II-VI: Technology For The Future (NASDAQ:IIVI)

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As a material science and optics company, II-VI (NASDAQ:IIVI) shows great opportunity for organic growth of its core business along with additional growth from the recent acquisition of Coherent. II-VI post-acquisition will be a global leader in optics and engineered materials, serving many high growth markets such as 5G deployment, semiconductor manufacturing, precision manufacturing, and more. II-VI experienced a significant drop in stock price while in a bidding war for Coherent, giving investors the opportunity to buy a high-growth company at a discounted price.

Overview

II-VI operates two segments: Photonic Solutions and Compound Semiconductors. Historically, II-VI has been primarily a material science company, but the acquisition of transceiver company Finisar in 2019 increased their Photonic Solutions business to about 66% of revenues and the recent acquisition of Coherent adds another big piece to their optics business. This segment has three business units: ROADM, Transceivers, and Advanced Optics. These business units provide components of optical systems that are used in telecommunication, data communication networks, data communication hardware, industrial lasers, and medical lasers along with consumer products like sensors, displays, and projection devices.

The Compound Semiconductor segment develops components of semiconductor capital equipment, such as EUV lithography equipment and laser cutting for super-hard materials, and the following specialty semiconductor materials: silicon carbide (SiC), aluminum oxide, bismuth telluride, zinc sulfide, zinc selenide, indium phosphide, and gallium arsenide. These materials are made into wafers, which are then treated, etched, and combined to build semiconductors. Each type of semiconductor has a specific purpose, which determines the type of material that needs to be used. Semiconductors are used in all electronic devices.

A small, yet important, piece of II-VI’s specialty semiconductor materials is their SiC business. The development of SiC substrates and wafers is crucial to the future of semiconductor manufacturing. SiC is an extremely difficult material to manufacture and takes considerably more time than making the typical Si wafers, but it provides advantages due to its ability to deliver higher voltages, widen the range of temperatures at which a semiconductor is usable, and increased switching speeds.

II-VI products serve a wide variety of end markets. Products from Photonic Solutions enable high speed optical transmission and optical transport, which is driven by the growing need for network bandwidth and the deployment of 5G networks. II-VI also operates in the industrial market, which develops components for precision manufacturing and laser cutting. Photonic Solutions are also used in aerospace and defense products to enable intelligence, surveillance, and reconnaissance devices on military aircraft.

The life sciences market requires II-VI solutions for biotech, such as diagnostics, genome sequencing, and imaging, along with medical lasers. II-VI also makes optical products for smartphones, tablets, computer mice, and other consumer products. The most recognizable application is the facial recognition on the iPhone. Lastly, II-VI optics are increasingly being used in the automotive industry as sensors for driver assistance systems like lane departure warnings and blind spot detection.

On July 1, 2022, II-VI completed its acquisition of Coherent, an optical subsystem company. Coherent operated in the microelectronics, precision manufacturing, instrumentation, and aerospace and defense markets. Each of these businesses overlap with a market currently served by II-VI, creating an optics company that can create both optics components and the subsystems. Microelectronics refers to lasers used in semiconductor manufacturing as well as OLED, LCD and MicroLED displays.

Similarly, precision manufacturing is composed of lasers used to manufacture things like automotive parts, medical devices, and consumer goods at lower costs with more control. The instrumentation market refers to surgical lasers as well as lasers for scientific research. Coherent products served many purposes within aerospace and defense such as directed energy weapons, target designation, laser countermeasures, gyroscopes, and surveillance devices.

Pros

II-VI combined with Coherent creates a company that is one of the biggest in the optics industry. The combined business units, which operate in many of the same markets are better positioned in each segment as they make both components and subsystems, which should stimulate growth and opportunities to scale other areas of the business. Examples include medical lasers, aerospace and defense, precision manufacturing, and sensing. As a combined company with Coherent, II-VI has a broad range of markets to play into due to its ability to create almost any type of laser, laser subsystem, or laser component.

New innovation drives the need for II-VI technologies. Laser technology has grown rapidly and will continue to be used more as technology advances. The deployment of 5G networks is dependent on II-VI for both optical communications and precision manufacturing required to make other 5G hardware. II-VI also plays an important role in the development of the Metaverse with optics and displays. They have even recently collaborated with Artilux to develop a 3D camera to enhance user experience within the Metaverse. They are also finding more ways to embed lasers in the automotive industry with experimental technology that will sense a person’s body position and deploy airbags to the most vulnerable locations on a person’s body during a crash.

II-VI’s aftermarket sales for laser components are strong as they set a record in Q3 2022. While they do not disclose aftermarket revenue, Chief Strategy Officer Giovanni Barbarossa described this combined with record global sales in March as indicating high usage rates for lasers and “a good proxy for industrial activity overall.” End users are increasingly choosing II-VI laser technology because of its unmatched precision and efficiency.

