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Good day, ladies and gentlemen, and welcome to the II-VI Incorporated Fiscal Year 2018 Second Quarter Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions]. As a reminder, this conference call is being recorded.
I would now like to turn the conference over to your host, Mary Jane Raymond, Chief Financial Officer. Ma’am the floor is yours.
Thank you, Andrew, and good afternoon. I'm Mary Jane Raymond, the Chief Financial Officer here at II-VI Incorporated. Welcome to our second quarter earnings call for fiscal year 2018. With me on the call today are Dr. Chuck Mattera, our President and Chief Executive Officer; Dr. Giovanni Barbarossa, our Chief Technology Officer and the President of the Laser Solutions segment; and Gary Kapusta, our Chief Operating Officer. This call is recorded on Thursday, February 01, 2018.
Just as a reminder, any forward-looking statements we may make today during this teleconference are given in the context of today only. We do not take any obligation to update these statements to reflect events subsequent till today.
With that, let me turn it over to Dr. Chuck Mattera. Chuck?
Thank you, Mary Jane. And thanks to everyone for joining us this afternoon. It was a strong quarter for II IV, of course our main market drivers. Both our revenue and our adjusted EPS were at the high end of our range.
Adjusted EPS is without the effects of the Tax Cuts and Jobs Act.
Our second quarter’s revenue of $282 million was a new quarterly record, thanks to both our progress in our growth markets and in our core markets. Our book-to-bill ratio of 1.05 also led to a new record backlog. Revenue grew 21% compared to Q2 FY'17 ,8% sequentially and all three segments had double-digit revenue growth compared to last year.
Organic growth was 18% and acquisitions contributed 3%. Our core markets of industrial communications and military contributed 30% of the growth in the quarter and our growth markets for consumer, automotive and EUV lithography contributed 70% of the quarter’s growth over the prior year.
3D sensing production and development efforts this quarter proceeded on plan, and were highlighted. With our shipments this quarter, I believe we have established a solid manufacturing and development platform. We are optimistic about the 3D sensing market long-term and we continue our engagement with potential new customers as we work to evaluate new prospects.
The demand for EUV products was very strong in the quarter. Our growth rate was fairly similar sequentially and we expect this growth rate to remain steady for the second half of the year, even as we add capacity to meet increased demand.
[Indiscernible] light was strong the quarter. I will work to innovate our growth methods and expand our capacity, and throughput are ahead of expectations although increases in demand continued and we remain in a sold-out position.
This is especially true for demand for silicon carbide based power electronic devices including in electric vehicles. We expect our growth rate and silicon carbide to increase in the second half of FY'18 to as much as 50% over the second half of FY'17.
Regarding our core businesses, industrial continued along its recent trajectory. Demand around the world was wrong, especially in Europe and China. Our CO2 laser optics business remains strong with the book-to-bill ratio of nearly 1.2, and we are operating at maximum capacity.
The demand for fiber and direct diode laser components continued to ramp at both Tier 1 and Tier 2 customers. The communications end market continued to be stable for us in the quarter. The growth in orders was nearly 50% sequentially and our shipments in Q2 continued with no evidence of double bookings or debookings.
Optical China, with a portion of the China end market and communications grew 8% sequentially. They had accomplished nearly 19% of our total communications revenue, driven largely by our success and growing our intra-data center components including, through the IPI acquisition, wireless was 10%, optical transport including undersea comprised the remaining 71% of revenues.
Finally, regarding the Tax Cuts and Jobs Act and its effect on II-VI we have recorded the majority of the effects of the bill in this quarter, although some provisions will be re-evaluated during Q3, Q4 because their final resolution is dependent on the FY'18 year end position in earnings, and/or cash and our businesses around the world.
The new bill accounts for a reduction of EPS of $0.24 per share and all that 16% of our tax rate in the quarter. Our Q2 tax expense is largely for the withholding tax per expected cash repatriation from our nine U.S. locations to fund certain aspects of our global strategy and to reduce outstanding debt on our credit facilities.
We do anticipate that we will have some degree of cash repatriation annually going forward. With that, I like to turn the call over to Dr. Giovanni Barbarossa to highlight some of our products introduced here at Photonics West as well as at the consumer electronics show in early January. Giovanni?
Thank you, Chuck. It was an exciting month for trade shows in January, including this week at Photonics West. Over the past month, we introduced a series of new products and capabilities across the markets we serve.
Broadly speaking, they fall into the categories of innovations in advanced material processing and application-specification Thin Film Coating technologies including some for the life sciences market.
With respect to advanced material processing, this week we introduced our free-form beam-shaping laser optics for fiber lasers and diode lasers. Our industry leading diamond turning capabilities enabled us to deliver high power laser optics with optonically [Ph] precise surface finishes.
These allow our customers to design application specific bean shaping systems to improve the efficiency of laser processing heads.
We launched smaller and lighter scan lenses that enabled faster processing of micro materials by combining zinc, sulphide and pure silica optics. Scan lenses for carbon monoxide lasers or CO lasers were also introduced.
