2023-10-17 18:20:18 ET
Summary
- Coherent (formerly II-VI) has faced operational headwinds and a debt overhang, leading to a re-rated stock.
- Shares have doubled in a few weeks due to AI/ML hype over the past summer but have since dropped back to low-thirties.
- The outlook for fiscal year 2024 is soft, with double-digit revenue declines and no realistic earnings expected.
In May, I believed that a laser focus was required in the case of Coherent Corp. ( COHR ) . Coherent, formerly known as II-VI, has been hurt by the debt overhang and pricey deal related to Coherent, as the deal coincided with operational headwinds hurting the business.
A re-rating looked very interesting, provided that no dilution was incurred, which is a big if, as Coherent looked like a premium recovery play in the semiconductor sector with those for a tolerance for risks.
With shares trading at multiple year lows in May, after a debt-loaded combination was facing operational headwinds, I saw appeal, but this was far from a riskless proposition. Ever since, shares have doubled in the time frame of just a few weeks on the back of the AI/ML hype, but as this did not manifest itself in the 2024 outlook. Shares are back to the low-thirties, amidst a still promising positioning, not being backed up by the actual results.
A Small Recap
In the summer of 2021, it became evident that II-VI was outbidding peers Lumentum ( LITE ) and MKS Instruments ( MKSI ) in their bidding war for Coherent. In the end, II-VI emerged as the "winner," as it paid $7 billion for Coherent, a deal financed with an ever-increasing cash component of $5.4 billion by the time of the final offer.
With shares of II-VI trading around the $100 mark at the time, II-VI commanded a $12 billion valuation, with II-VI generating $3.1 billion in sales, and with Coherent set to add $1.3 billion in annual sales. The strategic and expensive deal could play out great in the long haul, but it could backfire as well given the debt taken on.
At least the business should become much more diversified. Still reliant for nearly half of sales on networking revenues, the business was complemented by an equally large materials and lasers business, serving communications, industrial, electronics and instruments markets (with the last two being smaller).
Upon the final deal announcement, II-VI operated with 138 million shares which traded at $60, giving the business an $8.3 billion equity valuation, while net debt was seen at $5.2 billion. The resulting $13.5 billion enterprise valuation indicated that quite some value had gone up into smoke with II-VI itself trading at an $11 billion valuation ahead of the $7 billion deal for Coherent.
The deal for Coherent closed in July 2022. The company posted first quarter sales at $1.35 billion in November that year, with sales coming in at $1.37 billion in the second quarter, as third quarter sales fell to just $1.24 billion. The falling revenue numbers hurt profitability, key as net debt was still seen at $3.5 billion, as Coherent furthermore accepted $2.2 billion in mezzanine equity from Bain in the process to manage leverage ratios.
With 139 million shares trading at $27 in May, the market value has shrunken to $3.8 billion, for a $7.3 billion enterprise valuation if we factor in net debt, although that that the valuation rose further to $9.5 billion if mezzanine equity is involved. The issue is that of the fourth quarter guidance, which called for $1.15 billion in sales and earnings between $0.33-$0.43 per share, looked soft. This would not leave a lot of room from operating missteps, although it resulted in great potential if the company could turn the page, though assuming that would be a risky endeavor.
Stagnant Shares
Trading at $27 in May, shares doubled to the $55 mark by mid-June as the company has seen strong operating momentum, as shares came crashing down to the low thirties in August again. Ever since, shares have been trading in the low thirties, trading at $34 per share at the moment of writing.
Much of the momentum run appeared to be linked to the rise and enthusiasm around artificial intelligence, as the fourth quarter earnings release in August created a reality check. Fourth quarter sales came in at $1.21 billion, which is better than guided for, with adjusted earnings reported at $0.41 per share.
For the year, the combination generated nearly $5.2 billion in sales on which it posted adjusted earnings of $3.00 per share, while GAAP loses were reported at $2.93 per share, with the discrepancy mostly the result of amortization charges, stock-based compensation expenses, restructuring charges, etc. Net debt came in at $3.5 billion, with mezzanine equity flat at $2.2 billion.
The problem is that no quick recovery is in sight despite the momentum around expectations. In fact, the contrary appears to be the case. First quarter sales for the fiscal year 2024 are seen at just around $1.00-$1.10 billion, with adjusted earnings seen at just $0.05-$0.20 per share. Moreover, a 139 million share count was set to increase to 153 million shares by the end of the first quarter.
Furthermore, the outlook for the entire year is very soft, with sales seen at just $4.5-$4.7 billion, suggesting double-digit revenue declines for the year to come. Adjusted earnings are seen at just $1.00-$1.50 per share, indicating that no realistic earnings are seen in 2024, which makes that leverage is no longer coming down.
In October, Coherent announced that DENSO and Mitsubishi Electric were to invest an aggregate $1 billion in the company's silicon carbide business, with both companies obtaining a 12.5% stake in the business, essentially valuing the unit at $4 billion and that is for a business which is generating just a couple of hundred millions in revenues here.
What Now?
The truth is that I am a bit puzzled here. On the one hand, I am concerned about the soft Coherent Corp. outlook for the fiscal year 2024, amidst a still heavy debt load. The momentum craze invited by AI over the summer created a short boom-bust cycle, and while the news about the silicon carbide business is encouraging, I am not impressed by the outlook.
Nonetheless, the investment into the silicon carbide business comes at a welcomed time and provides some much-needed cash. Despite this, I am not too comfortable to invest a considerable amount in Coherent given the circumstances at this point in time.
For further details see:
Coherent: Not Sending A Coherent Message