Description

Our investment thesis for II-VI is exceedingly simple: Here is a stock that has historically traded at 20x FCF, but currently trades at less than 12. If that were not enough, the stock has about a fifth of its market cap in cash on the balance sheet not included in the FCF multiple, and a very valuable call option (one likely to be cashed in deep in the money in our opinion) on a relatively large acquisition that the sell side has almost unanimously hated. We think the stock is very attractive here.

Company Description

II-VI (pronounced “two six”) is a mini-industrial conglomerate made up of five segments that have been put together over the years through acquisition. The unifying thread among the disparate businesses is a focus on optics/opto-electronics (primarily lasers and telecom-related optical components) and engineered materials (also primarily related to lasers, but also some non-optical materials that we’ll discuss in the segment breakdown). These segments are as follows:

• Infrared Optics

• Near-Infrared Optics

• Military and Materials

• Advanced Products

• Active Optical Products

We’ll take you through each of the first four segments, as well as its relevant financial history. We’ll wrap it up with our valuation, a discussion of the free option you get with the recent acquisitions that make up the Active Optical Products Group, and some other reasons why we like II-VI as a long term holding.

Segment Analysis

Infrared Optics - this is the segment that II-VI started with when it was founded in 1971. Infrared optics deals almost exclusively in optical components that go into CO2 lasers, mostly high-powered models that are used in industrial applications such as cutting, welding, drilling, heat-treating, etc. The TAM for CO2 optical components is estimated by the company to be about $500M annually, of which II-VI is the biggest player with somewhere in the range of 35% market share. The components made by II-VI for CO2 lasers generally require highly engineered materials such as Zinc Selenide and Zinc Sulfide, which II-VI produces internally at low cost (its key competitive advantage in this area).

• Beyond CO2 Laser components, II-VI also operates the HIGHYAG subsidiary in this segment, which manufactures and markets add-ons for one micron laser systems such as laser processing heads and beam delivery systems. This business accounts for about 12% of segment revenue. For a discussion of CO2 systems, and one-micron systems, see below.

• II-VI also has a very small CVD diamond business in this segment that is mostly dedicated to the EUV Lithography customer base. This has been growing rapidly, but off a very small base and is currently in the mid-single-digit millions of dollars in annual revenue.

The financials here for the past few years are as follows:

The key numbers here are:

                 2013       TTM

Revenue:   203M       208M

EBITDA:     58M        54M

Maintenance capex here is minimal, EBITDA margins are quite high, and pre-tax returns on total assets are >20% range, which is very high (remember this is an industrial business, and we’re using total assets as the denominator - ROIC is likely much much higher). The TTM number is a bit skewed because II-VI does not try to embellish its perceived performance by separating “corporate” expenses into a different bucket, and the two quarters thus far in FY14 have had large corporate expenses due to acquisitions, some restructuring, and growth of headcount at headquarters to account for the larger businesses II-VI is now running. Based on our conversations with management, these expenses should normalize in the next few quarters and margins should come back to historical levels. Additionally, revenue growth in this business has started to accelerate in the last 4 quarters so we are optimistic here in the near term.

We might as well address the bear case on II-VI here because it is centered in this segment, and we’ll preempt at least some of the questions that we know we’ll face in the comments. Yes, we know that solid-state one micron lasers, primarily fiber lasers today and probably direct diode lasers a decade from now, will over time replace the majority of CO2 lasers out there. Historically, II-VI’s very generous multiple was due to its unassailable dominance in the CO2 laser business. But as it stands right now, there’s almost no question that over time, CO2 lasers will be on the out, and solid state lasers will replace them (this is for a variety of reasons including power efficiency, but coming down to total cost of ownership). The key words there, though, are “over time” - this is going to take a while. There are about 60-70K CO2 laser systems out there, depending on who you ask. These systems last for >20 years, and new ones are still being sold as we speak (about 3500-5000 per year, also depending on who you ask). In fact, enough new systems are being sold that the stock of CO2 laser systems in existence is actually increasing. In my extensive discussions with management at II-VI, their expectation is that we will reach “peak-CO2-laser” sometime over the next decade, probably around five years from now.

