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II-VI INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) FORWARD-LOOKING STATEMENTS Certain statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations are forward-looking statements. Forward-looking statements are also identified by words such as "expects," "anticipates," "believes," "intends," "plans," "projects," or similar expressions. Actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including risk factors described in the Risk Factors set forth in Item 1A of this Annual Report on Form 10-K, which are incorporated herein by reference. OVERVIEW The Company generates revenues, earnings and cash flows from developing, manufacturing and marketing high-technology materials and derivative products for precision use in industrial, military, telecommunications, photovoltaic, medical and aerospace applications. We also generate revenue, earnings and cash flows from government funded research and development contracts relating to the development and manufacture of new technologies, materials and products. Our customer base includes OEMs, laser end users, system integrators of high-power lasers, manufacturers of equipment and devices for the industrial, military, telecommunications, photovoltaic and medical markets, and U.S. Government prime contractors, various U.S. Government agencies and thermoelectric integrators. CRITICAL ACCOUNTING ESTIMATES The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America and the Company's discussion and analysis of its financial condition and results of operations requires the Company's management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1 of the Notes to our Consolidated Financial Statements contained in Item 8 of this Annual Report on Form 10-K describes the significant accounting policies and accounting methods used in the preparation of the Company's consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates. Management believes the Company's critical accounting estimates are those related to revenue recognition, allowance for doubtful accounts, warranty reserves, inventory valuation, valuation of long-lived assets including acquired intangibles and goodwill, accrual of bonus and profit sharing estimates, accrual of income tax liability estimates, accounting for share-based compensation and self-insurance for workers' compensation. Management believes these estimates to be critical because they are both important to the portrayal of the Company's financial condition and results of operations, and they require management to make judgments and estimates about matters that are inherently uncertain. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the foregoing disclosure. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in estimates used in these and other items could have a material impact on the financial statements. 30 -------------------------------------------------------------------------------- The Company recognizes revenues when the criteria of SEC Staff Accounting Bulletin ("SAB 104") (as defined below) are met. Revenues for product shipments are realizable when we have persuasive evidence of a sales arrangement, the product has been shipped or delivered, the sale price is fixed or determinable and collectability is reasonably assured. Title and risk of loss passes from the Company to its customer at the time of shipment in most cases with the exception of certain customers. For these customers title does not pass and revenue is not recognized until the customer has received the product at its physical location. We establish an allowance for doubtful accounts and warranty reserves based on historical experience and believe the collection of revenues, net of these reserves, is reasonably assured. Our allowance for doubtful accounts and warranty reserve balances at June 30, 2011 was approximately $0.8 million and $1.2 million, respectively. Our reserve estimates have historically been proven to be materially correct based upon actual charges incurred. The Company's revenue recognition policy is consistently applied across the Company's segments, product lines and geographical locations. Further, we do not have post shipment obligations such as training or installation, customer acceptance provisions, credits and discounts, rebates and price protection or other similar privileges. Our distributors and agents who comprise less than 10% of consolidated revenue and have no additional product return rights beyond the right to return defective products that are covered by our warranty policy, are not granted price protection. We believe our revenue recognition practices are consistent with SAB 104 and that we have adequately considered the requirements of ASC 605 Revenue Recognition. Revenues generated from transactions other than product shipments are contract-related and have historically accounted for less than 5% of the Company's consolidated revenues. The Company establishes an allowance for doubtful accounts based on historical experience and believes the collection of revenues, net of these reserves, is reasonably assured. The allowance for doubtful accounts is an estimate for potential non-collection of accounts receivable based on historical experience. The Company has not experienced a non-collection of accounts receivable materially affecting its financial position or results of operations as of and for the fiscal years ended June 30, 2011, 2010 and 2009. If the financial condition of the Company's customers were to deteriorate causing an impairment of their ability to make payments, additional provisions for bad debts could be required in future periods. The Company records a warranty reserve as a charge against earnings based on a historical percentage of revenues utilizing actual returns over a period that approximates historical warranty experience. If actual returns in the future are not consistent with the historical data used to calculate these estimates, additional warranty reserves could be required. The Company records a slow moving inventory reserve as a charge against earnings for all products on hand for more than twelve months to eighteen months depending on the products that have not been sold to customers or cannot be further manufactured for sale to alternative customers. An additional reserve is recorded for product on hand that is in excess of product sold to customers over the same periods noted above. If actual market conditions are less favorable than projected, additional inventory reserves may be required. The Company tests goodwill and indefinite-lived intangible assets on an annual basis for impairment or when events or changes in circumstances indicate that goodwill or indefinite-lived intangible assets might be impaired. Other intangible assets are amortized over their estimated useful lives. The determination of the estimated useful lives of other intangible assets and whether goodwill or indefinite-lived intangibles are impaired involves judgments based upon long-term projections of future performance. Estimates of fair value are based on our projection of revenues, operating costs and cash flows of each reporting