Description

II-VI is viewed as an optical component supplier in a commoditized industry, but the reality is that II-VI is extremely well position in the supply chain exposed to several megatrends (5G, electrification, LiDAR, AR/VR, IoT). One way to think about II-VI is that Silicon has reached its capacity for conductivity and its starting to be replaced by other materials that can conduct higher power more efficient (e.g., silicon carbide, gallium nitride, indium phosphide). The core of II-VI products is in photonics (science of light, making lasers) and they also have wideband gap materials that are essential for high power conductivity (e.g., Gallium Nitride and Silicon Carbide). I will skip explaining the benefits and comparison, you can easily google or read lengthy sell side notes on how these materials differ and benefit chips vs chips on traditional silicon. We think the stock can easily double by 2023 to $120 and over $150 by 2025 based on conservative estimates and a 20x earnings multiple, which is a premium to II-VI 15x and COHR 17x average during the last 5 years, but a higher multiple is reasonable because the growth areas that are small Today will become a higher % of the future mix, and the combine company will be significantly stronger in the supply chain. There is also the fact that each company have traded above 20x P/E for several times during the last 5-years, and II-VI was being more appropriately valued at $100/share a few months ago until COHR acquisition was announced.

Why the opportunity exists?

In addition to being a hard company to model which shies away some investors and viewed as a cyclical name, the key event that created this price dislocation started back in March when II-VI entered into a bidding war to acquired laser company Coherent, which is exposed to the cyclical OLED screen market. Investors were also not happy with the $7 billion price tag to acquire Coherent, plus the increasing leverage (adding $3.4bn in new debt + $2.1bn in Pfds, effectively going from net cash to ~3.5x leverage post-merger). With no other near-term catalyst, the stock went on to decline to mid-to-high $60s and later to low $50’s after postponing the expected merger conclusion from Dec/’21 to ~Mar/’22.

What the market is not realizing is that the combine company will be a laser powerhouse and if you talk to any experts in the industry, you will hear that Coherent is seen as the golden standard when it comes to laser technology. We are confident that the combined Company will take share in each of their respective markets as well as new markets, for example, threatening IPG’s leadership on high power lasers that are essential for EV battery welding (an upcoming huge market). The market is also not paying attention that the cyclical markets that each company is exposed to (OLED and telecom/datacom spending) all have positive outlooks for the next few years. And probably the biggest and obvious untapped value within II-VI is their silicon carbide business. To illustrate this, just look at Wolfspeed with a $10 billion market cap while the market is assigning a ZERO value for II-VI’s SiC is business, despite II-VI currently having 50% share in the commercial SiC wafer market and being the only other company with 30+ years of experience growing silicon carbide crystals. At the current $59 share price, you are getting SiC for free and only paying 16x earnings for 2022 Pro-Forma (ex-synergies).

Bain Capital is providing the $2.1bn in total Pfds. They will effectively own ~16% of the PF company assuming they convert at year 5 and take full dilution effect of the interest in PIK. Another way to look at this is that those Pfds have a 5% PIK for 4 years and they convert at $85/share. So if you make the math the $2.15bn of Pfd becomes $2.489bn in 4 years. So dividing 2489 by 85 gets you 30.75 shares, if we divide 2.15bn by 30.75, Bain is effectively buying the common at $70/share. So you get to buy shares 20% below Bain Capital.  

II-VI currently reports in 2 segments: Photonics Solutions (65% of sales) and Compound Semiconductors (35% of sales). They also breakdown by end markets (Industrial, Communication, Aerospace & Defense, Consumer, Other). We don’t find the way they break-down sales very helpful for modelling purposes, so we had to dig deeper from earnings calls and talk to the company to come up with a different revenue break-down (see below).

And this is Pro-Forma with Coherent.

Thesis summary:

·         Optical Communications & Wireless or we can call it “Telecom/Datacom”– (44% of Pro-Forma sales)

o   Positive customer’s capex spending outlook at least until 2023 but most likely extending to 2025 and beyond.

o   Telco industry is carrying aggressive fiber builds (see charts 1 and 2 below). AT&T and Verizon plans to more than double its fiber subscribers by 2025

o   Except for T-Mobile, Telco is also in early days for 5G buildout. Just look at AT&T, Verizon “the Big 2” are combined rising capex spending by > 30% by 2022.

o   Hyperscalers are entering a replacement cycle for higher bandwidth equipment for the 200-300 meters distance. This is due to increasing need of data to be transfer within the same data center (e.g., AI/Machine Learning, edge network). As higher bits of data are required to be transferred, the distance reach of the typical “electrical transceivers” decreases. So in order to maintain the same 200-300 meters distance reach for more data to travel, those transceivers need to be replaced with optical transceivers based on VCSEL. We are only aware of 2 companies that makes VCSEL lasers at scale (II-VI and LITE).

o   Datacom overall is also going to a replacement for higher bandwidth throughput transceivers > 100G, and II-VI has a higher exposure to Cloud (30% of standalone sales vs ~7% for LITE). IoT, EV cars, eventually autonomous cars, AI/ML, edge networks, all these are ongoing trends that will continue to increase the need for next-gen transceivers and ROADMs.

