II-VI Inc (IIVI) 2006 Q4 法說會逐字稿

Good morning. My name is Stephanie, and I will be your conference operator today. At this time, I would like to welcome everyone to the II-VI Incorporated fiscal year 2006 fourth quarter and year-end earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you. Mr. Creaturo, you may begin your conference.

Thank you, Stephanie, and welcome to the fourth quarter fiscal year 2006 II-VI, Incorporated investor teleconference. As a reminder, this teleconference is being recorded on Tuesday, August 8, 2006. The forward-looking statements we may make during the teleconference speak as of today, and we do not undertake any obligation to update these statements to reflect events or circumstances occurring after today. Joining me today is Fran Kramer, our President and Chief Operating Officer. The prepared comments for today's teleconference include a review of the highlights and key points from a financial perspective and a business and operational review. Following these prepared comments, we will conduct a question-and-answer session. We're making a change in the format of this conference call, and we'll try to limit repeating information already presented in the press release.

There are about eight item that I would like to highlight regarding the financial performance of II-VI, Incorporated. First, the most obvious item in our press release is a recognition of approximately $17.6 million of a goodwill impairment charge for our Exotic Electro-Optics business unit during the just completed quarter. In the fourth quarter of each fiscal year, we perform impairment testing for all business units with goodwill balances. This year, the Step I impairment analysis that we've done for EEO determined that an impairment may be present, and during the Step II testing, the magnitude of the impairment was determined. The operations are improving at EEO, and have been doing so over the last two quarters, and we are squarely focused on improving the financial performance at EEO in the years to come to build on these recent improvements. With the impact of these non-cash, non-tax charges removed from our financial results, as more fully described in the last reconciliation in the press release, our quarterly earnings were a record at $0.31 per share, and our fiscal year 2006 earnings were also a record at $0.95 per share.

Second, the company backlog of June 30, 2006, remained strong, at approximately $85 million and reflected a full year booked-to-go ratio of 1.04. The backlog of June 30, 2005, was approximately $75.5 million. The components of the June 30, 2006, backlog are Infrared Optics at $25 million, Near-Infrared Optics at $21 million, Military Infrared Optics at $19.5 million, and Compound Semiconductor Group also at $19.5 million. Backlog is defined as bookings that have not been converted into revenues by the end of the reporting period. Fourth quarter bookings increased 17% over the same period last year, and we expect to see further bookings growth as we enter fiscal year 2007.

Third, our cash flow for the past fiscal year was very strong. This record level of cash generation was sufficient to fund our capital expenditures of nearly $15 million, pay down our debt by nearly $14 million, or 30%, repurchase $5.2 million of our company stock, and complete the acquisition of our German distributor for about $1.6 million. Our cash balance of June 30, 2006, increased to $26.9 million, or 24% over the prior year. Our lower debt balance gives us greater flexibility to address opportunities in the future.

Fourth, the payable effective tax rate changes before the special charge that were made this quarter were primarily a result of a mix change in our foreign source earnings versus our domestic source earnings. This resulted in more earnings than forecasted being taxed at, say, 10% to 20% tax rate versus higher rates in the U.S. This has the effect of reducing our full year effective tax rate to approximately 27% from the previous forecast in excess of 29%. During the quarter, the effective tax rate was approximately 20%. We expect the tax rate for fiscal year 2007 to approximate the rate for the just completed year with a slightly higher rate as a potential based on the expected financial performance improvements from our domestic operations.

Fifth, the gross margin for the quarter ended June 30, 2006, from manufactured products was 41.9% of revenues, even in line with our expectations, and was also consistent with the third quarter margin. This performance brought the full year gross margin up to 40.8% of revenues. We continue to take advantage of our international manufacturing operations, and are working to pass on increases in raw material prices for silicon and copper to our customers. We are encouraged by the significant increase in incoming revenue over the last six to nine months. We believe that with continued operation performance from our military infrared optics business, combined with expected improvement of certain other businesses, our fiscal year 2007 gross margin is expected to improve from the fiscal year 2006 level on a percentage of revenue basis.