unit considering historical and anticipated results, general economic and market conditions. The fair values of the reporting units are determined using a discounted cash flow analysis based on historical and projected financial information as well as market 31 -------------------------------------------------------------------------------- analysis. The carrying value of goodwill at June 30, 2011, 2010 and 2009 was $64.3 million, $56.1 million and $26.1 million, respectively. The annual goodwill impairment analysis considers the financial projections of the reporting unit based on the most recently completed budgeting and long-term strategic planning processes and also considers the current financial performance compared to the prior projections of the reporting unit. Changes in our financial performance, judgments and projections could result in an impairment of goodwill or indefinite-lived intangible assets. As a result of the purchase price allocations from our prior acquisitions and due to our decentralized structure, our goodwill is included in multiple reporting units. Due to the cyclical nature of our business, and the other factors described in the section on Risk Factors set forth in Item 1A of this Annual Report on Form 10-K, the profitability of our individual reporting units may periodically suffer from downturns in customer demand, operational challenges and other factors. These factors may have a relatively more pronounced impact on the individual reporting units as compared to the Company as a whole, and might adversely affect the fair value of the reporting units. If material adverse conditions occur that impact one or more of our reporting units, our determination of future fair value may not support the carrying amount of one or more of our reporting units, and the related goodwill would need to be written down. The Company records certain bonus and profit sharing estimates as a charge against earnings. These estimates are adjusted to actual based on final results of operations achieved during the fiscal year. Certain partial bonus amounts are paid quarterly based on interim Company performance, and the remainder is paid after fiscal year end. Other bonuses are paid annually. The Company prepares and files tax returns based on its interpretation of tax laws and regulations and records estimates based on these judgments and interpretations. In the normal course of business, the Company's tax returns are subject to examination by various taxing authorities, which may result in future tax, interest, and penalty assessments by these authorities. Inherent uncertainties exist in estimates of many tax positions due to changes in tax law resulting from legislation, regulation and/or as concluded through the various jurisdictions' tax court systems. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate resolution. The amount of unrecognized tax benefits is adjusted for changes in facts and circumstances. For example, adjustments could result from significant amendments to existing tax law and the issuance of regulations or interpretations by the taxing authorities, new information obtained during a tax examination, or resolution of an examination. The Company believes that its estimates for uncertain tax positions are appropriate and sufficient to pay assessments that may result from examinations of its tax returns. The Company recognizes both accrued interest and penalties related to unrecognized tax benefits in income tax expense. The Company has recorded valuation allowances against certain of its deferred tax assets, primarily those that have been generated from net operating losses in certain foreign taxing jurisdictions. In evaluating whether the Company would more likely than not recover these deferred tax assets, it has not assumed any future taxable income or tax planning strategies in the jurisdictions associated with these carry-forwards where history does not support such an assumption. Implementation of tax planning strategies to recover these deferred tax assets or future income generation in these jurisdictions could lead to the reversal of these valuation allowances and a reduction of income tax expense. In accordance with ASC 718 "Compensation-Stock Compensation" (formerly SFAS No. 123 (revised 2004), ("SFAS 123(R)") "Share-Based Payment"), the Company recognizes share-based compensation expense over the requisite service period of the individual grantees, which generally equals the vesting period. The Company is self-insured for certain losses related to workers' compensation for its U.S. employees. Additionally, third-party insurance is obtained to limit our exposure to these claims in excess of $0.3 million per occurrence and $0.9 million in the aggregate per policy year. When estimating its self-insurance liability, the 32 -------------------------------------------------------------------------------- Company considers a number of factors, including historical claims experience, demographic and severity factors and valuations provided by independent third party consultants. Periodically, management reviews its assumptions and the valuations to determine the adequacy of its self-insurance liability. EXECUTIVE SUMMARY The Company continued to see improvement in its worldwide markets in fiscal year 2011 resulting in increased customer demand. The acquisition of Photop made positive contributions to both the Company's revenue and earnings growth and the Company continues to integrate Photop's operations. In addition, the Company's recent acquisition of Aegis should provide momentum going into fiscal year 2012 by capitalizing on opportunities within the telecommunication markets. The Company's core industrial based segment, Infrared Optics has seen strengthening demand from its industrial based customers as laser machine utilization rates began to increase during fiscal 2011. The Company is anticipating building on this momentum into fiscal year 2012 by expanding its manufacturing capacity including capital expenditures at the majority of its business units to capitalize on the further strengthening of the worldwide economies. On May 17, 2011, the Company's Board of Directors declared a two-for-one stock split, in the form of a stock dividend, of the Company's common stock for shareholders of record on June 3, 2011. The stock split was distributed on June 24, 2011 issuing one additional share of common stock for every share of common stock held. The applicable share and per share data for all periods included herein have been restated to give effect to this stock split. Fiscal 2011 Compared to Fiscal 2010 RESULTS OF OPERATIONS Overview (millions except per share data) Year Ended June 30, % 2011 2010 Increase Bookings $ 520.2 $ 387.6 34 % Revenues 502.8 345.1 46 % Net Earnings attributable to II-VI Incorporated 82.7 38.6 114 % Diluted earnings per share 1.30 0.63 106 % The above results include MLA since the date of acquisition for the year ended June 30, 2011 only, as this acquisition was completed on December 6, 2010. The above results for the year ending June 30, 2010 include only six months of activity for Photop, as this acquisition was completed