·         OLED (~15-17% of Pro-Forma sales)

o   Coherent has a monopoly on “excimer lasers”, and this is the only laser that can cut glass substrate for manufacturing OLED screens.

o   Right now, the OLED market is an upcycle. The last time the market peaked was in 2018 and Coherent did $1.9bn in sales. Sell side estimates are calling for $1.7bn in FY23 total sales. We think those estimates are too low because we see reasons to believe the next peak should be bigger. OLED is thinner than LCD, leaving more space for larger battery which 5G phones will need and Apple is qualifying BOE as a 2nd supplier of OLED, disrupting Samsung monopoly. This is a HUGE catalyst for the OLED industry, as it will increase overall supply, thus decreasing unit cost, making OLED cheaper and able to accelerate penetration across multiple electronic devices that are currently using LCD. There are only 200-300 million smartphones shipped annually with OLED screens, from a total of 1.4 billion smartphones shipped globally. These are mostly iPhones and Samsungs, but as price decreases it becomes viable for other less expensive phones.

·         Silicon Carbide (3% of Pro-Forma sales, we estimate to become 9% of total sales by 2025 and 20% by 2030)

o   II-VI generated $150m in SiC sales, limited by capacity. Those sales are going entirely to the commercial wafer market. They have a 50/50 share with WOLF. The difference is that WOLF also makes wafers for internal use as they have epitaxial process and also make SiC devices and modules.  However, II-VI made recent acquisitions adding epitaxial and a recent license deal with GE for making devices and modules. Worth noting that GE have 20+ years of experience with SiC. As an example, in 2020 GE introduced the first aviation SiC converter. We think the market is completely ignoring the relevance of this deal.

o   SiC market size is projected to reach north of $5bn by 2025 from ~$500m-$1bn in 2020 where roughly 1/3 will be commercial wafers and 2/3 devices and modules. Recent fab announcements are making investors think this will become commoditized just like Silicon, but these fabs are coming from device manufacturers that just want to guarantee they won’t suffer any shortage in wafers. The reality is that quality matters a lot and II-VI will continue to be the #1-2 supplier of the best quality wafers. Their capacity should also be the highest or second highest as they are investing an additional $1 billion. (See table below)

o   Silicon Carbide is a significantly more complex material than traditional Silicon. To create the perfect crystal structure, each carbon needs to find the exact location in the crystal structure. Atoms that don’t fall into the right place generates defects in the crystal. Defects cause electronic devices to fail under high voltage/high temperatures. Larger wafer sizes become harder to make all atoms find the perfect places. These crystals must grow in extremely high temperature (~2400 Celsius) which makes it even harder. Competitors will not figure this out in 2-3 years, it will take them a lot longer. For example, the #1 concern we had was if the Chinese would commoditize this market. After talking to a lot of industry experts and several companies we came back confident the Chinese are at least 7-10 years behind in R&D from getting to where II-VI and WOLF are Today in terms of quality with scale.

o   The real opportunity starts after 2025. It is estimated that by 2030 this can be a $30bn or $40bn TAM (half EVs, half industrial power applications. A simple sensitivity at 10% market share @ 20% EBIT margins and 15x P/E would imply the SiC biz alone could add $50 per share in value.

·         3D Sensing (6.7% of Pro-Forma sales, we estimate become ~9% of sales in 2025)

o   IIVI became the 2nd supplier to Apple for VCSELs and gain a lot of share over the last 2 years. Right now, the entire market is basically Apple. There are only 2 companies that make those VCSELs at scale (II-VI and LITE), so they hold a monopoly and split a ~50/50 share supplying Apple. The market opportunity is big as there is a lot of growth areas for this product going forward (automotive LiDAR and in-cabin ADAS, more electronic devices with faceID and biometrics, VR/AR that also need to scan the surroundings). Within the smartphone market alone, android is highly under penetrated, leaving over ~1 billion smartphones that are yet to adopt VCSELs. FB is pushing metaverse even more aggressively, recently announcing 10k hires in Europe, in addition to the 10k people already working full-time on it. They did a deal with Ray-ban for smart glasses. Apple is close to launch their smart glasses. These are just examples of upcoming near-term products that require VCSEL lasers. II-VI did ~$300m in VCSEL/3D sensing sales in FY2021 and we think they will conservatively do $670m by FY25.

