II-VI Inc (IIVI) 2014 Q2 法說會逐字稿

Good day ladies and gentlemen, and welcome to the II-VI Incorporated fiscal year 2014 quarter earnings conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. (Operator Instructions). As a reminder this conference may be recorded. I would now like to turn the conference over to our host for today's call, Mr. Craig Creaturo. You may begin.

Thank you Latanya, and good morning everyone. I am Craig Creaturo, Chief Financial Officer and Treasurer of II-VI Incorporated. Thank you for participating in the second quarter fiscal year 2014 II-VI Incorporated Investor Teleconference. As a reminder this teleconference is being recorded on Tuesday, January 28th, 2014.

The forward-looking statements we may make during this teleconference speak as of today. We do not undertake any obligation to update these statements to reflect events or circumstances occurring after today.

Thank you Craig, I am Francis Kramer, President and CEO of II-VI Incorporated. Our prepared comments today will cover our various business segments as we review the highlights from the just completed quarter. I will cover the Infrared Optics business segment, while Chuck Mattera our recently appointed Chief Operating Officer will cover the other four segments, including the acquisitions we made during this fiscal year. In many ways the December 2013 quarter was a turning point for the Company. It marked the quarter in which we completed our fifth acquisition within a 12-month period. It marked the first quarter of integrating two large diverse businesses we acquired from Oclaro, and as Craig will articulate in his prepared comments, and as one can conclude after reviewing our updated financial guidance, it marked what we believe will be a low point for many of our financial metrics. However, in spite of the financial drag caused by the acquisitions from Oclaro, let me reassure you that I am pleased with the technology and intellectual property acquired in the transactions, and optimistic about their strategic long-term fit with II-VI Incorporated.

So let me begin today's discussion with a review of the Infrared Optics segments, the second quarter bookings for IR Optics which included HIGHYAG were $52.4 million, up 11% quarter-over-quarter, and up 18% compared to the second quarter of fiscal year 2013. For the IR Optics business in the Americas orders from OEMs increased 20% compared to the second quarter of last year. Shipments to these OEMs increased 5% year-over-year. In the North American aftermarket orders in increase decreased 10% quarter-over-quarter, which is typical for the second quarter and machine utilization is reduced due to the holidays, meanwhile aftermarket bookings increased 5% when compared to the second quarter of last year.

European bookings for the second quarter were up 10% quarter-over-quarter, and 17% year-over-year. The increase was primarily driven by a renewed demand for Diamond windows, and other related products for the EUV photo lithography systems. The aftermarket in Europe was up 12% year-over-year reflecting our increased efforts to win business in this segments along with improving economic conditions.

The total Asian bookings increased 9% quarter-over-quarter, and 7% year-over-year. Both high power and low power OEMs had strong second quarter bookings up 15% from Q1, and 26% from the second quarter of FY 2013. The Japanese Yen continued to weaken this quarter, which reduces the US dollar revenues for the same volume of sales. China bookings increased 12% quarter-over-quarter, which is typical for the holiday season. They did however exceed their second quarter FY 2013 bookings by 13%, driven by aftermarket and material sales. Chinese CO2 high power production has decreased, with lighter demand for pipe drilling application.

Also, the soft demand for leather and other fashion accessories has impacted the demand from low power OEMs. Other Asian countries, including Korea and Taiwan have the biggest increases with 46% improvement quarter-over-quarter, and a 28% decline from the second quarter of last year due to lower demand for the via hole drilling market. We expect this market to rebound in the second half of FY 2014 since we have seen increased demand for peripheral optics from our Japanese OEMs.

Now at HIGHYAG bookings of $9.5 million for the second quarter were up 26% quarter-over-quarter, and double from the second quarter of fiscal year 2013. A portion of the higher bookings in the second quarter were the result of our key OEM customers placing orders in advance of the move to our new facility in January 2014 which has done well so far. At HIGHYAG we recently appointed a new managing director, Dr. [Hobor Schluder] who brings 20 years of experience in the field of high-power lasers for industrial applications. We continue to see long-term growth in 1-micron welding, beam delivery, and 1-micron laser cutting markets.

Now that concludes my comments. Chuck will you please proceed?

Thank you Fran. My comments today begin with a report on the Near-Infrared Optics segment. Second quarter bookings at our Near-Infrared Optics segment decreased by 24% sequentially to $31.1 million. The majority of the decrease is attributable to a $5.5 million removal of order backlog as a result of the recently completed acquisition of the II-VI Network Solutions Division, a former external customer of Photop.

Segments revenues were down by 10% sequentially to $35.8 million also impacted by certain revenues becoming internal as a result of the acquisition. NIR bookings were down 13% year-over-year, largely a result of the reclassification of bookings previously considered to be external. Overall, NIR revenues were down by 2% year-over-year driven in part by price erosion on legacy optical components. Lower than expected bookings for the quarter were also impacted by delays in certain new product introductions, and inventory corrections at some key accounts. We also saw some product mix change during the quarter with strong demand for our leading-edge products. However, our legacy products are facing unusually aggressive price competition, and we experienced some loss of market share in certain accounts based on aggressive price bidding by our competitors.