on January 4, 2010. BOOKINGS Bookings increased 34% to $520.2 million in fiscal year 2011 compared to $387.6 million in fiscal year 2010. Included in bookings for the year ended June 30, 2011 and 2010 were approximately $118.4 million and $59.4 million, respectively, of bookings from Photop. Excluding Photop, the majority of the Company's business units also realized higher levels of bookings in fiscal year 2011 compared to fiscal year 2010. The Company began seeing improved customer demand during the second half of fiscal year 2010 as worldwide economies began to rebound from their lower levels in the later part of fiscal year 2008. This trend continued for the full year of fiscal 2011. In addition to the bookings recorded by Photop, the general increase in bookings was due to strong product demand from the Company's Infrared Optics, Military & Materials, and Compound Semiconductor Group segments. The Infrared Optics segment has benefited from growing levels of high-power laser systems being introduced into the global markets. As a result, bookings for Infrared Optics increased 39% during the current fiscal year when compared to the prior fiscal year. PRM recorded stronger 33 -------------------------------------------------------------------------------- bookings during the current fiscal year due to demand for its selenium and tellurium raw materials as well as favorable market pricing of these materials. The Compound Semiconductor Group segment grew bookings as a result of both the receipt of a government contract for silicon carbide growth and continued commercial acceptance of its silicon carbide products. In addition, the launch of Marlow's gesture recognition product in fiscal year 2011 contributed to the segment's bookings growth. WBG bookings for silicon carbide related products increased $15.0 million during the current fiscal year compared to the prior fiscal year while Marlow bookings increased $6.2 million during the current fiscal year compared to the prior fiscal year. These increases in bookings were somewhat offset by decreased bookings at the VLOC business unit due to delays in certain military related programs. REVENUES Revenues increased 46% to $502.8 million in fiscal year 2011 compared to $345.1 million in fiscal year 2010. Included in revenues for the year ended June 30, 2011 and 2010 was approximately $118.6 million and $46.9 million, respectively, of revenues from Photop. Excluding Photop, the majority of the Company's business units realized higher levels of revenues in fiscal year 2011 compared to fiscal year 2010. Specifically, revenue increased at the Company's Marlow, PRM, and Infrared Optics businesses by 46%, 40%, and 34%, respectively. This growth in revenue reflects strong customer demand and higher order volume for the products of these business units as the global economy showed signs of recovery during fiscal year 2011. NET EARNINGS Net earnings attributable to II-VI Incorporated increased 114% in fiscal year 2011 to $82.7 million ($1.30 per share-diluted) from $38.6 million ($0.63 per share-diluted) in fiscal year 2010. The increase in net earnings attributable to II-VI Incorporated during the current year compared to the prior fiscal year was primarily the result of the positive contribution of Photop to the Company's operating results. In addition, the increase in net earnings is the result of the incremental margin realized on higher revenue levels as well as favorable margins, yield improvements and operating efficiencies throughout the Company's business units. The Company also recognized a favorable impact on earnings as a result of certain of the Company's foreign currencies strengthening against the U.S. dollar during the current fiscal year. Furthermore, the Company benefited from certain foreign tax incentives and a higher mix of foreign sourced income which is taxed at lower rates than income generated in the U.S. As a result, the Company's effective tax rate was 18.4% for fiscal year 2011 compared to 24.5% for fiscal year 2010. SEGMENTS Bookings, revenues and segment earnings for the Company's reportable segments are discussed below. Segment earnings differ from income from operations in that segment earnings exclude certain operational expenses included in other expense - net as reported. Management believes segment earnings to be a useful measure as it reflects the results of segment performance over which management has direct control and is used by management in its evaluation of segment performance. See also Note 14 included in Item 8 of this Annual Report on Form 10-K to the Company's Consolidated Financial Statements for further information on the Company's reportable segments. Infrared Optics (millions) Year Ended June 30, % 2011 2010 Increase Bookings $ 193.8 $ 139.4 39 % Revenues 180.8 135.1 34 % Segment earnings 46.2 24.6 88 % The Company's Infrared Optics segment includes the combined operations of II-VI Infrared and HIGHYAG. Bookings for fiscal year 2011 for Infrared Optics increased 39% to $193.8 million from $139.4 million in fiscal year 2010. The increase in bookings in the current fiscal year was driven by strong demand from international OEMs and aftermarket customers as laser utilization rates and new laser applications continue to 34 -------------------------------------------------------------------------------- drive growth. Increases in demand are pervasive across all geographic locations including Asia, Europe, and North America. In Europe, new machine builds continue to increase by high power OEMs and laser utilitization rates continue to improve. Industrial applications in the low power and via hole markets in Asia have strengthened while replacement part demand and U.S. military orders in North American markets have realized strong growth. In addition, HIGHYAG bookings nearly doubled during fiscal year 2011 when compared to fiscal year 2010 as a result of increased manufacturing applications utilizing one-micron beam delivery components, laser light cables, and laser welding and cutting heads. Revenues for fiscal year 2011 for Infrared Optics increased 34% to $180.8 million from $135.1 million in fiscal year 2010. The increase in revenues during the current fiscal year compared to the prior fiscal year was primarily due to higher shipment volume to both OEM and aftermarket customers across all geographic markets as the segment continued to develop incremental opportunities in both high power and low power CO2 laser optics and components to capture developing markets and new laser applications. Segment earnings for fiscal year 2011 for Infrared Optics increased 88% to $46.2 million from $24.6 million in fiscal year 2010. The increase in segment earnings during the current fiscal year compared to prior fiscal year was primarily due to the incremental margin realized on the segments higher shipment volume. In addition, segment earnings were favorably impacted during the current fiscal year as a result of improved production yields as well as favorable absorption of overhead costs due to increased production volumes. Near-Infrared Optics (millions) Year Ended June 30, % 2011 2010 Increase Bookings $ 