Sixth, much of the improvement in the top line and bottom line performance for II-VI for fiscal year 2006 was due to solid financial performance from the Compound Semiconductor group by active sales and marketing, focusing on cost reductions, [inaudible] internationally in track training, particularly in Vietnam, and enhancing our crystal growth capabilities, this group improved its segment earnings year over year by $3 million. Our Marlow subsidiary continues to perform well, as it concluded its first full fiscal year under II-VI ownership.

Seventh, our selling and general administrative expense for the quarter as a percentage of revenues was 21.7%, and within a level comparable to the first and second quarters of the fiscal year. During the quarter, costs were up at service providers and legal expenses were higher than forecasted, and the company also recognized certain non-tax expense with regards to the II-VI stock held by the company's deferred compensation plan. Further, our record levels of bookings, revenues and earnings prior to the special charge led to additional increases in our worldwide profit-driven bonus programs. While full year selling, general and administrative expenses as a percentage of sales was 20.7%, it is our expectation that this metric for fiscal year 2007 will be reduced and may decrease under 20% toward the end of the fiscal year.

And finally, one last item to report on. During the quarter, the company completed the repatriation of $5.5 million from our international operations to take advantage of an 85% reduction in the repatriation rate under Section 965 of the Tax Code. While this caused a one-time increase to tax expense for the year of about $300,000, it resulted in a permanent cash savings to the company of over $1.6 million.

This concludes the financial highlights and key points, and Fran will now give a business and operational review. Fran?

Thank you, Craig. In following the theme of making this conference call more focused, rather than repeating information already contained in the press release, and to reflect an adjust completed fiscal year, I'll make my comments on the businesses of II-VI on a full year basis. We'll have time during the q-and-a session to answer any questions of a quarterly nature.

Infrared Optics business unit achieved record bookings during fiscal year '06, and we expect that order rates will exceed this level in FY '07. During FY '06, annual bookings growth at our subsidiaries in Singapore, China, Switzerland, Japan, Belgium, and Germany all significantly exceeded our expectations. Encouraged by the rapid industrial growth in China and Eastern Europe and the accompanying installation of large numbers of laser machines in these regions, our major OEM customers forecast strong replacement optics demand in fiscal year 2007. In FY '06, orders for our zinc-based materials used in optical components for military surveillance and targeting systems more than doubled compared to the prior year. Raw material costs for many of our optical substrates rose dramatically during the last year. Power silicon scrap material necessary for the production of single crystal silicon mirrors has increased in price as demand for solar cell applications appears to be consuming the available supply. The price of selenium fell starting October of 2005, eventually stabilized, and now is trending slightly upward. Our other key substrate materials, copper and germanium, also experienced price increases. To maintain our margins, we have raised the prices of our optical components that are made from these materials as needed.

In anticipation of continued solid bookings growth, during the second half of fiscal year '06, we initiated numerous efforts to expand capacity and capabilities in our plants in Pennsylvania, Singapore, and China. In Saxonburg we added equipment optical fabrication, diamond turning product test, and coating facilities. In China we'll expand a plant and add optical fabrication equipment. In Singapore we'll increase sink-dunk coating capacity in advance of process capability to enable the coating of more complex designs. We must add capacity to meet the projected demand, which is driven by the continued creation or refinement of new carbon dioxide laser materials processing applications. For example, we forecast sales of multi-element scan lenses for CO2 laser via drilling systems to grow significantly over the next few years. Vias are tiny holes drilled in multi-layer printed circuit boards that provide electrical connection between the different layers of circuitry. The miniaturization of printed circuit boards is being driven by greater cell phone performance, including higher resolution color displays, integrated cameras, and enhanced Internet connectivity. Our high-end mobile phone, for example, has approximately 100,000 via holes in its multi-layered circuit boards with an ability to produce 50- to 100-micron vias more effectively and efficiently than mechanical drilling systems or other systems. CO2 lasers are enabling this miniaturization.

