II-VI: Growth At A Reasonable Price (NASDAQ:IIVI)

Even at all-time highs, I like the outlook for II-VI (IIVI) shares. On the back of top-line growth led by its vertically integrated manufacturing capabilities across a range of promising end-markets such as optical and wireless communication, industrial lasers, and EUV lithography, IIVI looks well-positioned for the future. Additionally, the stock should also benefit from margin expansion as the company continues to pay down its debt load and unlock synergies. Net-net, I think IIVI shares are still reasonably priced at the current c. 0.9x PEG multiple.

An Exceedingly Positive Q3 Report

Earnings came in well above expectations for Q3 ’20 on better revenue and profitability in telecom and datacom, as 5G deployments and network infrastructure upgrades accelerated. Specifically, transceivers were a bright spot, as ROADM demand rose 50% Q/Q. For the most part, all categories, including industrial laser, contributed positively to the Q3 beat, driving consolidated revenue of $627 million, well above the high-end of management’s $550-600 million guidance range.

Source: IIVI Investor Update Presentation

For the quarter, IIVI recorded orders of $840 million (+26% Q/Q), driving the 12-month backlog to a record $893 million. Order strength was broad-based across key end-markets, with particular strength from communications (both datacom and telecom). As a result, IIVI’s book-to-bill rose to c. 1.3.

Non-GAAP gross margins also came in strongly above consensus at 38.3% on a favorable mix, synergies, and volume. Meanwhile, operating margins also tracked to 13.8%, as operating efficiencies and cost synergies related to the Finisar (FNSR) acquisition contributed positively.

Q4 ’19

Q1 ’20

Q2 ’20

Q3 ’20

Total Operating Margin

15.7%

14.9%

11.0%

13.8%

EBITDA Margin

22.4%

22.6%

23.3%

20.1%

Source: Company Data

IIVI’s non-GAAP EPS of $0.47 (adjusted for share-based compensation, impairments, and other one-off impacts), was, therefore, significantly above both consensus (c. $0.13) and prior guidance ($0.02-0.32 range). While EPS is down Y/Y, this is mainly due to incremental interest expenses related to the FNSR acquisition. On a pro-forma basis, net income attributable to common shareholders rose c.8.4% Y/Y.

Q4 ’19

Q1 ’20

Q2 ’20

Q3 ’20

Pro Forma Net Income to Common

43.8

37.1

41.6

44.1

Net Margin

12.1%

10.9%

6.2%

7.0%

Source: Company Data

Finisar Integration Tracking Ahead of Plan

IIVI has a strong track record of successful M&A integration, and much like Oclaro in 2013, Finisar is tracking well ahead of Street expectations. Though Finisar is of much greater size and scale, IIVI’s cost discipline has been paying off, with the latest quarter’s operating margins rising 2.8 percentage points Q/Q.

Source: IIVI Investor Update Presentation

While IIVI is certainly not yet out of the woods on integration, the meaningful traction management has shown across both FNSR and core IIVI amid COVID-19-led disruption gives me confidence in the near to medium-term outlook. For example, many competitors and other equipment vendors have noted sizable constraints to capacity during the quarter, yet IIVI has successfully avoided most of this at its IIVI and FNSR facilities, due to its vertical integration.

Additionally, where FNSR margins/business concentration has to date been an overhang, IIVI has offset this by moving ahead of schedule on delivering synergies, relative to the targeted $150 million within three years. The longer-term synergies are also quite compelling, as Finisar better positions it with new customers, and increases wallet share with existing customers, allowing IIVI to leverage the combined portfolio and scale to address a $22-billion market opportunity.

Source: IIVI-Finisar Investor Presentation

Defying the COVID-19 Backdrop

Looking ahead, IIVI has lifted Q4 ’20 guidance to $650-700 million in revenues, and non-GAAP EPS $0.50-0.70, both of which were well above consensus. This factors in a c. $50 million COVID impact related to factories being shut down in China, potential supply chain constraints, and a spike in cases on employees’ return. All this seems conservative, however, as II-VI has seen limited impact since factories began operating mid-March.

On the demand side, IIVI is still exposed to the Asian supply chain and, therefore, could suffer from increased US-China trade tensions. On the other hand, IIVI should also benefit from improving data points that suggest a rebounding post-COVID market in the region.

Source: McKinsey on Asia’s Manufacturing and Supply Chains

Encouragingly, resilience and cash generation are also key focus areas, and if demand were to weaken, the company still has levers to pull on. The primary lever is a reduction in growth capex, which has now been guided to a range of $125-140 million for the full year. As of quarter-end, IIVI’s liquidity position is strong, with a $388 million cash balance, and an additional $358 million available through its revolving facility.

Q4 ’19

Q1 ’20

Q2 ’20

Q3 ’20

Cash and Equivalents

204.9

441.7

385.2

388.1

Net Debt/Total Capital

23.1%

90.9%

93.0%

100.3%

Source: Company Data

Risks to Monitor

Despite the Q3 beat and raise, several key IIVI end-markets remain sluggish. For instance, the industrial end-market declined c. 24% Y/Y as weak aftermarket sales offset the positives from new industrial laser deployments. In the silicon carbide business, revenue from power electronics has also declined due to weakness in the electric vehicles market, but on the flip side, this has freed up capacity to meet increased demand in the RF business related to 5G infrastructure deployment.

The growth outlook in China, the US, and Japan also appears to be intact, but there are still risks elsewhere, with moderate growth in Europe and a muted outlook in India. Much like its peers, however, II-VI has already seen signs of an acceleration in 5G deployments globally, highlighting its record backlog and customer conversations around accelerating production and increasing capacity.

And as we said during the script — in the script that the acceleration of 5G, I would say really worldwide, isn’t really — it’s not just about China, but also other OEMs and other carriers worldwide can continue to get ready and ramp these 5G deployments. We have seen an increase in the RF, which has been really timed very well. As you may recall, we were sold out for several quarters in terms of capacity.

Growth at a Reasonable Price

The resilient demand for communications in Q3 ’20, along with the company’s solid execution in a difficult macro environment, is greatly encouraging to me. I also like IIVI’s positioning at the epicenter of several major growth stories as it pursues a $22-billion addressable market by 2022. While risks remain, I view current headwinds as temporary in nature, with IIVI shares presenting investors an attractive way to gain exposure to themes like 5G at a reasonable c. 0.9x PEG multiple. Going forward, I will be monitoring progress around the Finisar acquisition and related synergies, the adoption of new technologies such as Silicon Carbide, and US-China trade tensions.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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