Now, given that 90% of II-VI’s business here comes from repair and replacement parts to the stock of systems that exists out there, and not selling the components to the systems manufacturers for new machines, the total market here will grow for at least a few more years. In addition, II-VI is now in the midst of a major market share initiative in which it intends to sacrifice a few percentage points of EBITDA margin in order to gain share (you can already see this as EBITDA margins are down 150bp in FY13 vs FY12). This makes a lot of sense to us - in a mature business where the market’s growth is slowing and where II-VI has very significant cost advantages, it is in II-VI’s best interest to sacrifice some margin now, gain share, and when the market starts to slowly shrink 5 years from now, keep the revenue growth going through price increases. Thus, we see this business as a growth business - albeit a MSD and then LSD growth business - for the foreseeable future. Additionally, the HIGHYAG and CVD Diamond businesses (about 15% of segment sales) are similar margin-profile businesses, and the former actually benefits from the increased sales level of fiber lasers while the latter is unrelated to the industrial laser business and stands to benefit from the move to more advanced processes in semiconductor fabrication.

Near-Infrared Optics - Beyond our responses to the bear case that we mentioned in the IR segment, we believe that the Near-IR segment is the most underrated piece of II-VI and will provide the growth and rerating catalyst in the near to intermediate term. This entire segment, as it is currently reported, did not exist at II-VI before 2010, but is now arguably the most important driver of both revenue and earnings growth. The segment is comprised of Photop, a China-based company that develops, manufactures, and markets optical components, primarily for the telecom markets. Optical components and subcomponents that Photop manufactures and sells run the gamut of telecom equipment and include wavelength management components and modules, power management components, switch and routing components, etc. The best comp for this business is a company like JDSU, but as we shall see shortly, II-VI runs a much tighter higher-margin business than JDSU. Photop also does some optics business in the non-telecom arena, mostly related to fiber laser subcomponents, but this is a generally small business and accounts for less than 5% of segment revenues.

We present the relevant financials below:

There is frankly not much to present before 2011 because the business was only acquired in mid-2010 in the first place. The key numbers here are:

               2013     TTM

Revenue: 155M     153M

EBITDA:   37M      30M

What’s interesting to note here is that this is commonly viewed by the II-VI shareholder base (at least based on the people we’ve discussed our idea with) as the lower quality business segment. To the extent that the pre-tax ROA here is somewhere in the 9% range on 2013 numbers, it’s true that it’s a lower quality business than the core IR business. That said, there’s about $60M in goodwill in the asset base here, the elimination of which gets you to a pretax ROTA of about 11.5%. Additionally, the capex requirement here is higher because this is a growth business. Photop is an Asia-centered optical components company and it has been left twisting in the wind waiting for the official word on the upgrade to 100G. It has geared up the capacity and cost structure for Chinese 100G business, but that business has not yet manifested itself. Thus, the 2013 numbers show a level of revenue that includes significant cost pressure on the 40G side as general industry capacity increases (in expectation of 100G) have led to significant pricing pressure on 40G components. Even in the face of these business conditions, II-VI has managed to earn 24% EBITDA margins and double digit pretax returns on assets (which are higher and actually attractive once you turn those into ROICs). When you look at competitors like JDSU that trade at 12x Peak EBITDA and 20x TTM EBITDA, but generate EBITDA margins 1500bp lower than Photop’s (not a typo), you start to wonder what Photop would actually be worth as an independent entity without everyone focusing on how fiber lasers will eat II-VI’s lunch.