·         Semi Cap Equipment, Life Science, Industrial and Military (these 4 end markets make 16% of Pro-Forma sales in aggregate)

o   I admit is hard to get too granularly in modelling these smaller segments, but at a high level, you can feel comfort in the sense that II-VI’s products going into those markets are all facing tailwinds as lasers increase overall penetration. Within the semi cap equipment, the demand has never been stronger. Between 2020 and 2024 there were 72 new fabs planned to come online, where 20 are coming online in 2022 alone. Military spending is growing. Life Science and Industrials also need more lasers for more diagnostic machines, surgical procedures and the increasing need for lasers for electronic manufacturing as electronics keep getting smaller, lasers are required for making those thinner cuts and welding. As I said previously, the combined company will become a laser powerhouse, and essentially own the best industrial lasers. The only area that it won’t have a clear instant dominance is in the high-power fiber lasers that is dominated by IPGP, however we think they can seriously threaten this leadership (more on this below).  

 VALUATION

COHR had 22% operating margins during last OLED peak cycle and II-VI has achieved 19% margins before. We assume 23% op margins inclusive of synergies and that’s conservative. If you look at FY21 Pro-Forma sales of ~$4.6 billion and take the announced $250m synergies, that’s 5.4% (or 4% after-tax).

We also know that COHR had cost cutting plans of their own and we heard from mgmt. that synergies are not taking into consideration synergies in China. II-VI has a lot of physical presence in China while COHR has none, but COHR has a lot of services businesses in China.

We assume 20x earnings as more appropriate, but even at 15x it looks attractive.

Two areas we decided to leave out of our model, but we think it can add a lot of additional upside.

High-power fiber lasers going into EV battery welding

With the gigantic ramp in EV production, there will be a similar ramp in EV batteries. High power lasers are required for battery welding. This is where IPG has a dominant market leadership and where Chinese laser peers have struggle to gain share.  This will be a gigantic market. During the M&A call management gave a little hint into this potential opportunity, and we think they don’t want to disclose too much. Our conversations with former employees indicated this can be a big play and they think combined with II-VI’s capabilities, their laser will be of better quality than IPG. Coherent bought a company called Rosfin in 2016 that had a very good fiber laser technology and Coherent further developed in-house, however, they never commercialized this technology as they had zero business in the automotive industry. So that business never took off. Auto OEMs are hard to supply to. Design developments are years in advance and if you are a new supplier, it can take years to become qualified. On the other hand, II-VI have a lot of auto business and they make the additional electrical components and the software that controls the lasers, while COHR makes the more advanced proprietary components of the final machine which is the IP secret sauce for those fiber lasers. II-VI also has larger wafer scale at 6-inch than even IPG. So we think this can be a significant driver of growth but we decided to leave out of our numbers.

EV battery technology

II-VI recently unveiled that it has been working on lithium-ion batteries, specifically for cathode. They envision being part of the supply chain, supplying cathode materials (advanced sulfur and selenium cathodes) for battery makers. Most cathode chemistry is based on cobalt oxide, and the idea is that II-VI will replace cobalt with sulfur, which can store more energy than cobalt. This knowledge has been known in the industry for years, but the reason it hasn’t been commercialized yet is because sulfur migrates from cathode into electrolyte over time, degrading the battery. IIVI claims they found a way to fix that. Nonetheless, they say they’ve been working on this for the last 7 years and I don’t believe they would come out with this announcement if it wasn’t a serious development. They even hinted a go-to-market timeline of 2025. The battery hype has been around solid-state batteries and they said this technology can work in both liquid and solid-state batteries. This is completely new development, so we view as a nice free call option.

Key Risks:

1)      Biggest risk we see is a slowndown in Telecom & Datacom spending, but we don’t see any signs of this. It’s important to distinct spending going to low data speed products under 100G from higher speed products over 100G, which is where II-VI is gaining share.

2)      The other cyclical market to watch is the OLED, but we see as positive outlook as well. MicroLED is a new technology that also threatens OLED as its cheaper, but we think it’s too early and COHR is also working on that technology.

3)      China laser market is a risk. Currently II-VI is the key supplier of pump diodes and has been actually benefiting from the domestic Chinese laser peers that have been gaining shares since II-VI supplies all those companies. If Chinese start making competitive pump diodes it could be a headwind, however we think is a 5% sales headwind at the most.

4)      SiC is another key item to watch. We don’t see this getting commoditized and think quality will matter more than quantity, however ramping capacity is always a challenge. Good news is that II-VI has the 2nd largest capacity globally and even announced another $1 billion investment which is not being accounted in the table below. We think they will maintain #2 in global capacity after WOLF.

Keep in mind there the SiC capacity additions are changing by the day, so this table may not be fully up to date.

Catalyst

- Coherent merger in Q1 2022