more precise, and more reliable than the saws, drills, and other tools they are replacing.  In addition, laser processing is often cheaper since it enables a greater degree of automation than conventional methods.  Prior to the downturn, roughly 4,000 to 5,000 new industrial laser systems were being fielded annually.  Lasers' use has also grown in medical and military applications.

IIVI produces the beam delivery components of a laser system, such as the mirrors that help move the beam, lenses to focus the beam, and in some cases, the crystals that generate the beam.  Importantly, these components wear out with use, and in a factory environment, the optics need to be replaced every 100-200 hours.  (One of John Deere's plants has a vending machine that has been retrofitted to dispense optics instead of snacks, and IIVI replenishes this machine once a month.)  In a cleaner setting such as a hospital, optics can last for years.  IIVI sells to both laser OEM's and end users, though ongoing replacement demand from a growing installed base has progressively increased IIVI's exposure to the aftermarket.  IIVI's Infrared Optics segment is it's most heavily focused on industrial applications, and they estimate that roughly 90% of this segment's sales are tied to the aftermarket.  (In North America, the Infrared Optics segment serves the aftermarket directly, but outside of North America, customers prefer to buy optics through the laser OEM's, so it's difficult for IIVI to know how much of the content in those markets is split between newbuild systems and replacement demand.)  In IIVI's other three segments, roughly 50% of revenue comes from the aftermarket.

IIVI's competitive position varies somewhat by division, but in general, each division derives competitive advantages from a few key areas.  The first and most significant is their ability to grow their own crystals, which is the first step in optics production.  It takes roughly a decade to get down the basic process for growing a particular crystal, and even after that, the process is far from a hard science.  Even today, IIVI's R&D and manufacturing groups continue to collaborate extensively in the pursuit of higher yields, larger crystals, and lower costs.  The growth processes are also capital intensive and temperamental.  For example, in one of IIVI's crystal growth processes, the crystals can't be without power for more than 5 seconds at a time during a 30-35 day growth cycle.  As you might expect, such challenging processes occasionally result in yield problems, and the resulting earnings "slip ups" provide excellent opportunities to get into the stock.  Such challenges, however, have also resulted in limited competition, and growing its own crystals provides IIVI with important cost and quality advantages over its competitors.

IIVI's second competitive advantage is in precision manufacturing (i.e. fabricating the raw crystal into an optic, polishing that optic, and coating the optic to enhance it's natural properties).  As lasers have become increasingly powerful, the optics need surfaces that are progressively smoother, and IIVI is one of the only companies in the world that's able to fabricate and polish these temperamental materials to this level of precision.  Because the materials are difficult to work with, customers sometimes also delegate sub-assembly to IIVI since IIVI's optics expertise results in higher sub-assembly yields than the customers would be able to achieve on their own. 

Finally, I believe that management's long-term orientation and ability to absorb the inevitable bumps along the way is also a competitive advantage.  Few managements appear willing to undertake the multi-year, methodical incubation and development periods that IIVI has pursued and continues to advance. 

Business Segments

IIVI is organized around four segments, all of which currently have favorable dynamics that should translate into better results going forward.  IIVI's largest and most profitable segment is its Infrared Optics (IRO) segment.  IRO was IIVI's original business and produces Zinc-based materials and optics, including Zinc Selenide which is the best compound for transmitting energy from CO2 lasers.  IIVI is the largest producer and consumer of Zinc Selenide in the world, and it's competitive advantages in this area have made it the clear market leader with over 50% marketshare.  The main application of these materials is in CO2 lasers which are principally used in industrial applications such as cutting, though there are also military applications such as components for infrared cameras.

IIVI's second largest business is its Near Infrared Optics business (NIRO).  This division addresses various niches within the near infrared market and serves medical, industrial, scientific and military applications.  IIVI has a solid competitive position in this area, though it is not as pronounced as in the IRO division.

NIRO has undergone a number of significant changes in recent years.  In 2003, NIRO purchased a UV filter business from Coherent.  These UV filters could be used to detect missile plumes and provide an early warning system for military aircraft.  NIRO paid 2MM for this business and over the next five years realized 100MM of revenue (with apparently very good margins) selling into a program that retrofitted Apache helicopters with such equipment.  By FY08, that program had grown to roughly 40% of the segment's revenue, but it began to decline in FY09 and presented a significant multi-year headwind for that division.  Fortunately, they've been able to offset much of this UV business with non-UV military business which continues to grow. 