Anyhow, we are now seeing the “Chinese hockey stick” of 100G awards starting to filter out over the past few months. This will be pretty big news for Photop, and margins as this upgrade cycle accelerates will probably go back to the 30% range where they were in 2011. This is a cyclical business, no doubt about it. But Photop has shown that it can earn 25% EBITDA margin on average over the course of a cycle, and we think this would be given a very generous valuation if it were trading independently.

Military and Materials - In this segment, II-VI runs 4 mostly disparate businesses that cater to the defense industry with customers such as Lockheed and Raytheon:

• Lightworks is an optics-focused business focused on products such as infrared materials and components, as well as full-fledged manufacturing and assembly of optical systems and parts for defense OEMs.

• Max Levy Autograph is basically in the business of manufacturing precision patterns on specialty substrates. A good example of this is printing chrome on a glass substrate in a particular pattern such that the glass can be used in an x-ray system to allow the transmission of the appropriate wavelengths of light. Some of the more secretive stuff that MLA works on is proper patterning on defense equipment so that it is immune from electromagnetic jamming and interference.

• VLOC - a troubled part of the military and materials segment (and a significant part of the recent earnings guide-down for FY 2014), VLOC manufactures specialized optical components and grows crystals for applications in the defense industry. Some of the stuff that VLOC does is replicated in other parts of the II-VI “empire” but VLOC tends to have a very specific focus on battlefield applications and works exclusively in defense-related fields.

• Pacific Rare Specialty Metals, or PRM - this business used to supply tellurium and selenium to third party customers, but as of the crashing of the markets in those materials, II-VI restructured the business and PRM now works to provide these materials solely to other arms of II-VI that use them as raw materials. PRM does include a small business that refines certain rare earth metals for third party customers.

The relevant, but confusing, financial information is as follows:

2010-2013 are anomalous years. In 2007, II-VI acquired the PRM business we discussed above for $5M - that was sort of a ho-hum business with a solid revenue stream, but nothing really spectacular. It was based on the Phillipines, and it sold tellurium and selenium. In 2010, the rare-earth metals craze kicked into high gear, and tellurium and selenium prices increased dramatically. Suddenly, PRM was generating incremental EBITDA of $10M (see the EBITDA jump from 2010-2011 without much in the way of new acquisitions aside from MLA). Not bad for a business acquired for $5M. Unfortunately, 2012 saw those revenues and EBITDA crash and burn and start producing serious inventory writedowns. We calculated the EBITDA margins both including and excluding those inventory writedowns. The good news here is that the inventory writedowns are over, and revenue growth and margins have been on a tear in the past two quarters (revenue growth has been +15% YOY for both FQ1 and FQ2 of 2014, which ends June 30, and EBITDA margins have clocked in at 20% and 23%, respectively). We don’t expect the torrid pace of revenue growth to continue given the uncertainty of government spending as well as II-VI’s preannouncement guiding down earning partly based on the M&M segment. But we think EBITDA margins will more permanently climb back to the 14-16% range we saw before 2010, and that EBITDA for this segment will be in the $15M range for FY14 and $17M for FY15, with EBITDA minus Maintenance Capex coming at around $10-12M. We’ve already seen EBITDA-Capex come in at $8.5M in the TTM, and we think it will be a bit higher already for FY14 ending this June, and growing for FY15 as government spending uncertainty is resolved.

Advanced Products - this segment is also kind of a smorgasbord of businesses, all focused on specialty materials:

• Marlow, acquired in 2005, focuses on thermoelectric cooling technology and materials and will manufacture anything from the components of such systems to fully functioning systems that will go into OEM products such as seat-cooling systems in cars.

• Wide Bandgap Materials Group, or WBG, grows Silicon Carbide materials and produces SiC wafers for semiconductor applications that require high performance at extremely high temperatures or high power. SiC substrates are used in applications such as LEDs, high-radiation environments, and high-frequency semiconductors.