In our VLOC Near-Infrared Laser Optics division, bookings for fiscal year '06 increased by 25% over the prior year, with nearly two-thirds of this growth from the UV filter product line. Optics bookings also grew propelled by strong demand in the medical and instrumentation-related markets. The YAG bookings grew driven by medical- and military-related applications. For fiscal year, 2006, UV total revenues increased by 38% over the prior year. Optics revenues increased by 8% over the same period, led by windows utilized in eye surgery and debris shields for the industrial YAG lasers medical applications. These windows and debris shields have been very successfully manufactured in our Vietnam factory. Custom crystals and YAG revenues were down due to production and quality issues at our Florida facilities. Contract R&D revenues were also down due to the timing of certain contracts.

From the information in the press release and Craig's comments, you know the details of the goodwill impairment charge that was taken by our Military Infrared Optics business in the fourth quarter. I will focus my comments on the operational matters of this business unit. At Exotic Electro-Optics, bookings for fiscal year '06 grew by 10% over the prior year. The increase in core military and sapphire bookings was driven primarily by increased demand for infrared windows for the Apache helicopter targeting system and increased demand for sapphire windows for the advanced targeting pod sniper program used on the F-16 and F-15 fighter jets. Fiscal year 2006 revenues were a record of $29.4 million, up 8% from last year. The strong revenue performance in core military and sapphire businesses was led by increased shipments of infrared windows for heritage programs and the next generation modernized target acquisition and detonation site and pilot night vision sensor, also known as Arrowhead for the AH-64 Apache helicopter, and increased billings for sapphire development contracts related to the joint strike federal program. Fiscal year 2006 gross and operating margins were down significantly from last year due to production yield and associated scrap charges experienced in the first and second quarter. Also, on these difficult programs we incurred much greater than expected engineering and program management costs, as well as heavy rework costs as we persevered to produce products, often while in the development mode.

Several process improvements were implemented in the third and fourth quarters, resulting in improved production yield margin performance. While overall margins and profitability for the full year were below expectations, the EEO team worked through difficult issues in the first half of the year and showed solid second-half improvement. The strong overall bookings and positive fourth quarter results indicate that the business is improving. Our order backlog is strong, and we're poised to continue this positive performance in fiscal year 2007.

The Compound Semiconductor Group had its best year ever. In FY '06, it was profitable over the full year for the first time. Here's some highlights from the businesses that comprise our CSG unit. At Marlow, coat activity continued strong across all market segments. We experienced a significant increase in coat activity for the defense market during the latter part of the year. Significant progress continues to be made towards two new major industrial market design wets. Demand in the telecom market is gradually increasing, which is consistent with the slow recovery of the telecom equipment market. Both unit production and revenues in Vietnam continued to ramp up during the year, although some start-up problems led to delays which impacted the scheduled transfer of our final product line out of our Chinese subcontractor manufacturer. However, we are now on track toward the final qualification process and expect to receive ISO certification during the second quarter of fiscal year '07.

During the first quarter of fiscal year '07, we are scheduled for an increase in production activity in Vietnam, and since the installation of the element dicing operation there has been completed, this operation will be in full production also during the first quarter. For fiscal year '06, WBG bookings increased significantly, while revenues decreased slightly. The decrease in revenues was primarily due to timing on realizing contract revenues and continued price erosion that we're seeing in the market for our silicon carbide products. Recently our WBG division received a $1 million order for three-inch-diameter silicon carbide substrates to be delivered to a large domestic customer. This was our largest commercial order in the history of WBG. These substrates will support commercialization of gallium nitride-based RF power technology for wireless and base station applications. Expected use of this technology is to produce devices for 3G base station caller amplifiers with significant performance and cost advantages over silicon LD MOS, which is continued evidence of the early adoption of wide-bandgap electronics. WBG was awarded a new $1.1 million contract sponsored by the Air Force Research Labs and the National Automotive Center that will focus on defect reduction in large-area [inaudible] poly-type conducting substrates that power switching applications. WBG has completed the facility buildout in Starkville, Mississippi, an annual high-volume manufacturing facility. We have hired the first employees of a growing workforce and expect to start technology transfer in the current quarter.

