Coherent, Inc. (COHR) Q2 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the II-VI Incorporated Fiscal Year 2014 Quarter Earnings Conference Call. [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, Latonya, 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 28, 2014. 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.

Thank you, Craig. I'm Francis Kramer, President and CEO of II-VI Incorporated. Our prepared comments today will cover 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 4 segments, including the acquisitions we made during this fiscal year. In many ways, 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 2 large diverse businesses we acquired from Oclaro. And as Craig will articulate in his prepared comments and as one could conclude after reviewing our updated financial guidance, a mark 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'm pleased with the technology and intellectual property acquired in the transactions, and I'm optimistic about the strategic long-term fit with II-VI Incorporated. So let me begin today's discussion with a review of the Infrared Optics segment. 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 decreased 10% quarter-over-quarter, which is typical for the second quarter when 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 photolithography systems. The aftermarket in Europe is up 12% year-over-year, reflecting our increased efforts to win business in the segment 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 '13. The Japanese yen continued to weaken this quarter, which reduces the U.S. dollar revenues for the same volume of sales. China bookings decreased 12% quarter-over-quarter, which is typical for the holiday season. They did, however, exceed the second quarter FY '13 bookings by 13%, driven by aftermarket and material sales. Chinese CO2 high-power production has decreased, with lighter demand for pipe drilling applications. 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, had 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 '14 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 gone well so far. At HIGHYAG, we recently appointed a new managing director, Dr. Holger Schroeder, 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 delivery and 1-micron laser cutting markets. Now that concludes my comments. Chuck, would 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 Networks Solutions division, a former external customer of Photop. Segment 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 were facing unusually aggressive price competition, and we experienced some loss of market share at certain accounts based on aggressive price beating 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, data center and 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 MOCS [ph] and BMOCS [ph] for data centers and EDFA components for cable TV applications. We have also seen increased design-in opportunities for active components, driven by high-volume demand for data centers 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 data center applications. We have also introduced a new OCM product featuring high channel density with flexible bandwidth and an industry leading in small form factor that is in volume production for 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 micro amplifiers utilizing 100G transmission models, 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 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 rollout and the slowdown of the related Fiber-to-the-Home market in China. We also experienced lower than forecasted sales from a key large science customer of advanced filters, as that customer accelerated its end-of-life program. Overall, the NIR, Near-Infrared Optics segment, results remain strong in Q2, with growing demand for advanced optics for industrial lasers, instrumentation and life sciences. Now I will return -- now I will turn to the results of our Military & Materials segment. For the second quarter, our Military & Materials segment bookings of $24.1 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 were down 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. Consistent 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 off the majority of the inventory. We are pleased to report that any financial risk in the form of inventory write-down related to index price fluctuations has been mitigated. The PRM business achieved positive earnings again this quarter and based on operational improvements is progressing nicely in the rare-earth element refining 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 request 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 IR zoom lens assembly that we believe can generate at least $25 million in revenue over the next 5 years. In another example, we received a contract to design on optical assembly for an IR surveillance system, which we believe could add $8 million of revenue over the next 3 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-source 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 '14. I will now turn my attention to our Advanced Products Group. At our Wide Bandgap division, silicon carbide bookings for 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 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 U.S, Asia and Europe. This demand is being driven primarily by increased deployments in the wireless infrastructure and power device markets. At M Cubed technologies, our second quarter bookings were up 11% sequentially, while second quarter revenues increased 15% sequentially. Semiconductor component sales were the main contributor of the increase, driven by a strong demand for product required to support inspection and metrology to OEMs for advanced integrated circuit manufacturing. While sales to OEMs in the photolithography and process 2 areas remains 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 adapters 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 requests 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 segment is the combination of the 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 1, 2013. The bookings and revenue results were below our expectations, due mainly to the 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 3 major product lines, which rely on high performance and high reliability semiconductor laser chips that are fabricated at a world-class wafer fab in Zurich. The first of these laser component product lines is high-power lasers, which serves 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 high-volume components, which includes a broad family of semiconductor laser chips called VECSELS, which