• M-Cubed, acquired for $74M in FY2013, specializes in high-performance precision equipment in a variety of end-uses. These include ceramic wafer chucks for the semiconductor equipment industry, as well as various other precision materials used in power generation, automotive, defense, and nuclear applications.

The relevant financials for the group are as follows, but the M-Cubed acquisition makes it a bit confusing in 2013:

The business for the past few years has been a bit lumpy.

• The revenue/capex ramp in 2011-2012 was a function of Marlow winning the contract for the XBox Kinect motion sensor, and then being designed out and losing the revenue for the second half of 2012.

• The revenue ramp of 2013 is a function of the M-Cubed acquisition in Q2 of that year, offset by $10M in revenue declines due to the XBox contract loss. The margin decline in 2013 is a function of a bit of acquisition expenses, as well as the XBox revenue decline.

Key metrics here for 2013 vs TTM are:

              2013      TTM

Revenue: 96M       113M

EBITDA:  10M       15M

The twelve trailing months include a full year’s worth of M-Cubed revenues, probably in the $50M range, and FY14 will have a full year worth of M-Cubed revenue, and also start to see the ramp of Marlow winning some auto seat-cooling business. EBITDA margins for TTM have already increased to >13%, and will probably be a bit higher for FY14 given the ramp in the auto-seat-cooling business. We think it’s conservative to estimate normalized EBITDA margins at 15% (although that is what the segment will probably earn this year), because the M-Cubed annual revenues will reset at a much higher rate once semicap equipment spending for the next generation of process nodes gets under way (and that’s true whether we see EUV being used or 450mm wafers - either one will require the precision, light weight, and very high strength/weight ratios of the materials that M-Cubed engineers).

Sum of the Parts

Putting all the above numbers together gets us to a normalized EBITDA number, which we expect to be achieved in FY15 (ending about a year from now), of about $135M, with EBITDA-Capex of a bit over $100M. Add back in about $10M in stock-based comp, which is included as an expense in all the above numbers, and subtract about $8M in gross interest expense, and our estimate of 2015 pretax earnings is about $105M. Tax that at 25% for an FCF estimate of around $78M on today’s market cap of $916M, for a multiple of just under 12x. Given the strength of the businesses as outlined above, their attractive ROICs, and the significant catalysts of Chinese 100G spending, military spending uncertainty going away, and the next wave of semicap equipment spend brought on by the next generation of process nodes, we think this is a very attractive multiple to pay for the company.

But Wait, That’s not All!

The reason the street has been pretty negative on II-VI definitely has a lot to do with the perception that the business is almost entirely sensitive to CO2 lasers and that this business is dying. As I hope you realize by now, neither of those things are true - though they do contain elements of truthiness. To add to the street’s negative view, II-VI did a pair of acquisitions in the first and second fiscal quarter of 2014, which the street perceives as a last ditch effort of II-VI to stake a claim to some of the fiber laser market, and nobody thinks that II-VI will be successful. To that end, we wanted to discuss the acquisitions and explain why we think they will be valuable in the areas on which nobody seems to be focused.

The two acquisitions were done in quick succession:

• The Semiconductor Laser Business from Oclaro, which itself has 3 pieces:

• High power laser business that makes components for solid state lasers, primarily components that make up the most important part of the laser system - the diode.

• Vertical Cavity Surface Emitting Laser (VCSEL) business that manufactures components for lasers like those in an optical mouse.

• Pump Laser business - these are lasers that go into optical amplifiers that are sold to telecom equipment companies.

• Fiber Amplifier and Micro-Optics business from Oclaro

• This business manufactures the optical amplifiers in which the pump lasers go. These amplifiers are used in telecom equipment to amplify optical signals in data and communication networks.