149.6 $ 105.6 42 % Revenues 159.8 88.5 81 % Segment earnings 24.1 12.3 96 % The Company's Near-Infrared Optics segment includes the combined operations of VLOC and Photop. The above results include Photop for six of the twelve months ended June 30, 2010 as this acquisition was completed in January 2010. Bookings for fiscal year 2011 for Near-Infrared Optics increased 42% to $149.6 million from $105.6 million in fiscal year 2010. Included in bookings for the year ended June 30, 2011 and 2010 were approximately $118.4 million and $59.4 million, respectively, of bookings from Photop. Excluding Photop, bookings decreased during the current fiscal year when compared to the prior fiscal year. This decrease is the result of lower bookings at VLOC due to a Title III U.S. Government development contract that was received in fiscal year 2010 for the development of ceramic laser-gain materials. Due to recent changes in the government budgeting process, the funding of the next phase of this program was not extended in fiscal year 2011. Furthermore, the decrease in bookings at VLOC was due to lower orders for their UV Filter product line. Revenues for fiscal year 2011 for Near-Infrared Optics increased 81% to $159.8 million compared to $88.5 million in fiscal year 2010. Included in revenues for the year ended June 30, 2011 and 2010 was approximately $118.6 million and $46.9 million, respectively, of revenues from Photop. Excluding Photop, revenues decreased slightly due to a reduction in the shipment volume of the Company's military product line as a result of government budget constraints and the uncertainty surrounding funding to support military programs. Segment earnings for fiscal year 2011 for Near-Infrared Optics increased 96% to $24.1 million from $12.3 million in fiscal year 2010. The increase in segment earnings for the current fiscal year compared to the prior fiscal year was due primarily to the inclusion of Photop's operating results for the full fiscal year in 2011. 35 -------------------------------------------------------------------------------- The increase in segment earnings related to Photop were somewhat offset by lower profitability due to reduced shipment volumes of the military product line at the VLOC business unit. Segment earnings in fiscal year 2011 were also negatively impacted by $1.0 million due to the resolution of a customer dispute at VLOC. Military & Materials (millions) Year Ended June 30, % 2011 2010 Increase Bookings $ 92.0 $ 79.0 16 % Revenues 83.4 65.7 27 % Segment earnings 15.3 9.3 65 % The Company's Military & Materials segment includes the combined operations of the Company's Exotic Electro-Optics ("EEO"), PRM, and MLA. The above results include the results of MLA since the date of acquisition for the year ended June 30, 2011 only, as this acquisition was completed in December of 2010. The operating results of MLA were insignificant. Bookings for fiscal year 2011 for Military & Materials increased 16% to $92.0 million from $79.0 million in fiscal year 2010. The increase in bookings in the current fiscal year compared to the prior fiscal year was primarily the result of increased product demand at PRM. PRM continued to benefit from an increase in demand for its selenium and tellurium raw materials from its industrial-based customers, especially in China, as worldwide industrial markets became more active. In addition, higher market-index pricing for these two raw materials also contributed to the increased booking levels. Revenues for fiscal year 2011 for Military & Materials increased 27% to $83.4 million compared to $65.7 million in fiscal year 2010. The increase in revenues in the current fiscal year compared to the prior fiscal year was primarily due to stronger shipment volume of selenium and tellurium at PRM as well as increased pricing of such products. EEO realized increased revenues as a result of higher shipment volume of sapphire windows for the Joint Strike Fighter program. Segment earnings for fiscal year 2011 for Military & Materials increased 65% to $15.3 million from $9.3 million in fiscal year 2010. The improvement in segment earnings in the current year was primarily due to incremental margins realized on increased revenues at both EEO and PRM. In addition, PRM's margins were favorably impacted as a result of the higher market pricing of selenium and tellurium. Compound Semiconductor Group (millions) Year Ended June 30, % 2011 2010 Increase Bookings $ 84.8 $ 63.5 34 % Revenues 78.7 55.9 41 % Segment earnings 13.2 5.5 141 % The Compound Semiconductor Group includes the combined operations of Marlow, WBG and the Worldwide Materials Group ("WMG"). 36 -------------------------------------------------------------------------------- Bookings for fiscal year 2011 from the Compound Semiconductor Group increased 34% to $84.8 million from $63.5 million in fiscal year 2010. The increase in bookings in the current fiscal year compared to the prior fiscal year was primarily due to increased bookings at the WBG business unit for large diameter silicon carbide substrates and further product acceptance from Japanese customers. Specifically, WBG received a $5.2 million contract from the U.S. Department of Defense which focuses on improving the growth processes of large diameter silicon carbide substrates. Bookings at Marlow increased due to orders for the gesture recognition product line and increased demand from defense, medical and automotive markets. Revenues for fiscal year 2011 from the Compound Semiconductor Group increased 41% to $78.7 million compared to $55.9 million in fiscal year 2010. The increase in revenues in the current fiscal year compared to the prior fiscal year was primarily the result of higher shipments for gesture recognition product as the Marlow business unit continues to gain market share in the gesture recognition market. Additionally, shipment volumes for silicon carbide products at the WBG business unit continue to increase due to accelerated demand for such products within defense and commercial applications. Segment earnings for fiscal year 2011 for the Compound Semiconductor Group increased 141% to $13.2 million from $5.5 million in fiscal year 2010. The increase in segment earnings for the current fiscal year compared to the prior fiscal year was primarily the result of increased margins realized from the incremental revenues. In addition, the continued utilization of Marlow's low cost commercial production facility in Vietnam had a favorable impact on segment earnings. Overall: Manufacturing gross margin, which is defined as net domestic and international revenue less cost of goods sold, for fiscal year 2011 was $204.5 million or 42% of revenues compared to $131.7 million or 39% of revenues in fiscal year 2010. The increase in manufacturing gross margin for fiscal year 2011 compared to the prior fiscal year was primarily due to the incremental margin realized on higher shipment levels at the majority of the Company's operating units. In addition, product mix, yield improvements, pricing, operating efficiencies and favorable overhead absorption caused by higher shipment volumes at the Company's business units