For fiscal year '06, the eV products business realized improvements in both bookings and revenues over the prior year. Those revenue improvements, combined with cost containment measures, helped to improve the financial results of this business to the point that the unit made its first sizable after-tax profit in the fourth quarter. Our next-generation crystal globe furnace platform recently began contributing to the manufacture of products. Considered as a breakthrough in the crystal globe operation, this technology enables growth in larger size and higher quality single crystal cadmium and telluride. This major advancement is enabling us to meet the extremely demanding needs for nuclear medicine applications, including the pre-clinical testing of new drugs. Drug research often involves imaging of small animals that have received a new drug regime. Very fine details and imaging are necessary to see their response to the drugs, and the cadmium telluride detectors provide this degree of resolution, During fiscal year '07, our new products division will continue to focus on operational improvements, including increasing yields and reducing cycle times in its crystal growth and sensor fabrication areas. Our advanced materials development center continues in fiscal year 2007 to support the BLOC subsidiary as it increases production of UV sensor materials. EMDC also continues its forward-looking work on next-generation engineered materials platforms, including the development of ceramic materials for optical and opto-electronic applications. In conclusion, fiscal year '06 was a very good year from an operational and financial standpoint. It was a year in which II-VI took further steps in growth, profitability, technological advancements, and a year that attested to the expanding global nature of our business. We are looking forward to fiscal year '07 as we continue to look for opportunities to deliver value to our shareholders. Craig, that concludes my prepared comments.

Thank you, Fran. Before we begin the question-and-answer session, I would like to mention that these comments and answers to certain questions contain forward-looking statements which are based on current expectations. Actual results could differ materially. For information about factors that could cause the actual results to differ materially, please refer to the risk factor section of our Form 10-K for the fiscal year ended June 30, 2005.

Stephanie, we are ready to begin the question-and-answer session.

[Operator Instructions]. Your first question comes from Pierre Maccagno of Needham.

Congratulations for the quarter, Fran and Craig. Could you give us a breakdown of the backlog and the bookings for the compounds business?

We continue to repeat the backlog information for the business as a whole, we have--because we report that unit as a specific business segment, we are not able to give you a lot more specifics or a lot more color around that, but the backlog as of the end of the year was $19.5 million, and that's comprised of three business units--within that Marlow, eV Products, and our wide-bandgap materials group.

And then, regarding the sales from the VLOC, did you notice about the, there was $11 million during the quarter, quite a large jump from last quarter. Do you expect to see that continued level going forward, or is it going to come down a little bit? Because I think there was some push-out of orders for this quarter, correct?

We had back in the second and a little bit into the third quarter, we did have some products that we were making, that were ready to go, but just because of revenue recognition we actually physically did not ship them to the customer based on their delivery schedule and are now shipping those products in increasing volumes to the customer, and so for the quarter we just ended, plus the next couple quarters, for this UV filter product line, we will be having some very sizable and noticeable increases in sales year over year and quarter over quarter. And that's going to continue as we finish out the existing contract, which ends somewhere in the second quarter. Fran, do you want to add--?

Yeah, just repeat what Craig said, I do think the quarter we just completed is representative of our VLOC group will do in the quarters next year.

Okay, great. Congratulations again, and thanks.

Thank you.

You're welcome.

[Operator Instructions]. Your next question comes from Jiwon Lee with Sidoti and Company.

Good morning, gentlemen. My question is on plan, how do you see the future of the sapphire business? In other words, could you provide a little more color as to where do you see for some of the legacy product and the new products heading?

That's a good question. Let me go back a little bit just to clarify a few points. Most of our optics company, we bought them at six years ago. At the time it was a two-product company. It was making core military products and was also making CO2 laser optics. So at the acquisition time, we really paid heavily for the company and were interested in the CO2 laser business, and then the IR military business, we thought it would be important for us. So after a time we moved the CO2 business away from there, and we focused our Temecula business strictly on the military for the last two or three years. So I would guess about three years ago we entered the sapphire business, which now we find is very interesting. We've invested quite nicely, and had growing sales each year for the last three or four years, and there are probably two key programs that we're producing for the ATP program and the materials op program. ATPs a little bit further along. There's some, a little bit more than low rate in initial production. It's gone better and JSF is very early stage, only $0.10 of products have we ever received orders for, and that's stretched out over a couple of years, so we see sapphire as emerging business, so invested, we've developed along with it, it's [inaudible] and coming up to 20% or so of our sales of exotic, and I think it's going to continue to grow very nicely. The nature of it is we're in a development mode for our customers making these panels and shrouds, so the start-up, and it's going to be a longer than two-year start-up, maybe three- or four-year, we've been taking some expenses, like I said before, on raw engineering and more program management.