stands 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 predominantly 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 telecom communications 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 3 of these product lines as customers engage with us to get to know better our product roadmaps and manufacturing plants. In the industrial market, the interactions included -- introduction and sampling of our high-power laser pumps for fiber laser applications. We are focused on creating new opportunities for high-volume components at several consumer electronics and data center customers. Our 10G VCSEL chip was designed-in by a leading transceiver manufacturer, and subsequently qualified by a leading Tier 1 system integrator for data center 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 Zürich and lower its fixed cost 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 for game blocks to controlled amplifiers and also subsystems, which include a wide range of products from rack-mountable units to highly sophisticated line card solutions, which include full back plane integration into system vendors 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 Scheer [ph] 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 prime 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 out Photop Fuzhou manufacturing facility. We view this as a strong endorsement of the value of our unique vertical integration position and a prospect of associated cost, performance, service and lead time benefits that we expected to deliver. In addition, we made the first production shipments of a ROADM design win at a 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 being to come to fruition beginning in FY '15, as we complete the integration of the businesses acquired from Oclaro. Synergies include the design-in at several in feeds that will create a competitive cost reduction roadmap from our flagship products, as well as opportunity to gain market share by offering products that we believe can be matched -- 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 3 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 on the coming quarters to set the businesses on to 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 this 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 31, 2013 were a record $167.9 million, which was 33% above the same quarter last fiscal year. When the impact of the 3 acquisitions we completed in FY '13 and the 2 acquisitions we completed in FY '14 are removed, the bookings for the quarter would have been comparable to the prior fiscal year. The beginning backlog of our network solution amplifier business was $6 million, and was not included in the bookings for the quarter. Total company backlog at December 31, 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 Products 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 30, 2013 quarter gross margin of 37.5%. There were 3 main factors that caused the lower gross margin for the quarter: first, the quarterly gross margin continued approximately $3.7 million of purchase accounting adjustments, relating to writing up the acquired inventory to fair market value from the 2 businesses acquired from Oclaro. This 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 the impact of 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 '14, combined with the planned decrease in the inventory levels by that business unit. These negative factors overshadowed improving margin performance from several II-VI businesses, including Max Leavy, PRM, Marlow and WBG. As noted in the press release, all of the purchase accounting items related to inventory were expensed 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 30, 2013 quarter. The 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 '14 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. The projected effective tax rate for FY '14 could be reduced if there is an extension of the U.S. research and development tax credit. While we know some companies are including an expected renewal of the R&D tax credit in their financial productions and guidance, we have not assumed this so that our guidance matches what we are allowed to do from a U.S. GAAP and a tax reporting standpoint. As of December 31, 2013, outstanding borrowings on our credit facility and yen loan totaled $283 million, up $72 million from September 30, 2013, as a result of the borrowings needed for the semiconductor laser transaction and the network solutions transaction. Specifically, we borrowed $80 million to fund the fiber amplifier transaction, and during the quarter, we made 2 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 31, 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 just over 2x to 1, which will increase the cost of the borrowings under the credit facility by 25 basis points. We expect the debt-to-EBITDA ratio to be reduced from the current levels and project it to be under 2:1 by June 30, 2014. Our operating cash flow generation for both the quarter and year-to-date were 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 during the quarter, and was $213 million at December 31, 2013, the highest balance of the company's history. At this cash balance, about 3/4 of it is located outside of the U.S. The 2 most recent acquisitions of the company, the Laser Enterprise and network solution businesses form the fifth reportable segment, the Active Optical Product segment. For the just completed quarter, this segment captured a full 3 months of results from the Laser Enterprise business, as this business was acquired effective September 12, 2013, and included 2 months of the network solution business, as this business was acquired effective November 1, 2013. Of the loss reported for the segment for the quarter, $400,000 related to transaction expenses for this acquisition and $5.9 million related to purchase accounting matters such as increase in the 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 loss of $0.5 million was a result of the underlying operational performance of this business -- of these businesses during the quarter. Fran and Chuck, this concludes the prepared remarks we will make for today. Before we begin the question-and-answer session, I would like to mention that these comments and the 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 factor section of our annual form report on Form 10-K for the fiscal year ended June 30, 2013, and the quarterly report on Form 10-Q for the quarter ended September 30, 2013. Latonya, we are ready to begin the question-and-answer session.

[Operator Instructions] And our first question comes from Avinash Kant.