Our NIR optical components business has softened for 40G and legacy products, even on product lines such as optical channel monitors, where we have recently seen near record quarterly volumes but increased price erosion. However, in the 100G ROADM and datacenter in cable TV related areas, we continue to see significant opportunities. We have recently achieved several product design wins of passive modules for 100G transmission, including OCMs, multicast switches for high density and high flexibility ROADM line cards, optical beam up solutions for datacenters and EDFA components for cable TV applications.

We have also seen increased design in opportunities for active components, driven by high volume demand for datacenters and cable TV. We are making significant R&D investments for next generation high speed and high flexibility networks, with particular emphasis in the areas of 100G transmission, ROADM networks, and datacenter applications. We have also introduced a new OCM product featuring high channel density with flexible bandwidth in an industry-leading small form factor that is in volume production for one Tier 1 customer, and in trials at other Tier 1s. Synergies with the recently acquired fiber amplifier business in the active optical product segment, include expanded opportunities in high density components for microamplifiers, [heretoy], and 100G transmission modules, as well as advanced monitoring solutions for intelligent amplifiers and ROADM networks. Moreover, we have begun executing on a strategy to internally source components as in feeds into the amplifier business, and we expect that this will help drive component volume, and over the long haul should help lower our overall cost structure for amplifiers and related components.

In the communication markets, thin film filter product revenues remain soft due to the continued delays associated with the broadband China roll out, and the slowdown of the related fiber to the home market in China. We also experienced lower than forecasted sales from a key life science customer of advanced filters,as that customer accelerated its end of life program. Overall, the Near-Infrared Optics segment results remained strong in Q2, with growing demand for advanced optics for industrial lasers, instrumentation, and life sciences.

Now I will turn to the results of our Military & Materials segments. For the second quarter our Military & Materials segment bookings of $21.4 million were up 15% sequentially, but decreased 8% year-over-year. The quarterly bookings increase was due to the timing of a large recurring production order in our military business. The bookings decrease from Q2 of last year was due to a combination of reduced bookings at PRM following our announcement to discontinue certain product lines, and slightly lower military bookings. Revenues for the second quarter of $24.5 million weredown 7% sequentially but increased 19% year-over-year.

The revenue decrease was due to a combination of reduced shipments from our discontinued product line at PRM and minor supply chain delays in the military business. The revenue increase from Q2 of last fiscal year was due to the acquisition of the LightWorks Optics. Consist with our previously-announced plan to discontinue the tellurium product line at PRM, we completed all production of tellurium products during Q2. We satisfied all open customer orders for these products, and we sold or disposed of the majority of the inventory. We are pleased to report that any financial risk in the form of inventory write-down related to indexed price fluctuations has been mitigated.

The PRM business achieved positive earnings again this quarter, and based on operational implement is progressing nicely in the rare earth element reclining product line, which achieved $2 million of revenue for the quarter. The outlook for the PRM business for both the rare earth element product, and supply of high purity selenium materials to our IR Optics business is positive. The market outlook for the military business remains uncertain, due to funding constraints and downward pressure on the defense budget, but customer inquiries for new products and requests for quotes continue to be active. The LightWorks integration activities are progressing with the most notable synergy being the ability to attract new business opportunities, due to the complementary capabilities that resulted from the acquisition.

For example, we were awarded a contract for the development of an IRF zoom lens assembly that we believe can generate at least $25 million in revenue over the next five years. In another example we received a contract to design an optical assembly for and IRF surveillance system, which we believe could add $8 million of revenue over the next three years.

During the second quarter we received a follow-on order of $3 million for UV optical filter assemblies for the common missile warning system. We have been sole sourced on this program for many years, and we are optimistic about the outlook for continued funding over the next several years. Overall, our military business remains solid in spite of the lower defense spending. We expect modest revenue growth, and to be able to maintain historical levels of profitability through the remainder of FY 2014.

I will now turn my attention to our Advanced Products Group. At our Wide Bandgap Division silicon carbide bookings for the second quarter were up by more than 170% sequentially, driven significantly by the booking of a new $4 million Air Force advanced technology contract focused on optimizing our 150-millimeter substrate manufacturing process. This program will support the continued drive of WBG to remain Best-in-Class for both quality and cost, as we continue ramping shipments of our 150 millimeter substrates into the commercial markets.