favorably impacted manufacturing gross margin. Manufacturing gross margin was slightly offset by a $1.0 million charge recorded at VLOC relating to the resolution of a customer dispute. Contract research and development gross margin, which is calculated as contract research and development revenues less contract research and development expense, for fiscal year 2011 was $2.4 million or 24% of revenues compared to contract research and development gross margin of $2.9 million or 29% of revenues for fiscal year 2010. The contract research and development revenues and costs are related primarily to development efforts in the Near-Infrared Optics and the Military & Materials segments as well as activities in the Compound Semiconductor Group. The lower contract research and development gross margin for fiscal year 2011 compared to the prior fiscal year was primarily due to certain contract rate adjustments and a higher mix of contracts with lower profit profiles. Company-funded internal research and development expenses for fiscal year 2010 were $16.1 million or 3% of total revenues compared to $11.8 million or 3% of total revenues for fiscal year 2010. The increase in Company-funded internal research and development expense in the current fiscal year compared to the prior fiscal year is primarily the result of a full year of internal research and development activities at Photop focused on efforts to refine and improve its photonic crystal materials, optical parts, laser instrumentation and display optics. Selling, general and administrative expenses for the fiscal year 2011 were $92.0 million or 18% of revenues compared to $71.1 million or 21% of revenues for the same period last fiscal year. The increase in selling general and administration expense for the current fiscal year compared to the prior fiscal year was primarily due to the addition of a full year of expenses related to Photop as well as higher worldwide bonus 37 -------------------------------------------------------------------------------- expense resulting from improved operating profitability. Selling, general and administrative expense as a percentage of revenues improved during the current fiscal year compared to the prior fiscal year primarily as a result of increased revenues outpacing incremental operating costs. Interest expense for fiscal year 2011 and 2010 was $0.1 million. The low level of interest expense is the result of the Company having relatively low levels of average debt outstanding during fiscal years 2011 and 2010. The Company's $15.0 million of outstanding long term debt as of June 30, 2011 was the result of a borrowing made near the end of the current fiscal year in anticipation of the Aegis acquisition. Other income for fiscal 2011 was $3.1 million compared to other expense of $0.3 million for fiscal year 2010. The majority of other income for fiscal 2011 is the result of foreign currency gains as certain of the Company's foreign subsidiaries currencies strengthened against the U.S. dollar. In contrast, the Company incurred unrealized foreign currency losses during the prior fiscal year as a result of the Company's foreign currencies weakening against the U.S. dollar. The Company's effective income tax rate for fiscal year 2011 was 18.4% compared to an effective income tax rate of 24.5% for fiscal year 2010. The lower income tax rate in fiscal year 2011 was primarily the result of a higher concentration of income in foreign jurisdictions with lower tax rates as well as certain foreign tax incentives enjoyed in the current fiscal year. Fiscal 2010 Compared to Fiscal 2009 RESULTS OF OPERATIONS Overview (millions except per share data) Year Ended June 30, % 2010 2009 Increase Bookings $ 387.6 $ 261.1 48 % Revenues 345.1 292.2 18 % Net Earnings attributable to II-VI Incorporated 38.6 36.8 5 % Diluted earnings per share 0.63 0.61 3 % The above results include Photop for six of the twelve months ended June 30, 2010 as this acquisition was completed on January 4, 2010. BOOKINGS Bookings increased 48% to $387.6 million in fiscal year 2010 compared to $261.1 million in fiscal year 2009. Included in bookings for the year ended June 30, 2010 was approximately $59.4 million of bookings from Photop. Excluding Photop, the majority of the Company's business units realized higher levels of bookings in fiscal year 2010 compared to fiscal year 2009. The Company began seeing improved customer demands during the second half of fiscal year 2010 as worldwide economies began to rebound from their lower levels in the later part of fiscal year 2008 and in fiscal year 2009. In addition to the bookings recorded by Photop, the major factors that contributed to the general increase in bookings include: • The Company's PRM business which is included in the Company's Military & Materials segment recognized an increase in bookings of over $20 million or 265%. The Company benefited from an increase in demand and pricing for its selenium and tellurium rawmaterials from its industrial-based customers, especially in China as worldwide industrial markets became more active. • The Infrared Optics segment experienced an increase in bookings of over $19 million or 17% as a result of increased demand as its customer base began to increase laser machine utilization rates and replenish their inventory levels of spare optic parts. 38 -------------------------------------------------------------------------------- REVENUES Revenues increased 18% to $345.1 million in fiscal year 2010 compared to $292.2 million in fiscal year 2009. Included in revenues for the year ended June 30, 2010 was approximately $46.9 million of revenues from Photop. Excluding Photop, the increase in revenues during fiscal year 2010 compared to fiscal year 2009 was primarily due to increased revenues recognized at the Company's Military & Materials segment as the Company's EEO and PRM units each recorded revenue increases in excess of 10%. NET EARNINGS Net earnings attributable to II-VI Incorporated increased 5% in fiscal year 2010 to $38.6 million ($0.63 per share-diluted) from $36.8 million ($0.61 per share-diluted) in fiscal year 2009. The increase in net earnings attributable to II-VI Incorporated during fiscal year 2010 compared to fiscal year 2009 was primarily the result of the positive contribution of Photop to the Company's operating results. In addition, incremental margins realized on higher shipment volume at certain of the Company's business units during fiscal year 2010 also favorably impacted net earnings. Net earnings were negatively impacted in fiscal year 2010 by approximately $5.1 million, pre-tax of increased share-based compensation expense as the Company continues to utilize this form of compensation to incentivize its employees and also used equity compensation for the Photop integration. The Company's effective income tax rate for fiscal year 2010 was approximately 24.5% compared to an effective income tax rate of 16% for fiscal year 2009. The lower effective income tax rate for fiscal year 2009 was the result of recording a favorable income tax benefit relating to the reversal of approximately $4.7 million of unrecognized income tax benefits. SEGMENTS