I have a few questions here. The first one is that you are giving guidance for the March quarter and of course now you don't anticipate any charges from the acquisitions. Could you walk us through a little bit about in terms of the model, like the gross margins, operating margins and the tax rate, 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 we just completed was kind of a low point for -- really for the gross margin specifically. I think going forward, we're going to see some 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 you're expecting -- we're expecting that gross margin to go up 300 basis points or so, something like that, in the third quarter, and probably improve a little bit further in the fourth quarter. I think if you look at our tax rate, our current effective tax rate that we were at today for the full -- for the 6-month period, we did say in our prepared remarks we expected to pay a little bit lower than that. Not much -- much actively lower, but we do have a couple of 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 a kind of the new run rate of II-VI. Historically, prior to the recent acquisitions we had been more in the 4.5% to 5% range in 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 little bit more insight on some of the specifics for 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 be probably flattish, Avinash. We'll actually probably continue to get some leverage. We had not been adding as much as SG&A as proportionate of the sales we've been adding, so the amount of sales increase that we're expecting for the second half of the year we're not needing to add a lot into the SG&A mix. So it's 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 have been seeing some price competition there. Could you give us a little bit more color in terms of where is that price competition coming from? A particular region, or a particular competitor? And what is the catalyst for that? Is it like a lot of inventory out there? Or is it somebody has a better process? If you could throw some light, that will be good.

Okay. Avinash, first of all, we -- the biggest focus on it has been on our legacy products so 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 6-month or every 12-month bidding processes for some of the large system customers. So I think the best answer to your question is that -- legacy products, other Chinese companies can make them, and the environment is set simply for price bidding.

I see. I see. And then 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 had seem to have a lot of visibility in there. So how do you see the JSF program revenues? Are they going to be up in fiscal year '14, and do you see that going up again in fiscal year '15?

Well, I think we're nicely set on the JSF program, and we've had a steady running rate and we've seen that continuing through the year. We look out, we've kind of just completed a 5-year lookout on the program. Yes, it will trend up for us. We'll have a little bit more businesses as the next few years go on. And we're not expecting any grand return to building JSF at the rapid rate that was once thought. We always plan to be about in the neighborhood of maybe half what the original dreams were, and that's about what we're calibrated for. But it trends up nicely over the next 5 years.

Is it a double-digit growth trend? Or single-digit?

No, I wouldn't say that. For us -- let's see, it depends on which year you're looking at. Yes, we're 7% to 9% maybe on a trend.

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

I have -- based on your full year guidance and the guidance you're giving for the fiscal third quarter really suggests a pretty steep sequential increase in Q4 revenues. So I'm wondering if you could walk us through some of the components that get you to the stronger fiscal fourth quarter revenues?

Jim, I'll start out and I'll let Fran and Chuck add to it, as they see fit. I would say that we definitely expect a continued improvement throughout the fiscal year in several of the businesses. And if you look just at the segments specifically, our fifth reportable segment, the Active Optical Products 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 of the fiscal year. We have that same phenomenon at several other businesses as well. For instance at Marlow Industries, just with the kind of the way the patterns have shaped up as far as the order book from both the industrial and some consumer customers, 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 thing you're picking up is correct from really most -- all 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's probably on -- through most -- every one of our businesses, that certainly IR business has always been a strong fourth quarter. So you might have Q4 over Q3 at 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 quarter four. So that's the big pick up there. And what Craig just said on AOP, I think, is very true. If we -- we thought we'll be 300 to 400 basis points better in Q3 compared to Q2 for AOP, add another 100 basis points to it for Q4, maybe more. We're starting to get our hands around the cost of AOP is not at all -- not solved, but we're understanding and we do see just what Craig said, purchase accounting is done and we're starting to get a feel for. So I think we've got 3 or 4 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're assuming a pickup presumably in -- even in the military business in the back half of 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'd have to refer to just the guidance we put out there, and we have given you at Q4 700, 710 range. I think that's pretty much our best judgment. To break it down more, I think we've tried to do that as we have this discussion now, the nice growth that we've had in IR. It's not the rate that we've 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's been a mainstay group that we've had at a larger growth rate, maybe are now 5% to 6% to 7%. Our near-IR discussion on that all hinges around the China project, and Chuck did report that we're down this quarter compared to what we've expected, but I think there are some bounce back coming late third, or early fourth quarter. And then -- yes, I don't mean to overlook the Military & Material. Our whole elimination of the PRM problem to set that business up pretty well. And then going to AOP I made those comments. So I really can't do better than that under this real short -- we're trying to give everybody a good chance to hear everything, but recapping all that again, Jim, would be a little bit too much for me.