The future of SiC in the semiconductor industry is bright. II-VI believes this as well as they are planning to devote $1 billion in capital expenditure to improve and scale their SiC manufacturing. SiC provides a better wafer compared to Si substrates as it is faster, delivers higher voltages, and can withstand temperature changes better than Si. By enhancing the manufacturing process for a product that is notoriously hard to make, they should improve their competitive position in the SiC market.

II-VI has proven themselves to be adept when it comes to integrating new acquisitions. Since 2010, II-VI has completed five transformative acquisitions across their business units. II-VI’s largest acquisition before Coherent was Finisar, which was completed in 2019. II-VI has been able to grow Finisar’s transceiver business into a large, high margin product for II-VI. The acquisition of Finisar helped increase the photonic solutions revenue by 140.54% from 2019 to 2020. The acquisition of Coherent is expected to increase current revenues by about 50%. There are integration risks for this acquisition including the possibility that II-VI overpaid for Coherent, a miscalculation of synergies, the realignment of management, and the effective merging of groups like research and development; however, acquisitions of this magnitude can be transformational if executed well. II-VI plans to gain significant advantages of scale in research and development, sales and marketing, and manufacturing.

II-VI is currently discounted compared to peers. Some of II-VI’s closest peers include IPG Photonics (IPGP), Lumentum (LITE), and ON Semiconductor Corporation (ON). II-VI experienced a decline in valuation during their acquisition of Coherent due to the previously mentioned integration risks, leading to a buying opportunity for investors. II-VI forward P/E is currently 12.00, while IPG Photonics has 22.39, Lumentum has 13.59, and ON Semiconductor has 13.83.

II-VI also sees discounts in its price/sales, price/book, and price/cashflow valuations, which are 1.74, 1.77, and 8.07, respectively. These valuations are all discounted compared to IPG Photonics which sees valuations of 3.54, 2.07, and 15.16, Lumentum with 3.87, 3.40, and 11.19, and ON Semiconductor with 4.05, 5.70, and 16.10 respectively, according to Zack’s Research. II-VI is valued under the S&P 500 averages, while its competitors are valued close or above average in most categories.

Cons

II-VI experiences cyclicality in some business units. The consumer business has seasonality as its biggest customer is Apple (AAPL), which sees its strongest sales in the calendar fourth quarter. The semiconductor business has, what management believes, a multiyear demand cycle for semiconductor capital equipment. The semiconductor cyclicality is more concerning because it is one of two business segments, which was 34.4% of revenues in 2021.

The laser technology market is dependent on the development or acquisition of new technology. II-VI runs the risk of new competitors developing new technology and current competitors competing for more market share. They must be on the cutting edge of new technology and laser applications to continue their impressive growth.

II-VI has significant exposure to China through their semiconductor segment. About 75% of the world’s semiconductors come from China, which leaves II-VI subject to supply chain struggles from China’s COVID lockdowns as well as political and trade tensions. There is no way around this problem for II-VI unless semiconductor manufacturing moves to more countries. This has constrained II-VI’s growth in their semiconductor business recently due to the semiconductor shortage as shown by their 5.5% decline in Q3 Compound Semiconductor revenue compared to their 31.5% growth in the sector during Q3 of 2021.

II-VI is an incredibly complex company. Their technology and products are not easily understood without significant research. This potentially leads to limited coverage by analysts and a lack of retail investors, which might result in a valuation discount compared to companies with similar growth characteristics and growth opportunities.

Conclusion

With the Coherent acquisition, II-VI is now a global leader in laser technology, optical technologies, and engineered materials. While II-VI has strong competitors across all of its business units, they have become one of the leading companies in a high growth industry. The long-term growth potential is strong, as the applications for optics, lasers, and semiconductors have become more intertwined with everyday life. Optical communications, aerospace and defense, medical lasers, manufacturing, sensing, and SiC all provide great avenues for growth as new products continue to adopt II-VI’s technology.

For example, the automotive industry has adopted laser technology in almost all new cars in the form of driver assistance systems. II-VI has rapidly expanded the past 11 years, growing from revenues of $503 million to $2.4 billion while adding 16 new major products and completing multiple acquisitions. Through this growth, they have shown that they are up to the task of developing new technologies or acquiring and integrating them to stay ahead of the competition.

II-VI stock has performed poorly since it made its initial offer to purchase Coherent in February 2021, having declined by more than 45%. During this same period, the S&P 500 has risen about 7%. The decline in market value is likely due to concerns that II-VI overpaid for Coherent, as it was in a bidding competition with rival Lumentum. The price weakness also reflects concern over II-VI’s ability to successfully integrate Coherent and because it took on additional debt to finance the purchase. While there are significant risks related to the integration of Coherent, I believe II-VI’s discounted valuation compared to its peers, its track record for executing successful acquisitions, and its leading position in a high growth industry makes II-VI an attractive investment, and recommend its purchase for long-term investors.