Total revenue for the second quarter increased by 36% sequentially due in part to the growing demand for 150-millimeter substrates, for both RF and power products at OEMs in the US, Asia, and Europe. This demand is being driven primarily by increased deployments in the wireless infrastructure and power device markets. At NQ technologies our second quarter bookings from up 11% sequentially, while second quarter revenues increased 15% sequentially. Starting to up the component sales were the main contributor of the increase, driven by strong demand for product required to support inspection in metrology tool OEMs for advanced integrated circuit manufacturing.

While sales to OEMs in the photolithography and process tool areas remained on par with the prior quarter, we did see an increase in demand for components required to support EUV lithography products indicative of an anticipated increase in EUV tool demand in the long run. Q2 marked the first shipments of our directly polishable silicon carbide optical material for industrial semiconductor and defense applications. Early adaptors of the technology were focused on deployments in high power CO2 laser applications as a substitute for metallic alternatives.

At Marlow Industries, bookings for the second quarter decreased 40% sequentially, and decreased 25% year-over-year. The sequential bookings decrease was expected, and was largely a result of a major personal comfort bedding customer having pulled forward their annual production order into Q1 of this year, as well as some life science orders that were rescheduled to the current quarter, Q3, based on customer request as that customer balanced their year-end inventory levels. Some of the decrease was offset by increases in the telecom market. The second quarter revenues were flat sequentially, and decreased 8% year-over-year.

Finally, I turn to our active Optical Products segment, bookings in the second quarter were $30.6 million, while segment revenues were $33.4 million. This segments is the combination of our II-VI Laser Enterprise business that we acquired from Oclaro on September 12, 2013, and our II-VI Network Solutions Division that we acquired from Oclaro on November 1st, 2013. The bookings and revenue results were below our expectations due mainly to customer inventory corrections and some delays in new product follow-on bookings that we had anticipated.

The II-VI Laser Enterprise business is made up of three major product lines which rely on high performance and high reliability semiconductor laser chips that are fabricated at our world class wafer fab in Zurich. The first of these laser component product lines is high-power lasers that serve the broad industrial market for fiber lasers and direct diode lasers, which are being deployed in materials processing applications, as well as life science applications and include medical and elective cosmetic procedures, as well as high performance digital offset printing, and other print on demand applications. The second laser component product line is Drive line components, which includes a broad family of semiconductor laser chips calls VCSELs, which stand for vertical cavity surface emitting lasers, and also low power Edge emitting lasers.

The third laser component product line is 980 pump lasers, which are used in optical amplifiers for optical communication networks, and which predominately serve the telecom customers who make their own optical amplifiers, and are also critical components of our own optical amplifiers. In addition, they are also serving key OEMs in the high-reliability segment of the undersea telecommunications market, in which we believe we have opportunities for market share gains.

During Q2 II-VI Laser Enterprise experienced increased customer interactions on new design opportunities in all three of these product lines, as customers engaged with us to get to know better our product roadmaps and manufacturing plans. In the industrial market the interactions including a sampling of our high power laser pumps for fiber laser applications, we are focused on creating new opportunities for our high volume components at several consumer electronic and datacenter customers. Our 10G VCSELs chip was designed-in by a leading transceiver manufacturer, and subsequently qualified by a leading Tier 1 system integrator for datacenter applications.

We experienced increased interest and began shipping increased quantities of our industry-leading dual chip 980 pumps. We also conducted multiple executive and strategic meetings with key customers, who are excited about our latest acquisitions. We received valuable customer input on a longer term approach to cost savings and synergies, including those that could be realized once we disengage from our reliance on Oclaro for temporary manufacturing services. In addition, a number of cost reduction programs have been launched to improve the productivity and efficiency of our gallium arsenide fab in Zurich, and lower fixed costs through investments that were long overdue.

The II-VI Network Solutions division, which offers a wide range of optical networking solutions is primarily made up of optical amplifiers and subsystems, but also includes micro-optics. Optical amplifier modules include conventional board mounted products with different levels of control from gain blocks to controlled amplifiers, and also subsystems which include a wide range of products from rack multiple units to highly sophisticated line card solutions, which include full back plane integration into system vendor's network equipment. During Q2 II-VI network solutions customers reacted positively to the II-VI acquisition of the optical amplifier business.

We were successful in winning 2014 share allocations in line with our expectations. We also started reengaging customers on new design-in opportunities, where engagement had been put on hold by the customers, due to the uncertainty in the future of the business under its prior ownership. As part of our focus on improving quality and stabilizing our supply chain, we recently entered into a strategic agreement with an existing contract manufacturing partner.

In December we received a preliminary notification from a Tier 1 customer of our first design-in of a new product that we plan to manufacture at our Photop Peugeot manufacturing facility. We view this as a strong endorsement of the value of our unique vertical integration position, and the prospect of associated cost performance, services and lead time benefits that we expected to deliver. In addition, we made the first production shipments of a [rotor] design win Tier 1 system integrator that had also been put on hold by another customer prior to the business acquisition due to uncertainties. We anticipate that several synergies between the AOP segment business and the other II-VI segments will begin to come to fruition beginning in FY 2015 as we complete the integration of the businesses acquired from Oclaro. Synergies include the design-in of several win feeds that will create a competitive cost reduction roadmap for our flagship products, as well as the opportunity to gain market share by offering products that we believe can be manufactured more competitively than anyone else in the industry.