In January, 2010, IIVI announced the acquisition of Photop Technologies.  Photop is an optics producer that is based in China and will be included in the NIRO segment, more than doubling NIRO's revenues.  Photop's optics are somewhat adjacent to IIVI, but the real motivation for the acquisition appears to be to expand IIVI's presence in China and to provide it with a more competitive cost structure in certain products.  NIRO has historically manufactured its products in Florida, but this left it with a cost structure that was too high to compete in Asia.  Many of the fabrication capabilities that Photop uses for telecom optics are the same ones that NIRO needs to produce its products for the Asian market, so Photop should enable NIRO to expand geographically.  Thus far, Photops revenues and margins have come in far ahead of expectation.

IIVI's third segment is it's Military & Materials segment (M&M).  This segment is really an amalgamation of two unrelated divisions.  The military side produces large scale optical components that prime military contractors use in imaging and targeting systems.  One exciting new program for this division is large area sapphire windows for the Joint Strike Fighter (JSF) that IIVI will produce on a sole source basis.  This division also recently unseated an incumbent and won a contract to provide the JSF with components for a missile early warning system.  The Materials side of M&M runs a recycling operation in the Philippines that extracts selenium and tellurium from other companies' waste streams.  IIVI acquired this operation in order to improve it's access to these two critical raw materials, and also to provide the IRO segment with lower cost selenium.  This division sells to external customers as well. 

IIVI's fourth segment is its Compound Semiconductor Group (CSG).  This segment's largest division makes Thermo Electric Coolers (TEC's) which are solid-state semiconductors that can be used to heat, cool, or stabilize the temperatures of other components or systems.  TEC's are used in a wide range of applications including military, telecom, medical, and consumer.  The CSG has also been incubating a division that produces Silicon Carbide crystals for emerging high performance military and telecom applications. 

Outlook

Over the long term, IIVI should continue to grow as lasers continue to proliferate in industrial, medical, and military applications.  In the short-to-medium term, all of IIVI's divisions should benefit from the economic recovery, as well as certain discrete drivers.  The IRO segment, for example, is benefiting from rebounding aftermarket demand (which is a leading indicator), but it is also benefiting from new product introductions and a margin recovery that has been a long time in the making.  In FY07 and FY08, IRO's operating margins were depressed by significant yield problems as well as high selenium prices.  IRO's yields had been restored by 1H09, and were at record levels by 3Q09, but it takes a few quarters for these to work through inventory and into COGS.  In addition, IRO's selenium costs should have begun to benefit from the Philippine recycling operation in late FY09, and then additionally from lower selenium market prices around mid-FY10.  (Mid-FY10 was the approximate time that lower market prices would begin to flow through to COGS.)  Lastly, the former yield problems noted above precluded IIVI from selling raw Zinc-based materials to third parties since it needed these materials for internal consumption.  Such sales to third parties are usually high margin, and IRO was able to re-enter this market in FY09.  During the downturn, IRO has been selling raw zinc-based materials at lower than normal prices in order to use otherwise idle capacity, but as the environment normalizes, I'd expect them to raise prices on these products.  It is difficult to be precise about when IRO's margins will be restored to the mid-20%'s or higher, but management has indicated that this improvement is on the horizon.  I suspect that we would have already seen more improvement if we were in a normal economic environment.

NIRO's non-UV military business is expected to continue ramping over the next twelve months.  The M&M's military business is beginning to benefit from "military reset" (i.e. repairing and overhauling all of the equipment that's begun to return from Iraq) as well as the initial ramp of the JSF.  Over the long-term, the JSF represents a very large opportunity for IIVI, though it is difficult to quantify since management believes that the military will eventually develop a second source of sapphire windows for this highly strategic weapons platform.  Lastly, the CSG's TEC business has a high volume program that had been expected to begin shipping in June quarter. 

Valuation

As shown in the table below, IIVI's stock has traded within a relatively predictable valuation range since FY03. 

Historic P/E Multiples

*IIVI's FYE is June 30, so the stock price figures for FY10 are known, but the earnings are based on my most recent estimate.

Earnings should advance dramatically in FY11 as the overall economy continues to recover and the specific drivers mentioned above further advance IIVI's results.  My initial EPS estimate for FY11 is $1.77, and I wouldn't be surprised if that proves conservative.  At $29.70 (less $3.01 of cash per share), IIVI is thus trading at 15.2x, near the bottom of the historic range.

Lastly, I've included portions of my model below, including my long-term forecasts.  The expected annual stock returns under those forecasts may appear modest at only 10-15%, but it's important to note that I am being very conservative and assuming that the IRO division grows considerably slower in the future than it has in the past.  I'm also using conservative growth rates for the other three segments.  (My general approach is to look for situations where I can get a 10% return using assumptions that are likely to be proved conservative.)

LONG TERM PROJECTIONS. . .

Catalyst