No, that's helpful. I mean, I think I get a better idea what the components are.

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

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

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's usually a little bit lighter than that September quarter. So we did have -- the revenues go down. To your point, that segment does bear 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 productions during the quarter that pulled some period cost that were on the balance sheet into the income statement. I would say that we are not experiencing any significant yield challenges. We're not experiencing any significant cost drivers from our, say, our Asian operation. I would say, though, that we'll continuing -- continue to be aggressive and win market share, specially at aftermarket accounts, and I think that -- we're definitely taking that focus -- have had that focus for a while. And I think that is the charge of the group to continue to do that. So I don't think there's anything necessarily -- there's no systemic problems that we're worried about or wringing our hands about. I think it's mostly driven by that lower revenue in the December quarter, going down about $5 million or so from the prior quarter. And we do expect that to bounce back and we do -- we think you will see a nice recovery in the profitability of that segment beginning in the March quarter.

Another point, Mark, would be that -- in the IR business, we tend to find this December month not only be a challenge from the -- and that's happened over the last 5 years to be our weakest order month and shipment month. So we take the time and we never did that up until maybe 4, 5 years ago. We'd shut down from operations for a week or 2 around December. So we carry a lot the fixed cost when we're not running, and those furnaces dust create some cost. So we lose 400, 500 basis points for the IR in December, and the average of the quarter pulls it down.

Okay. Can you talk about what's 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 give in some -- 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. For 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 comment that I made specifically, it's apparent to us that customers were building some safety stock in at least a quarter or 2 before the acquisition. So I think there's not a -- we are focused on serving them and identifying other opportunities for us to be able to grow in. And Photonics West, the team will be there. It will have some of their products to be discussed and rolled out. I think that's probably the best characterization I can give.

So I would add to it, Mark, that of the business 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're determined to be good customer -- good suppliers and are attuned to those customer's needs, and some cases, you got to turn on the diamond, that's what we're trying to learn how to do. We're not set up for it yet, but that's going to be our plan.

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

I would say we really have to be cautious about that because we're just trying to learn how to run this business and see one of the Achilles' heels are, and there are a lot of them in it. And so we want to hear all the things, but we can't overpromise now and we've been cautious, but really have our ear to every customer, we just haven't -- we don't -- we want to have our 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?

Yes, sure. Certainly, Americas, I gave you the increase. That was about a 20% quarter-over-quarter here in the U.S. And that it will be both high power 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 photolithography business that we're doing with the diamond business. And then down in Asia whether 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 Chinese CO2 high color, that was down. They were buying pretty well from us through pipe drilling application, but then the low power also seems to be down in China. It's just the way things are being deployed, leather processing and all those soft goods kind of things seem to be down right now. With the fiber laser coming in, it seems like the one that's being -- not so much affected at all by fiber is this low-power applications. CO2 and low-power seems to have really well into that niche in China in that whole Asia manufacturing of soft goods kind of environment.

Okay. And then finally, did I hear you right that HIGHYAG's orders improved?

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

Okay. And then is that also implying that automotive is still going strong in deploying 1-micron?

Oh yes, for sure. In HIGHYAG, they're pretty good at welding using 1-micron and welding, but many other applications across the world. Certainly U.S. foothold is good too for HIGHYAG.

And our next question comes from Jiwon Lee from Sidoti & Company.

Just a couple of quick questions. First going back to the ACP. Previously, I was expecting on $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 first?

You're talking about -- Jiwon, just to make sure we have your question, you're talking about AOP section, the fifth reportable segment, is that your what you're asking about?

Yes.

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

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

I think the data point we shared today when we strip out all the pieces that impacted the business because of the purchase accounting and the transaction costs if you say we're starting at about an 18% gross margin and you think -- we do sense that, that -- should be really our low point going forward. And we definitely have things that are in motion, things that we're working on to improve that. I think it's a little bit early to try to quantify it more specifically than that, but I think directionally, Jiwon, I think you're going to see the results in the future quarters in as early as the March quarter here improve 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? Is that what you said?