I am grateful to our employees for their commitment and dedication that the integration work is requiring. We now understand that during the quarters leading up to these acquisitions customers were building safety stock and slowing down some of their longer-term engagements with these three product lines. As a result we experienced the effects of this overhang during the second quarter, in which we had lower bookings and revenues than expected. We have much work still to do in the coming quarters to set the businesses onto a sustainable growth foundation, but based on the breadth and depth of the technology platforms, and the product and IT portfolio, as well as the world-class team that we acquired, we remain positive on the long-term strategic value to our customers and shareholders.

This concludes my prepared remarks. Now Craig, will you provide some insight into our financial performance?

Thank you Chuck. The next portion of the call will focus on some financial highlights, and we will begin the section with a review of our bookings and backlog. As detailed in today's press release, consolidated bookings from continuing operations for the quarter-ended December 31st, 2013 were a record $167.9 million, which was 33% above the same quarter last fiscal year. The impact of the three acquisitions we completed in FY 2013 and the two acquisitions we completed in FY 2014, the bookings for the quarter would have been comparable to the prior fiscal year. The beginning backlog of the network solution amplifier business was $6 million, and was not included in any bookings for the quarter.

Total Company backlog at December 31st, 2013 was $202 million. The components of the backlog were Infrared Optics at $44 million, Near-Infrared Optics at $30 million, Military & Materials at $63 million, Advanced Products Group at $40 million, and Active Optical Product segment at $25 million. The gross margin for the quarter was 31.1%, and was 37.8% for the same quarter last fiscal year. The gross margin for the just completed quarter was down when compared to the September 30th, 2013 quarter gross margin of 37.5%.

There were three main factors that caused the lower gross margin for the quarter. First, quarterly gross margin contained approximately $3.7 million of purchase accounting adjustments relating to writing up the acquired inventory to fair market value from previous systems acquired from Oclaro, these negatively impacted gross margin for the quarter by over 200 basis points. Second, the large mix of revenue contribution from the AOP segment pushed down the overall gross margin of II-VI as a whole. More specifically, when impacted the inventory adjustments and other purchase accounting adjustments are removed from AOP, that segment operated at a gross margin level of around 18%. Third, our Infrared Optics business saw some slight temporary margin deterioration on revenues that were lower than Q1 of FY 2014, combined with a planned decrease in inventory levels by that business unit. These negative factors overshadowed improving margin performance from several II-VI businesses, including Max Levy, PRM, Marlow, and WBG. As noted in the press release, all of the purchase accounting items related to inventory were spent by the end of the just completed quarter, so going forward we expect the gross margin percentage that we just experienced to be the low point for the fiscal year, and for the foreseeable future.

The effective income tax rate for the quarter was 21.9%, which was lower than the rate for the second quarter of last fiscal year, and lower than the rate from the September 30th, 2013 quarter. A lower tax rate for the just completed quarter was primarily a result of improved profitability in certain lower tax countries, including the Philippines. The year-to-date effective tax rate now stands at 23.7%, and we expect the full year FY 2014 rate to be slightly lower than this rate. as a result of the expected expiration of the statute of limitations for certain specific tax items. A projected effective tax rate for FY 2014 could be reduced if there is an extension of the US research and development tax credit. While we know some companies are including and expected renewal of the R&D tax credit in their financial projections and guidance, we have not assumed this so that our guidance matches what we allotted from US GAAP and a tax reporting standpoint.

As of December 31st, 2013 outstanding borrowings on our credit facilities and NIM loans totalled $283 million, up $72 million from September 30th, 2013, as a result of the borrowings needed for the semiconductor laser transaction and network solutions transaction. Specifically, we borrowed $80 million to fund the fiber amplifier transaction, and during the quarter we made two payments on our credit facility. The first payment was a mandatory quarterly term loan payment of $5 million, and the second was a voluntary repayment of the line of credit of $3 million.

The interest rate on our borrowings at December 31st, 2013 was approximately 1.7%, and it is expected to increase slightly to around 2% due to an increase in our debt-to-EBITDA ratio to adjust it over 2 times to 1, which will increase the cost of the borrowings under the credit facility by 25 basis points. The expected debt-to-EBITDA ratio to be reduced from the current levels and projected to be under 2 to 1 by June 30th, 2014. Our operating cash flow generation for both the quarter and year-to-date is strong, and our capital spending has been reasonable to allow for good free cash flow generation.

