II-VI Still Taking Five

By Stephen D. Simpson, CFA | April 30, 2012 AAA

II-VI (Nasdaq:IIVI) is one of those quality small caps that tends to stay under the radar. There's not much sell-side coverage, and frankly not much institutional ownership by the standards of this market. While II-VI still has yet to recover from the Thai floods that disrupted business, the company's strong share in various laser optics markets makes it one worth watching.

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Third Quarter Earnings Still Challenged
While many of II-VI's industrial markets have seen solid recoveries, II-VI is still lagging in terms of financial performance. Revenue rose just 2% this quarter, with good growth in military (up 21%) and OK performance in infrared optics (up 5%) offsetting weakness in near infrared (down 6%) and advanced materials (down 10%).

Margins are even uglier. Gross margin slid six points from 2011, helping to fuel a one-third drop in operating income. Margins are getting hit from product mix shifts and costs tied to the Thai flooding, as well as significant declines in tellurium prices.

SEE: Understanding The Income Statement

Bookings Show No Good News Today
One of the issues with II-VI's current business is the significant slowdown in the telecomm space, as major carriers like Verizon (NYSE:VZ) and AT&T (NYSE:T) have significantly cut back on spending. Given the earnings reports from the likes of Alcatel Lucent (NYSE:ALU) and Juniper (NYSE:JNPR), it's pretty clear that the carrier spending market is still iffy; it may be a "when, not if" market, but the "when" still doesn't look like it's coming soon.

Overall, bookings rose just 2% this quarter. Infrared and military bookings were solid, and the sum total represented a new record, but there needs to be more growth here for the stock to really work.

One other factor affecting bookings is the health of overseas markets. II-VI garners about 60% of its revenue from outside the U.S., and both Europe and China have slowed significantly, with capital goods orders falling sharply in China.

SEE: Earning Forecasts: A Primer

Can II-VI Adapt with the Times?
Large parts of II-VI's business include replacement laser components like optics and lenses and various components that go into military laser and infrared systems. In fact, the majority of the infrared business (which is dominated by sales to industrial customers) is replacement parts and this is generally a less cyclical business than that of laser manufacturers like Rofin-Sinar (Nasdaq:RSTI). Moreover, once a company like Caterpillar (NYSE:CAT) becomes a customer, they tend to stay put.

Unfortunately, the world is changing. The cost and utility of fiber lasers is improving and making them more competitive with the legacy CO2 lasers that II-VI supports. Unfortunately, fiber lasers have fewer components and parts, and thus less replacement revenue potential. While this migration is likely inevitable, keep in mind that there's a large installed base of CO2 lasers out there, and big laser users like auto manufacturers are not in a big hurry to swap out expensive equipment.

While the military is not likely to stop using lasers anytime soon, there are issues of defense budgets to consider. Military sales are about one-quarter of the total, and if customers like Northrop (NYSE:NOC) and Lockheed Martin (NYSE:LMT) see lower orders, that's going to filter down to II-VI.

The Bottom Line
I like the business at II-VI a great deal, as it holds significant shares of lucrative replacement markets and management has been smart and opportunistic in making small acquisitions. That said, I don't necessarily love the stock today.

Even if I assume that revenue recovers in the next few years and that the free cash flow margin moves back in the low teens, it's hard to drive a fair value higher than the low $20s. With bookings growth so low and uncontrollable, and external factors like tellurium pricing and the health of the Chinese economy weighing on results, I'd be more inclined to watch than buy II-VI today.

SEE: Analyzing An Acquisition Announcement

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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