Yes. Yes, Fran.

Well, every one of those 5 business we're in, we expect to achieve kind of what we've guided you to right now. And everyone of our executives meeting those units, that's where they're devoted. And if it's -- some of them is -- are because we're in some yield driven businesses, we 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 in to this business kind of from a little distant position, we don't know enough and we're going to make that happen, but every one of them are high priorities. There's not one of those that we want to back off or put emphasis to and not the other. Every one we're going to be working hard on.

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

I think we saw some slight continued improvement, Jiwon, from the level that we were at just this past quarter. So again, similar to several of the businesses that as far as our forecasting goes, we are expecting some improvement from that at least for the remainder of fiscal '14.

And just so you have the picture, that it might not be so much in the third quarter, it's the fourth because when you move a factory and you try to get it running already we have a few start-up challenges, but we've got a handful of customers also that we'd like to have been delivering better, stronger, more reliably over the last 3 or 4 months. So this next couple of months starting the new factory and getting it running, I think in the fourth quarter, you sure have the orders. We will be able to hit a bigger number that's for sure.

[Operator Instructions] And our next question comes from Bob Fuhr [ph], he's a private investor.

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.

I think -- Bob, I think we are starting to see that flow through there. We are starting to -- that is -- because of the way our manufacturing process works, it does take a while for the changes in prices 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 that had been some headwind, and we believe you're starting in the next couple of quarters, you 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's not directly influenced by the pricing of selenium, it is a way that we generate a substantial and noticeable portion of our needs are through recycling of our scrap materials, so we continue to find more and more ways that we can get scraps in selenide to our sister company in the Philippines, so they can provide us back that starting high-purity selenium material.

I also wanted to ask about VLOC military. When you moved it from one reporting segment into another and restated the financials, it appeared to me that the -- you guys actually isn't profitable at least during fiscal year '12. I was wondering if you could comment on the plans for that division. And whether it is profitable at this point.

I think -- Bob, I think one of the reasons to pore into the Military Materials business was really part and parcel with what the focus or the change of that business was, and that is to really make it -- I think the term is dedicated to military; dedicated to the military -- servicing military markets. Some of those other products had been manufactured by other II-VI 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 shelter program that we talked about a little bit. We gave you a little bit of color about receiving some orders on that here recently. That businesses, I would say that we continue to work to refine the profitability of that business. It is a business that has not met our profit achievements and targets over the last couple, let's say 2 years or so. But definitely, we have made some nice strides recently and that, that is a business that is currently right about at breakeven level. We expect it to improve from there so...

I have a question about cash overseas. And I think that -- basically in 2 general areas. One would be cash flow, and I'm wondering whether that is actually proportional to revenue, which you do report? So -- to kind of get the 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 point of your question, the generation of it. I would say it does generally follow kind of the revenue breakout. For this quarter, we were about 2/3 international, about 1/3 U.S. So I'd say in general terms, it does follow that breakout where we are now generating a bit more cash outside of the U.S. than inside of the U.S. From a capital spending perspective, it's probably pretty fairly evenly split, I would say, between the CapEx in the U.S. versus those outside of the U.S. That definitely does change from period to period, time to time. For instance, we have some large projects, as far as the new facility space that we're moving into in Germany that's going to drive spending there, but I would say in general terms, that spending has been more evenly split between U.S. and non-U.S.

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

I'll take a first crack at it, and then Chuck will probably -- really we don't report that, we don't go to that level of detail where we are in 10G and 40G. It's just so far down. We're down in the food chain. So we're making components and -- passive components that sometimes -- in general, we really don't build inventory -- build for these -- we got a 3- and 4-week order backlogs, so we have a very short response and that's how we produce building the inventory, not usual. I can't give you a comment because I just wouldn't go there about how we would be if we get stuck with any 10G or 40G. But in general, we don't carry inventory on those products.

I'm 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 31, 2014, is currently scheduled for Tuesday, April 29, 2014, before the market opens with a conference call to follow that same day at 9:00 a.m. Eastern time. Thank you for participating in today's conference call.

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