The total Company cash balance increased by approximately $18 million in the quarter, and was $213 million at December 31st, 2013, the highest balance of the Company's history. Of this cash balance, about three-quarters of it is located outside of the US. The two most recent acquisitions of the Company, the Laser Enterprise and Network Solution businesses, form the fifth reportable segment, the Active Optical Products segments. For the just completed quarter this segment captured a full three months of results from the Laser Enterprise business, as this business was acquired effective September 12, 2013, and included two months of the Network Solution Business, as this business was acquired effective November 1st, 2013.

Of the loss reported for this segment for the quarter, $400,000 related to transaction expenses for this acquisition, and $5.9 million related to purchase accounting matters such as increasing inventory to fair market value, as well as depreciating and amortizing the values of fixed and intangible assets, based on the preliminary allocation of purchase price. The remainder of the segment's loss of $0.5 million was a result of the underlying operational performance of these businesses during the quarter.

Fran and Chuck, this concludes the prepared remarks we will make today. 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 the factors that could cause the actual results to differ materially, please refer to the Risk Factors section of our Annual Report on Form 10-K for the fiscal year-ended June 30th, 2013, and the Quarterly Report on Form 10-Q for the quarter-ended September 30th, 2013. Latanya, we are ready to begin the question-and-answer session.

Thank you. (Operator Instructions). Our first question comes from Avinash Kant. Go ahead.

Hi Craig and Chuck.

Good morning.

A few questions here. The first one is, you are giving guidance for the March quarter, and of course now you don't anticipate any charges from that acquisition. Would you walk us through a little bit about in terms of the model, like the gross margins, operating margins and the tax base primarily that you have assumed in your March quarter guidance?

Yes. I think for the rest of the fiscal year Avinash, we do believe that the quarter that we just completed was kind of a low point for the gross margins specifically. I think going forward with the new system we see significant improvement there. Specifically as it relates to the removal of some of the purchase accounting items we incurred during this just completed quarter. So we are expecting the gross margin to go up 300 basis points or so, something like that in the third quarter, and probably includes a little bit further in the fourth quarter. I think if you look at our tax rate, our current effective tax rate is where we are at today for the six month period, we would say compared with March we expect it to be a little bit lower than that. Not much, not drastically lower, but we do have a couple things that will push that favorably and should push that rate down a little bit lower.

From an internal R&D perspective I think the quarter you saw is probably indicative of kind of the new run-rate of II-VI. Historically prior to the recent acquisitions we have been more in the 4.5% to 5% range as far as internal R&D as a percentage of sales. This quarter we jumped up over 6%. I think it will graduate down and be more in the 6% range or so for the rest of the fiscal year. So hopefully that gives you a bit more insight on some of the specifics of the guidance.

And on the SG&A side should we expect it to be flattish from here, or move up a little bit with revenues?

I think it will probably be flattish. Actually probably continue to get some leverage. We have not been adding as much SG&A as a proportion of the sales that we have been adding. So the amount of sales increase that we are expecting for the second half of the year, we are not needing a lot into the SG&A mix, so it is probably going to be at or just slightly down from the run rate that you saw this past quarter.

Okay. And I think in his prepared remarks Chuck was talking a little bit about the Near-Infrared Optics business, and how you guys are seeing some price competition there. Could you give us a little bit more color in terms of where is the price competition coming from, a particular region or a particular competitor, and what is the catalyst for that, is there a lot of inventory out there, or is it somebody has a better process?If you could through some light, that would be good?

Okay. Avinash, first of all, the biggest focus on it has been on our legacy products. These are products which have been in production for quite some time. I would say that most of the competition are coming also from Chinese suppliers, and I would say that the arena for it usually gets set up by either every six months or every 12-months bidding processes for some of the large system customers. So I think the best answer to your question is that they are legacy products, other Chinese companies can make them, and the environment is set simply from price bidding.

Okay. And the final question maybe, you did talk about some growth in the defense business despite the concerns that are out there. Could you specifically talk a little bit about the JSF program?You seem to have a lot of visibility there, so how do you see the JSF program? Are they going to be up in fiscal year 2014, and do you see that going up in fiscal year 2015?

I think we are nicely set on the JSF program, and we have had a steady run rate, we see that continuing through the year. We look out, we have just completed a five year lookout on the program. Yes, it will trend up for us. We will have a little bit more business as the next few years go on, and we are not expecting any grand return to building our JSF at the rapid rate that was once thought. We always planned to be about in the neighborhood of maybe half what the original dreams were, and that is about what we are calibrated for, but it trends up nicely over the next five years.

Is it a double-digit growth plan?

No. I wouldn't say that. For us, it depends on which year you are looking at. We are at 7% to 9% maybe on a trend.

Okay. Thank you so much.

And our next question comes from Jim Ricchiuti of Needham & Company. Go ahead.

Based on your full year guidance and the guidance you are giving for the fiscal third quarter, it really suggests a pretty steep sequential increase in Q4 revenues. So I am wondering again, if you could walk us through some of the components that get you to the stronger fiscal fourth quarter revenue?