But we really like that business. We're investing, and I think we have the commanding position in that sapphire large window and shroud business of any supplier in the U.S. And we're not able to point to a competitor that we have that's significant. So we're excited about it, we're working hard at it. We've had some difficulties, but difficulties are more of our exotic with this goodwill impairment, for example. It's not associated at all with our sapphire business or too much with the military. We had some difficulties, and that took us over the edge on the impairment in the first and second quarter, but the impairment issue might have been really related to how the acquisition of Laser Power Corporation was accounted for back five and a half or six years ago. We've struggled with "Is that goodwill impaired or not?" each year for the last three or four years, and this year I think our first half performance is what switched just into yes, it was impaired.

Okay. Now turning on to this segment a little bit. If we phase out the goodwill charge during the quarter, we found the military infrared segment profitable?

Yes, it was, Jiwon.

Okay. And on to the tax rate, your fourth quarter tax rate [inaudible] was about 20%. Yet you paid out on a blended tax rate of about 27% in my SIC calculation. Are you suggesting this is sort of the rate that we should look forward to in '07 with a slight upward variation?

Jiwon, your math is correct for both the quarter and for the year, excluding the special charge. We do think the U.S. businesses will generate some more income in the half than has been in this past fiscal year, so we think the tax rate's going to be roughly the same, but it has the possibility to trend upward at some of our domestic businesses, so we're expecting better operational financial performance from them.

Great. And what is the selenium prices these days?

Selenium prices, the market right now is about $23 a pound. In our case, we purchased well ahead, so our weighted inventory costs are more than that, but our customers are understanding how we've purchased and how we're passing along that cost to them, so they've watched and in the six- to eight-month period of time, the price per pound on the market was reported to be $52 or $53 a pound, dropped to $18, and now climbed back to $23. So the market is seeing one set of signals, and we're trying to pass those cost increases and decreases in a logical manner to our customers, and we've had very good success, I would have to say.

Great. And finally, a quick [inaudible] question. Your percentage of foreign sales during the [inaudible]?

Percentage of foreign sales was, leveled out 42% for the quarter.

Great. That's all for me, and thank you very much.

Thanks, Jiwon.

Your next question comes from Joseph Gardner with Emerald Asset Management.

Good morning, gentlemen. Forgive me if I missed this part of the call, but I was wondering if you could talk a little bit more regarding the bookings and the book to bill level. With it being a little under one, given your forecast it looks like you guys are pretty confident in where you are in terms of sales levels going forward. Are we seeing some seasonality here with shipments being so strong in the fourth quarter, or is there, if you could talk a little about what kind of gives you the confidence in the revenue line going forward?

Sure. In the first three quarters of the year, we did have bookings exceeding the sales in some cases by quite a large margin. In fact, in one of those quarters we had bookings almost of $63 million in our second quarter. We almost repeated that with $61 million in the third quarter, and we're really comfortable overall with the metric, the 1.04 for the whole year. We have about, almost $9 million more in backlog than we did at this time last year with the same business unit, giving us good visibility in really all the businesses that we have. So we definitely have plenty to work on. I think our, and our manufacturing facilities around the world are definitely busy and so a little bit of it, the bookings down where it is in this quarter here, doesn't give us long-term concern. I think as Fran mentioned before, simply within the Infrared Optics Group, we're seeing many of our customers expand their capacity at increased shifts, et cetera, and we know that that's just going to continue to be more potential growth for the Infrared Optics Business itself. So overall, we're not concerned about the quarter in particular. We're really pleased with the overall effect for the year.

Okay, just to add to that--the seasonality that you have.

Yes, the fourth quarter is usually always our highest revenue quarter, and then at first quarter, we, I think, this is the most predictable, slightly run-up in orders in the fourth quarter turns into a slight run-up in revenues out the door in the first quarter, and I think Craig made a comment about that, what we'll see in the first quarter. A little less in the revenues, but I think the long-term trend, or at least the four quarters going forward, we are very confident that this business is headed up very nicely.