Bookings, revenues and segment earnings for the Company's reportable segments are discussed below. Segment earnings differ from income from operations in that segment earnings excludes certain operational expenses included in other expense - net as reported. Management believes segment earnings to be a useful measure as it reflects the results of segment performance over which management has direct control and is used by management in its evaluation of segment performance. See also Note 14 to the Company's Consolidated Financial Statements included in Item 8 of this Annual Report Form 10-K for further information on the Company's reportable segments. Infrared Optics (millions) Year Ended % June 30, Increase 2010 2009 (Decrease) Bookings $ 139.4 $ 119.3 17 % Revenues 135.1 130.9 3 % Segment earnings 24.6 28.0 (12 )% The Company's Infrared Optics segment includes the combined operations of II-VI Infrared and HIGHYAG. Bookings for fiscal year 2010 for Infrared Optics increased 17% to $139.4 million from $119.3 million in fiscal year 2009. The increase in bookings in fiscal year 2010 was primarily driven by improved worldwide industrial product demand as customers began to replenish their relatively low levels of inventory spurred by the global recovery that began during fiscal year 2010. In particular, bookings from customers in Asia and North America increased approximately 46% and 18%, respectively, in fiscal year 2010 compared to fiscal year 2009 as low power OEMs saw increased demand in new laser systems for marking, engraving and material processing. Revenues for fiscal year 2010 for Infrared Optics increased 3% to $135.1 million from $130.9 million in fiscal year 2009. The improvement in revenues during fiscal year 2010 was the result of increased shipments to the segment's high and low power CO2 laser optics aftermarket customers in the second half of fiscal year 2010 as higher laser machine utilization rates drove demand for replacement parts and replenishment of spare parts inventory. 39 -------------------------------------------------------------------------------- Segment earnings for fiscal year 2010 for Infrared Optics decreased 12% to $24.6 million from $28.0 million in fiscal year 2009. The decrease in segment earnings during fiscal year 2010 compared to fiscal year 2009 was primarily due to increased share-based compensation expense recorded in fiscal year 2010 of approximately $3.3 million. Near-Infrared Optics (millions) Year Ended June 30, % 2010 2009 Increase Bookings $ 105.6 $ 37.8 180 % Revenues 88.5 45.6 94 % Segment earnings 12.3 7.1 73 % The Company's Near-Infrared Optics segment includes the combined operations of VLOC and Photop. The above results include Photop for six of the twelve months ended June 30, 2010 as this acquisition was completed in January 2010. Bookings for fiscal year 2010 for Near-Infrared Optics increased 180% to $105.6 million from $37.8 million in fiscal year 2009. Included in bookings for fiscal year 2010 was approximately $59.4 million of bookings from Photop. Excluding Photop, bookings increased during the fiscal year 2010 primarily due to the timing of receipt of its UV Filter product orders compared to the timing of the order receipt in fiscal year 2009. In addition, the segment recorded higher YAG bookings in fiscal year 2010 as compared to fiscal 2009 due to increased demand from its industrial-and medical-based customers located in China and Germany. Revenues for fiscal year 2010 for Near-Infrared Optics increased 94% to $88.5 million compared to $45.6 million in fiscal year 2009. Included in revenues for the fiscal year 2010 was approximately $46.9 million of revenues from Photop. Excluding Photop, revenues decreased primarily due to the continued planned reduction in the shipment volume of the Company's UV Filter product line as a result of reduced demand from the Company's military customers. In addition, the segment also realized lower external contract revenues in fiscal year 2010 due to the delay in the receipt of a contract in the current year. Segment earnings for fiscal year 2010 for Near-Infrared Optics increased 73% to $12.3 million from $7.1 million in fiscal year 2009. The increase in segment earnings for fiscal year 2010 compared to fiscal year 2009 was due primarily to the inclusion of Photop's operating results. The increase in segment earnings related to Photop was somewhat offset by lower profitability due to reduced shipment volumes of the UV Filter product line. Military & Materials (millions) Year Ended June 30, % 2010 2009 Increase Bookings $ 79.0 $ 50.0 58 % Revenues 65.7 57.0 15 % Segment earnings 9.3 6.5 43 % The Company's Military & Materials segment includes the combined operations of EEO and PRM. Bookings for fiscal year 2010 for Military & Materials increased 58% to $79.0 million from $50.0 million in fiscal year 2009. The increase in bookings in fiscal year 2010 compared to fiscal year 2009 was primarily the result of increased product demand at PRM, which saw its bookings level increase by over three-fold from fiscal year 2009. PRM benefited from an increase in demand and pricing for its selenium and tellurium 40 -------------------------------------------------------------------------------- raw materials from its industrial-based customers, especially in China, as worldwide industrial markets became more active. In addition, higher market-index pricing for these two raw materials also contributed to the increased booking levels. EEO experienced a 14% increase in bookings in fiscal year 2010 compared to fiscal year 2009 primarily as a result of the Company's continued expansion of its sapphire product line for the Joint Strike Fighter Program. Revenues for fiscal year 2010 for Military & Materials increased 15% to $65.7 million compared to $57.0 million in fiscal year 2009. The increase in revenues in fiscal year 2010 compared to fiscal year 2009 was primarily due to revenue improvements at both EEO and PRM. EEO realized increased revenues due to increased volume of shipments of its sapphire product line. PRM contributed to the segment's revenue increase as PRM began benefitting from the increasing worldwide industrial demand for both selenium used in glass and steel manufacturing and tellurium utilized in the photovoltaic industry. Segment earnings for fiscal year 2010 for Military & Materials increased 43% to $9.3 million from $6.5 million in fiscal year 2009. The improvement in segment earnings in fiscal year 2010 was primarily due to incremental margins realized on increased revenues at both EEO and PRM. In addition, PRM's margins were favorably impacted as a result of the sale of ancillary materials such as gold and silver which carry a higher profit margin than the PRM's main products. Compound Semiconductor Group (millions) Year Ended % June 30, Increase 2010 2009 (Decrease) Bookings $ 63.5 $ 54.1 17 % Revenues 55.9 58.7 (5 )% Segment earnings 5.5 6.2 (11 )% The Compound Semiconductor Group includes the combined operations of Marlow, the Wide Bandgap Group ("WBG") and the Worldwide Materials Group ("WMG"). Bookings for fiscal year 2010 from the Compound Semiconductor Group