Jim, I will start out, and I will let Fran and Chuck add to that as they see fit. I would say that we definitely expect to continue improvement throughout the fiscal year in several of these areas, and if you look just at the segments specifically, our first reportable segment, the active optical product segment is one that sticks out as one that we expect to see continuing improvement throughout the year. To your point, for that segment in particular we do anticipate that the fourth quarter will be the best quarter of the fiscal year.

We had that same phenomenon in several other businesses as well. For instance, At Marlow Industries this kind of the way the patterns have shaped up as far as the order book, from both industrial and some consumer customers, it does look like our June quarter will be a very, very strong quarter for Marlow in particular. So those would be a couple ones that I would point out specifically, but I think in general the things you are picking up is correct for really most all of the II-VI businesses is improvement in Q3, followed by further improvement in Q4. Fran, do you want to add to that?

No. I would just say it is probably on almost every one of our businesses. Certainly IR business has always been a strong fourth quarter, so you might have a maybe 5%, maybe 6% something like that, and near-IR the delay of the China project right now, the idea is it could be China, or quarter four, so that is the big pickup there, and what Craig just said on AOP I think is very true. We think it will be 300 or 400 basis points better in Q3 compared to Q2 for AOP, and add another 100 basis points to it for Q4. Maybe more. We are starting to get our hands around the cost of AOP. It is not at all solved, but we are understanding it, and we do see just what Craig said. Purchase accounting is done, and we are starting to get a feel for it. So I think we have got three or four pieces lifting us in the fourth quarter.

Okay. Fran, maybe another way to look at this is, if you can give us a sense as to, if you look at the different business units for the full year, it sounds like you are assuming a pickup presumably in the military business in the back half the year. For the year as a whole, can you give us some sense as to what kind of growth you might see in the different business units, and maybe that will help get us to the guidance, the implied guidance for Q4?

I guess I would have to refer to just the guidance we have put out there, and we have given you a Q4 a 700 to 710 range. I think that is pretty much our best judgment. To break it down more I think we tried to do that as we had this discussion now. The nice growth that we have had in IR, it is not the rate that we have had in the past, and that might be a thing to let everybody know, that I think the IR growth rate won't be double-digit. It will be in the mid-single digit numbers, and part of that business that is coming a little faster is the HIGHYAG business, so that has been a mainstay group that we have had at a larger growth rate, and they are now 5 to 6 to 7.

Our near-IR our discussion on that all hinges around the China project, and Chuck did report that we are down this quarter compared to what we have expected, but I think there is some bounce back coming late third, early fourth quarter. And then I don't mean to overlook the Military & Materials, our whole, the PRM problem has set that business up pretty well, and then going to AOP I made those comments, so we really can't do better than that on this real short, we are trying to give everybody a good chance to hear everything, but recapping all of that again, Jim, would be a little bit too much.

That is helpful. I think I get a better idea of what the components are. Alright. Thank you. I will jump back in the queue.

Alright. Talk to you later.

And our next question comes from Mark Douglass of Longbow Research. Go ahead.

Hey. Good morning, gentlemen.

Good morning.

Can you provide some color on the IR Optics margin? Big drop year-over-year sequentially, I believe stock expense was a step down from 1Q. Was there price pressure in the channel? Can you just explain a little bit more where IR Optics is, and where you think it is going?

Yes. I think it was a combination, Mark, we had a good September quarter we for the last couple of years have experienced a December quarter that is usually a little bit lighter than the September quarter, so we did have the revenues go down a few points. That segment does bare the lion's share of some of our stock-based compensation and some other charges. The margins were impacted a little bit by some inventory reductions during the quarter, that will in periods costs will on the balance get into the income statement.

I would say that we are not experiencing any significant yield challenges, we are not experiencing any significant cost drivers from say our Asian operations. I would say that we will continue to be aggressive and win market share, especially at aftermarket accounts, and I think definitely taking that focus, have had that focus for a while, and I think that is a charge of the group to continue to that. So I don't think there is anything necessarily, there are no systemic problems that we are worried about according to our [hand trials], I think that it is mostly driven by that lower revenue in the December quarter going down to about $5 million or so from the prior quarter, and we do perfect that to bounce back, and we think you will see a nice recovery in the profitability of that segment beginning in the March quarter.

The other point, Mark, would be that the IR business we tend to find this December month, not only be a challenge from the, and it has happened over the last five years to be our weakest order month and shipment month, so we take the time and we never did that up until maybe four or five years ago. We shut down some operations for a week or two around December. So we carry a lot of fixed costs when we are not running, and those furnaces just create some costs, so we lose 400 or 500 basis points for the IR in December, and the average of the quarter it pulls it down.