We see two major upsides to the business, one of them speculative, and one of them close to a slam dunk. The more speculative one is the high power laser diode business. Currently, IPG Photonics dominates the fiber laser market with 60-70% market share. The reason for this is that IPG is totally vertically integrated and can manufacture its diodes cheaply. There are other fiber laser manufacturers, but they aren’t very competitive in their cost structure with IPG, primarily because they don’t produce their own diodes - they buy them from third party suppliers. One of those suppliers is the Oclaro High Power Laser Diode business that II-VI acquired. Unfortunately, at the current cost structure and resulting diode price, this business is not able to help IPG’s competition. Those who are familiar with Oclaro know that the operational reputation they have can be summarized in one word: disaster. The opportunity here is for II-VI to use its current manufacturing facilities or rationalize the Oclaro facilities in order to cut costs and sell a competitive diode - this would have the double effect of both making the current business they acquired profitable, while also kickstarting IPG’s competition to the point where they are able to gain market share through lower costs. This all sounds like a great story. Will it happen? We’re not betting on it at all. The analysis above essentially assumes that II-VI blew $190M on two acquisitions that will generate nothing in the way of profits. Ever. But if II-VI is successful in the laser diode business, this is a $50M revenue business today that will be growing really fast.

The more interesting opportunity in these acquisitions is the $100M+ in optical telecom equipment sales that II-VI acquired (pump lasers and amplifiers). The way Oclaro ran their operations is that they essentially outsourced all the subcomponent assembly, then assembled the components of this equipment themselves in high-cost facilities in Europe. II-VI will bring 100% of the subcomponent assembly in-house because it already has it in Photop. And it will move the assembly of this equipment to China. And it will also take advantage of the fact that its Photop customers don’t think it’s an inept operational disaster like Oclaro. This will take 1-3 years based on our discussions with management, but they seem extraordinarily certain that they will be able to generate solid profits from this business. If this business were to generate 20% EBITDA margins, we’re talking about a significant increase in II-VI’s earning power. Plus, management thinks that the increased throughput in the Photop facilities will bring down the costs for the Near-IR segment, so margins there could expand further. Again, we didn’t value this in the above analysis, but we are almost certain that there is significant value here that no one on the Street is discussing just because it can’t be estimated for the time being.

In addition to the Oclaro acquisitions, II-VI also has $200M of cash on the balance sheet. We didn’t count this cash above in our FCF yield, because we consider this a non-core asset - there’s no good reason for II-VI to have the cash on the balance sheet, besides the fact that it’s mostly stashed overseas. But the way II-VI structured the Oclaro acquisition will allow it to bring back that cash as debt repayment over the next few years, which will probably be used for share buybacks given the amount of acquisition integration management currently has to deal with.

Finally, we would be remiss if we didn’t mention that this is a management team that we have a lot of respect for. They allocate capital well, they run a very tight ship, their manufacturing facilities generate margins that are the envy of their comps, and their history of acquisitions is actually extremely impressive. To wit:

• They spent $4M in 2008 buying 75% of the HIGHYAG business and $9M recently to buy the rest of the business. For $13M, they acquired a business that currently does >$5M in EBITDA annually.

• The various parts of the Photop business were acquired for $140M in 2010 and 2012 and they generated - in a bad year - $30M in EBITDA and close to $40M in peak EBITDA.

The jury might be out on the hundreds of millions invested in recent acquisitions, but their track record is not one of speculative gamblers - it’s one of skating to where the puck is headed.

So here’s what you get when you buy II-VI today:

• A set of high quality businesses that trades at 12x FCF and is moderately leveraged at 2x EBITDA

• Significant upside optionality in competing in the fiber laser space

• In-the-bank cost synergies in its optical telecom components business, but where the amount of cost savings is currently uncertain

• $200M in cash

• A management team that has allocated capital well historically, and owns 15% of the outstanding stock (10% owned by founder and chairman of the board who is no longer the CEO as of 2007, CEO owns 2% of the stock). This is also a culture that eschews “non-GAAP earnings,” doesn’t excuse itself with “one-time charges” and counts stock-based comp quite legitimately (though we prefer to subtract it).

Catalyst