increased 17% to $63.5 million from $54.1 million in fiscal year 2009. The increase in bookings in fiscal year 2010 compared to fiscal year 2009 was due to increased bookings at Marlow, which benefited from increased product demand from the majority of its markets in fiscal 2010, including defense, telecom, consumer and medical markets as customers introduced new products which require thermoelectric cooling and/or power generation technology. In addition, during the fourth quarter of fiscal year 2010, Marlow booked $2.0 million of a contract from a government agency for the development of advanced cooling modules for military applications. Revenues for fiscal year 2010 from the Compound Semiconductor Group decreased 5% to $55.9 million compared to $58.7 million in fiscal year 2009. The decrease in revenues in fiscal year 2010 compared to fiscal year 2009 was primarily the result of lower shipments at Marlow due to lower demand from industrial-based customers as a result of the general economic stagnation that existed during the first-half of fiscal year 2010. The lower revenues at Marlow were partially offset by increased revenue volume at WBG as the Company's product portfolio continued to gain commercial acceptance from its customer base. Segment earnings for fiscal year 2010 for the Compound Semiconductor Group decreased 11% to $5.5 million from $6.2 million in fiscal year 2009. The decrease in segment earnings for fiscal year 2010 compared to fiscal year 2009 was primarily the result of the lower shipment volume at Marlow primarily as a result of the general economic environment that Marlow encountered during the first half of fiscal year 2010 relating to its industrial-based customers. 41-------------------------------------------------------------------------------- Overall: Manufacturing gross margin, which is defined as net domestic and international revenue less cost of goods sold, for fiscal year 2010 was $131.7 million or 39% of revenues compared to $113.1 million or 40% of revenues in fiscal year 2009. The increase in manufacturing gross margin stated in dollars for fiscal 2010 compared to fiscal year 2009 was primarily due to increased revenues recorded by the Company. Gross margin percentage decreased during fiscal year 2010 as a result of the inclusion of Photop which has lower gross margin levels in comparison to the Company's historical margins. Contract research and development gross margin, which is calculated as contract research and development revenues less contract research and development expense, for fiscal year 2010 was $2.9 million or 29% of revenues compared to contract research and development gross margin of $3.0 million or 28% of revenues for fiscal year 2009. During fiscal year 2010, the Company recorded $0.6 million less in contract revenues compared to fiscal year 2009 as a result of external delays in the awarding of contracts from the various government agencies. The higher gross margin for fiscal year 2010 despite lower contract revenues compared to fiscal year 2009 was the result of a more favorable mix of contracts related to defense and military programs which historically have higher profit margins. Company-funded internal research and development expenses for fiscal year 2010 were $11.8 million or 3% of total revenues compared to $10.2 million or 3% of total revenues for fiscal year 2009. The increase in Company-funded internal research and development expense in relative dollars in fiscal year 2010 compared to fiscal year 2009 was primarily the result of the inclusion of the research and development activities at Photop. Selling, general and administrative expenses for the fiscal year 2010 were $71.1 million or 21% of revenues compared to $58.1 million or 20% of revenues for fiscal year 2009. The increase in the dollar amount of selling general and administration expense for fiscal year 2010 compared to fiscal year 2009 was primarily due to the addition of Photop as well as higher worldwide bonus expense resulting from improved operating profitability in fiscal year 2009 as well as increased levels of share-based compensation expense. Interest expense for fiscal year 2010 was $0.1 million compared to $0.2 million for fiscal year 2009. The low level of interest expense was primarily the result of the Company having relatively low levels of debt outstanding for the fiscal years 2010 and 2009. Other expense for fiscal 2010 was $0.3 million compared to other expense of $1.3 million for fiscal year 2009. Other expense for fiscal year 2010 consisted of foreign currency losses of $2.9 million due to the weakening of the Euro, which resulted in unrealized foreign currency losses for certain U.S. dollar denominated obligations at several of the Company's international subsidiaries. Foreign currency losses during the fiscal year 2010 was partially offset by other income including equity earnings from the Company's investments, interest income on excess cash reserves and unrealized gains on the Company's deferred compensation plan. Other expense for fiscal 2009 consisted of foreign currency losses offset by equity earnings from the Company's equity investments and interest income on excess cash reserves. The Company's effective income tax rate for fiscal year 2010 was 24.5% compared to an effective income tax rate of 16.0% for fiscal year 2009. The lower income tax rate in fiscal year 2009 was primarily the result of the Company recording a favorable income tax benefit of approximately $4.7 million relating to the reversal of unrecognized tax benefits resulting from the completion of the Internal Revenue Service's examination of certain of the Company's federal income tax returns LIQUIDITY AND CAPITAL RESOURCES Historically, our primary source of cash has been provided through operations and long-term borrowings. Other sources of cash include proceeds received from the exercise of stock options and sales of 42-------------------------------------------------------------------------------- equity investments. Our historical uses of cash have been for capital expenditures, business acquisitions, payment of principal and interest on outstanding debt obligations and purchases of treasury stock. Supplemental information pertaining to our sources and uses of cash is presented as follows: Sources (uses) of cash (millions): Year Ended June 30, 2011 2010 2009 Net cash provided by operating activities $ 73.5 $ 72.4 $ 48.8 Proceeds from exercises of stock options 6.2 2.6 1.8 Proceeds from collection of note receivable 2.0 - - Net proceeds/(payments) on long-term debt 15.0 (0.6 ) (0.5 ) Additions to property, plant and equipment (40.9 ) (13.8 ) (15.6 ) Purchase of businesses, net of cash acquired (12.8 ) (45.6 ) - Payment on cash earnout arrangement (6.0 ) - - Purchases of treasury stock - - (12.9 ) Investment in unconsolidated businesses (1.1 ) (4.8 ) (4.9 ) Cash provided by (used in) operating activities: Cash provided by operating activities was $73.5 million and $72.4 million for the fiscal years ended June 30, 2011 and 2010, respectively. Despite the higher net earnings and non cash charges in fiscal year 2011, cash flows from operations remained consistent