Okay. Thank you. Can you talk about what is happening with your new diode laser group? How are the talks going with fiber and direct diode OEMs? Have you had a pickup in orders there, or is it still a lot of dialogue with the customer base to convince them that II-VI has a better handle on things than Oclaro did? Can you just dig a little bit more into that?

Okay, Mark. Mark, I would say that first of all our engagements with the customers are at a very high level, where the key accounts that the business have been serving we are providing a lot of executive coverage into those accounts. I think much like the optical amplifier comments that I made specifically, it is apparent to us that the customers were building some safety stock in at least a quarter or two before the acquisition. So I think we are focused on serving them and identifying other opportunities for us to be able to grow in. At Photonics West the team will be there. They will have some of their new products to be discussed and rolled out. I think that is probably the best characterization I can give.

Well, I would add to it, Mark, that of the business that we bought from Oclaro, there were existing very good customers that are building fiber lasers, and that are building direct diode lasers. So those customers are happy with the product, and our guys are right in there close, and I think it will become even better. We are determined to be good suppliers, and in tune to those customers' needs, and in some cases you have got to turn on a dime, and that is what we are trying to learn how to do. We are not set up for it yet, but that is what we have planned.

Okay. Are you seeing any of those customers with accelerating sales, give you some confidence that maybe the back half gets better?

I would say we really have to be cautious about that, because we are he just trying to learn how to run this business and see where the Achilles heels are, and there are a lot of them in it. So we want to hear all the things, we can't overpromise now, and we have been cautious that we really have our ear to every customer. We want to have a complete handle on the throttle yet.

Okay. And then, Fran, can you walk through again what the laser OEMs are like, what their orders are like again in the different geographies?

Well, yes. Sure. In the Americas I think the increase that was about a 20% quarter-over-quarter here in the US, and that would be both high power and low power were up in orders for the quarter. Go to Europe that would have been 10% up, and a lot of that was driven by the total lithography business that we are doing with the Diamond business. Then down in Asia, you spread it between Japan and China. It was up in general 7% to 10% in Asia. Maybe the turn down a little would be the Chinese CO2 high power. That was down. They were buying pretty well from us a lot, they were just pipe drilling applications, but then the rural power also seems to be down in China. That is just the way things are being deployed, the way they are processing and all those cost goods kind of things seem to be down right now. With the fiber laser coming in, it seems like the one that is being not so much affected at all by fiber is these low power applications, CO2 and low power seems to have really well into that niche in China, in that whole Asia manufacturing soft goods kind of environment.

Okay. And finally did I hear you right that the HIGHYAG orders improved?

Yes. 26% quarter-over-quarter. Very nice performance and certainly we are happy to have moved into this new facility, we just got into last week and it certainly will take us a little while to shake that down, but with our new managing director, I think we have got our HIGHYAG business in a little better condition than where it has been.

Okay and is that also implying that the automotive still going strong in deploying on Micron?

Oh, yes. For sure. In HIGHYAG they are very good at the welding using 1-micron and welding, but many other applications across the world. Certainly a US foothold is good too for HIGHYAG.

Okay. Thank you.

Okay.

And our next question comes from Yiwon Lee of Sidoti & Company. Go ahead.

Hi. Good morning. Just a couple of quick questions. First going back to the ACP, previously I was expecting $130 million to about $135 million in revenue for the fiscal 2014. With this new guidance that you put out, what is roughly the contribution level?

You are talking about, Yiwon, just to make sure we have your question, you are talking about the AOP section of the fifth reportable segment, is that what you are asking about?

Yes.

Okay. I think our run-rate for that business I would say it is probably takes it down from our original expectation, probably down to about 10% or 15% or so. I think that is probably about the right guidance we can give you without getting into a lot more specific details, but I think it is down from somewhere around that 15% range or so.

Okay. That is helpful. And then is it a little early to talk about sort of a more normalized, or meaningful margin improvement that you expects from that business?

I think the data point we shared today, when we strip out all of the pieces that impacted the business because of the purchase accounting and the transaction costs, if you say we are starting at about an 18% gross margin and you can, indeed since the data should be really our low point going forward, and we definitely have things that are in motion, things that are we are working on to improve that. I think it is a little bit early to try to quantify it more specifically than that, but I think directionally, Jiwon, you are going to see the results in future quarters, as early as the March quarter here improve this from that level that we just reported.

And one more thing on that business. Since you are expecting substantial revenue rebound by the fourth quarter, what are the priorities to meet that implied target?

You say what are the priorities?

Yes.

Is that what you said?

Yes, Fran.

Every one of those five businesses that we are in, we expect to achieve kind of what we have guided you to right now, and every one of our executives in those units that is what they are devoted, and some of them are, we are in some yield driven businesses, we have got to keep fixing our processes in the AOP section, we have to get closer to the customer, because when you come in, like we have come into this business kind of from a little distant position, we don't know. And we are going to make that happen, but every one of them are high priority. There is not one of those that we want to back off of, or put the emphasis to and not the other. Every one we are going to be working hard on.