Okay. Can you talk a little bit more in terms of how things are going in the manufacturing side with capacity, then, and some of the bottlenecks you've been trying to address over the last several months? How that's come along and what additional work you need to do, if any?

We just hit a few, not in every division, but certainly the Infrared Optics division is using its capacity fully, utilization is very high across the board, and we're bringing on growth in more materials here. That capacity's coming along, Asian manufacturing or fabrication in China and Singapore, that addition's coming, and right at the moment our tightest area would be in our thin film coating business, so we're putting on more capacity, so we're picking it up. I think we'll stay right along with the demand. We're coming along nicely, that's in the IR Optics business. Probably our other groups, just to talk about, would be the groups to use in our Vietnam factory, our Marlow group, and our VLOC group. Both have made nice progress with Vietnam. Factory's coming up very nicely. As I said in my comments, we're moving the last product line out of our subcontractor into Vietnam, so that capacity, moving well, but it's a scare issue when we're learning to do these processes in Vietnam, which neither of them have been done there before, but moving well. Overall, the other divisions, the EEO group's in good shape for capacity, just got to keep our scrap under control. Our group at VLOC, it is also moving well the UV product, which is ramping up, is continually challenged to produce enough of these hard-to-make materials. We produce out at the AMDC center and at Florida, and they're staying right on target there. Have a great delivery record, very good quality record, and just a nice constant challenge to keep moving the capacity up, and they've been able to do that.

Okay. And then the final question on the inventory side, Craig. It looks like you guys have done fairly good job there in terms of keeping the inventory under control despite what you've been seeing on the raw materials side. I wonder if you could talk a little about that and where you see the inventory levels going from here?

I think we are doing a better job. I think there was a lot of focus on that at this fiscal year. I think there was, as Fran touched on before, that we maybe in fiscal year of '05, we had insufficient material on hand, and we've been just trying to focus on that, really at all of our production locations, but we're also trying to do a better job of that at our sales and marketing locations as well. We would expect the inventory levels to check up in FY '07, but we really want to continue to focus on that. We still think there's a fair amount of room to improve those terms, and that will still be big area of focus for us as that ramps up.

Okay. Thanks a lot, and congratulations.

[Operator Instructions]. Your next question comes from Chris McDonald with Kennedy Capital Management.

Good morning, gentlemen. Could you repeat the question on the guidance? I know you took the guidance up quite nicely, and you wanted to give just a little more detail on what's going on in driving your outlook?

I'll maybe start on that trend and let Fran add onto it, Chris. I think when we put out our first guidance for fiscal year '07, we did that back in April. In between that time we've completed our budgeting process, we've looked at several of our business units, and actually several of those are projecting more opportunities and more revenue enhancement, more operational efficiencies than what we originally anticipated than when we gave that first guidance. We're seeing that. We're also encouraged by talking with our customers about the Infrared Optics business, the continued strength and demand in the business, and we're looking at all the businesses that we have and saying that we're just feeling overall that we're able to be more comfortable with that higher guidance that we gave for this quarter, so--that we gave with this press release. So we're just feeling a little bit more confident, we feel like we have a little better appreciation and understanding of the pockets of demand and certain things that come to pass a little more favorably than anticipated, say, about three months ago. Fran, do you want to add anything to that?

Well, that's a real good recap, Craig. Just a little bit more of the right things keep occurring. Certainly the improvement at our Exotic Electro-Optics group in the fourth quarter, we'd been expecting it, and now, I know it's hard to see the numbers on how well they did with that goodwill write-off, but they, they were nicely profitable in the fourth quarter. I think if we have three or four quarters of that kind of performance next year, it will improve us a lot. So, just many good results that I think will help us and will keep right on going in '07.

Okay, thanks, guys.

At this time, there are no further questions. Gentlemen, are there any closing remarks?

There are no more questions. I would like to thank everyone for participating today. Our next earnings release for the quarter ending September 30, 2006, is currently scheduled for after the market closes on Monday, October 23, with a conference call to follow on the next day, Tuesday, October 24. Thank you for participating in today's conference call.

This concludes today's conference call. You may now disconnect.