with fiscal year 2010 primarily due to increased working capital requirements necessary to support the current level of business activity. Specifically, the Company increased its inventory levels as a result of a planned inventory build to support the current level of demand for the Company's products as well as higher prices of selenium and tellurium. Cash provided by operating activities was $72.4 million and $48.8 million for the fiscal years ended June 30, 2010 and 2009, respectively. The increase in cash provided by operating activities for fiscal year 2010 compared to the fiscal year 2009 was due to improved working capital management relating to the Company's inventory, accounts payable and accrued other current liabilities during fiscal year 2010. In addition, cash provided by operations in fiscal year 2010 was also favorably impacted by the operating results of Photop. Cash provided by (used in) investing activities: Cash used in investing activities was $52.5 million and $65.1 million for the fiscal years ended June 30, 2011 and 2010, respectively. The decrease in cash used by investing activities in the current fiscal year compared to the same period last year was primarily the result of the Company's cash consideration paid for its acquisition of Photop in prior fiscal year offset somewhat by increases in capital spending during the current fiscal year. Cash used in investing activities was $65.1 million and $18.3 million for the fiscal years ended June 30, 2010 and 2009, respectively. The increase in cash used by investing activities in fiscal year 2010 compared to fiscal year 2009 was primarily the result of the Company's cash consideration paid for its acquisition of Photop in the amount of $45.6 million. Cash provided by (used in) financing activities: Cash provided by financing activities was $19.2 million for the year ended June 30, 2011 compared to $3.0 million for the year ended June 30, 2010. During fiscal year 2011, cash generated from financing activities included $15.0 million in proceeds from long-term borrowings, $6.2 million from the exercise of stock options and $4.1 million of excess tax benefits from share-based compensation expense. These cash inflows were somewhat offset by a $6.0 million payment of a cash earnout arrangement in connection with the acquisition of 43 -------------------------------------------------------------------------------- Photop. During fiscal year 2010, cash generated from financing activities included $2.7 million of proceeds from the exercise of stock options and $1.0 million of excess tax benefits from share-based compensation expense. These cash inflows were slightly offset by $0.6 million of payments made on the Company's Yen loan. Cash provided by financing activities was $3.0 million for the year ended June 30, 2010 and cash used in financing activities was $10.3 million for the year ended June 30, 2009. During fiscal year 2010, cash generated from financing activities included $2.7 million of proceeds from the exercise of stock options and $1.0 million of excess tax benefits from share-based compensation expense. These cash inflows were slightly offset by $0.6 million of payments made on the Company's Yen loan. During fiscal year 2009, the Company repurchased approximately $12.9 million of treasury stock. In June 2011, the Company replaced its existing credit facility that was set to expire in October 2011. The new credit facility is a $50.0 million unsecured line of credit which, under certain conditions, may be expanded to $80.0 million. The new credit facility has a five-year term through June 2016, and has interest rate of LIBOR, as defined in the agreement, plus 0.625% to 1.50%. Additionally, the facility is subject to certain covenants, including those relating to minimum interest coverage and maximum leverage ratios. As of June 30, 2011, the Company was in compliance with all financial covenants. In conjunction with the credit facility replacement, the Company recorded approximately $0.1 million of deferred financing costs, which will be amortized over the term of the facility. The weighted average interest rate of total borrowings was 1.7% and 2.2% for the fiscal years ended June 30, 2011 and 2010, respectively. The Company had available $34.1 million and $59.1 million under its line of credit as of June 30, 2011 and 2010, respectively. The amounts available under the Company's line of credit are reduced by outstanding letters of credit. At June 30, 2011 and 2010, total outstanding letters of credit supported by the credit facilities were $0.9 million. Our cash position, borrowing capacity and debt obligations are as follows (in millions): June 30, June 30, 2011 2010 Cash and cash equivalents $ 149.5 $ 108.0 Available borrowing capacity 34.1 59.1 Total debt obligation 18.7 3.4 The Company believes cash flow from operations, existing cash reserves and available borrowing capacity will be sufficient to fund its working capital needs, capital expenditures and internal and external growth for fiscal 2012. Additionally, in July 2011, the Company acquired all the outstanding shares of Aegis for $54.5 million in cash which was funded by cash on hand at June 30, 2011. OFF-BALANCE SHEET ARRANGEMENTS The Company's off-balance sheet arrangements include the Operating Lease Obligations and the Purchase Obligations disclosed in the contractual obligations table below as well as letters of credit as discussed in Note 9. to the Company's Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. The Company enters into these off-balance sheet arrangements to acquire goods and services used in its business. 44-------------------------------------------------------------------------------- TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS Payments Due By Period Less Than 1-3 3-5 More Than Contractual Obligations Total 1 Year Years Years 5 Years ($000's) Long-Term Debt Obligations $ 18,729 $ 3,729 $ - $ 15,000 $ - Interest Payments(1) 646 157 245 244 - Capital Lease Obligations - - - - - Operating Lease Obligations(2) 42,286 6,215 10,019 7,499 18,553 Purchase Obligations(3) 26,140 20,051 6,027 62 - Other Long-Term Liabilities Reflected on the Registrant's Balance Sheet - - - - - Total $ 87,801 $ 30,152 $ 16,291 $ 22,805 $ 18,553 (1) Variable rate interest obligations are based on the interest rate in effect at June 30, 2011. (2) Includes obligations for the use of two parcels of land related to PRM. The lease obligations extend through years 2039 and 2056. (3)A "purchase obligation" is defined as an agreement to purchase goods or services that is enforceable and legally binding on the Company and that specifies all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. These amounts are primarily comprised of open purchase order commitments to vendors for the purchase of supplies and materials and unpaid purchase price and contingent earnouts for the Company's recent acquisitions of HIGHYAG and Photop. The gross unrecognized income tax benefits at June 30, 2011 which are excluded from the above table are $5.0 million. The Company is not able to reasonably estimate how the liability will increase or decrease over time. |