I think I understand. Lastly for me, what kind of a revenue assumption did you put in for the second half of the fiscal year for HIGHYAG?

I think we saw some slight continued improvement, Jiwon, from the level that we were at just this past quarter, soagain similar to several of the businesses that, as far as our forecasting goes, you ought to see some improvements from that for the remainder of the fiscal business.

And just so you have the picture that it might not be so much in the third quarter as the fourth, because when you move a factory and you try to get it running, already we have a few startup challenges, but we have got a handful of customers also that we would like to have been delivering better, stronger, more reliably over the last three or four months, so this next couple of months, starting the new factory and getting it running, I think in the fourth quarter we should have the orders.

We should be able to get a bigger number. That is for sure.

Okay. Thanks so much.

Okay.

(Operator Instructions). And our next question comes from [Bob Fiore]. He is a private investor. Go ahead.

Thank you, good morning. I thought I heard in the answer to Mark's question that lower cost selenium has started coming through infrared inventory. I was wondering if you could give a bit more color on that, because I see that margins seem to be down in that segment?

Bob, I think we are starting to see that pull through there. We are starting to see, that is because of the way our manufacturing process works, it does take a while for that, those changes in the price really to flow through ultimately to our infrared optics customers, but we are starting to see that, we are starting to see some tailwind to that, for the last couple of years there have been some headwind, and we believe we are starting in the next couple quarters, we start to see a little bit more of a tailwind from lower cost selenium. Also too, we continue to find more and more ways that our PRM business in the Philippines can recycle scrap material that we have, which even though that is not directly influenced by the pricing of selenium, it is a way that we generate a substantial and noticeable portion of our own needs are through recycling both scrap materials, so we continue to find more and more ways that we can get scrap and selenide through our sister company in the Philippines, so they can provide us fast, starting high purity selenium material.

Thanks. I also wanted to ask about BLOC military. When you moved it from one reporting segment into another, and restated the financials, it appeared to me that the unit actually isn't profitable at least during fiscal year 2012. I was wondering if you could comment on the plans for that division, and whether it is profitable at this point?

Bob, I think one of the reasons to put it into the military materials business was really part and parcel with what the focus of the change in that business was, and that is to really make it, I think the term is dedicated to the military. Dedicated to the military, servicing the military market. Some of those other products have been manufactured by other locations, but we have focused it and made it really dedicated to the military. Changed the organizational structure, changed the reporting within our management line reporting, and done a lot of changes that made sense for us to move it into the military.

It is centered around a lot of good long-running legacy programs, including our UV filter program that we talked about a little bit, and gave a little bit of color about getting some orders on that here recently. That business is, I would say that we continue to respond to the profitability of that business. It is a business that has not met our profit achievements and targets over the last couple say two years or so, but definitely we have made some nice strides recently, and that is a business that is currently right about at breakeven level. We expect it to improve from there.

Thanks. I have a question about cash overseas, and I think that basically two general areas. One would be cash flow, and I am wondering whether that is actually proportional to revenue, which you do report in, so to kind of get a sense of where cash is coming in, what percentage overseas, and what percentage domestic? And the other question along cash, is domestic versus international CapEx spending?

I would say to the first one of your questions, the generation of it, I would say it does generally follow kind of the revenue breakout, and for this quarter we were about two-thirds International, about one-third US. I would say in general terms it does follow that breakout, where we are now generating a bit more cash outside of the US than inside of the US. From a capital spending perspective, it is probably pretty fair to evenly split I would say between the CapEx in the US versus those outside of the US. That definitely does change from period-to-period, time to time, for instance, we had some large projects as far as the new facility space that we are moving into Germany, that is going to drive spending there, but I would say in general terms that spending has been more evenly split between US and non-US.

Okay. Thanks. And I guess my last question is about if you can give any color on Photop inventory of 10G and 40G equipment?

I will take a first crack at it and then Chuck will probably, clearly we don't report that, we don't go to that level of detail of where we are on 10G and 40G. It is just so far down in the food chain, so we are making components and have some components that sometimes in general we really don't build to inventory. We build to, we have got a three and four week order backlog, so we have a very short response, and that is how re pre dues. Building to inventory is not usual. I can't give you a comment, because I just wouldn't go there, about how we would be if we would get stuck with any 10G or 40G. But in general we don't carry inventory on those products.

Thank you very much for answering my questions. Best wishes for continued success.

Alright Bob.

I am showing no further questions at this time. I would now like to turn the conference back to management.

If there are no more questions, I would like to thank everyone for participating today. Our next earnings release for the quarter ending March 31st, 2014 is currently scheduled for Tuesday, April 29th, 2014before the market opens, with a conference call to follow that same day at 9.00 AM Eastern Time. Thank you for participating in today's conference call.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation, and have a wonderful day.