CO lasers operate at the wave length of five microns and are particularly advantageous in cutting glass, including curve-cutting. This makes them very useful in providing the desired shapes for OLED, LED and LCD displaying used in consumer electronics product.
Our Thin-film coating technology was showcased in many products at Photonics West. The increasing use of larger displays in consumer electronics is driving the demand for fast color [Ph] inventory capabilities to increase the throughput of display, calibration on the production line.
Our tristimulus colorimeter filters have earned high praise from our customers in the color analyzer market. Earlier this month, we introduced our wide incidents angle mirrors for lighter applications. These new mirrors also enable folded laser beam geometrist [ph] that are essential to achieving compact lighter designs and are able to operate in extreme operating conditions.
We introduced ultraviolet fluorescence filters for a new generation of bio medical instruments that use new [Indiscernible]. In addition, we unveiled our new laser head series that achieves extremely stable and low noise optical output power needed to enable greater accuracy of measurement in the next generation of flow cytometers.
The high measurement sensitivity flow cytmeters is critical for clinicians who need to accurately identify residual traces of target cells or markets. Next on our schedule is the optical fiber communications conference in March, where you can expect truly a most exciting product announcements from Q6.
With that, I will hand it over to Gary.
Thank you Giovanni. We have established a series of cross functional initiatives to improve our operating efficiency and utilization of assets. I will share a brief update on three of them this afternoon.
First, with regard to our company’s quality program. Three years ago we launched an initiative to unite the many site specific quality programs we have worldwide.This efforts resulted in a majority of our locations achieving ISO 9001 2015 qualifications and our Dallas Texas facility receiving its ISO 1345 registration for the design and manufacturer of FDA-approved bio medical assemblies.
This latter very special ISO certification marks the successful implementation of the specific requirements to support the design and manufacturer of medical devices and systems for FDA approved equipment.
It’s an important milestone as we continue to build our lifesciences business. All of these efforts have been instrumental and are being able to ramp significant growth on several fronts this year.
Secondly, we have united our procurement efforts worldwide, with procurement growth for both cost reduction and on time delivery. This has particularly aided the ramp and helped maintain or improve margins across the company.
Finally, I will comment on the use of both of these initiatives to improve working capital use. We are focused on improving inventory turns and the cash conversion cycle. One very good example of this is the consolidation of our European sales office into one Central customer operation center in Germany to serve our European customer base.
Features of this operation include, a single inventory location in Europe with fully integrated systems capabilities, and state-of-the-art warehouse capabilities. All of these efforts supported our margin expansion in fiscal year 2017 and are important to progressing them along the ranges that we set for the fiscal year 2018 as a whole, that are included in our investor presentation.
With that, I’d like to turn the call back to Mary Jane.
Thank you Gary, and hi everyone on the call. Regarding our second quarter reported financial results, as a reminder, on the second page of our press release, we show the segment result. That page detailed by segment, the book-to-bill ratio, the revenue, operating income, and the operating income margin.
Our Q2 revenue grew significantly over Q1 at 8% compared to our normal Q1 to Q2 growth pattern more like 4% or 5%. The distribution of our Q2 revenue by end market was 38% in communications, including wireless, optical and data communications 28%, 29% in industrial, 10% in military and the remainder in consumer, semiconductor capital equipment automotive and life sciences.
Our Q2 sales were geographically distributed 42% in North America, 19% in both Europe and China, 8% in Japan and 12% for the rest of the world. The company's overall gross margin for Q2 was 38.9% down compared to Q1 FY'18, Q2 FY'17. This is due to our significant ramp of several products serving our end market, some of which are in a sold-out position. And this includes earlier capacity additions now coming online.
The operating margin for this quarter was 11.5%, 20 basis points under that of Q2 FY'17. The EBITDA margin was 19.1% for this quarter compared to 20.8% for Q2 of FY'17 when we had $4 million of net positive one-time items including a $5.5 million positive currency effect.
On a comparable basis, the EBITDA margin advanced 30 points. The acquisition of IPI and the U.K. fab contributed $6 million of revenue combined in the quarter and were diluted by $0.02. The IPI acquisition has been integrated into the photonic segment, and the U.K. fab has been integrated in the later solution segment.
With respect to the segment operating margin, laser solution margin advanced 520 basis points sequentially with the ramp of new products, including about 400 basis point investment in new capacity.
As for the photonics operating margin of 15.3% it is now in line with its more recent levels and the performance product margin is at 10%. We finished the quarter with a record backlog of $404 million crossing the $400 million mark for the first time. This consists of $151 million in performance product, $131 million in photonics and $122 million in laser solutions.
The backlog contains orders that were shipped over the next 12 months. We had $4.5 million in share-based compensation, excuse me $5.4 million in share-based compensation for Q2, an increase of 38% over Q2 of FY'17’s expense of $3.9 million primarily due to the higher share price and shorter vesting periods for the new FY'18 equity grants approved by the board in late August.
These August 2017 grants replaced lower share price equity plants that rolled off now for being fully expensed. We expect the annual expense for share comp, share based compensation to be about $20 million compared to the FY'17 total of $16 million.
To provide comparability to those who report on a non-GAAP basis, we had $1 million of stock compensation in the cost of sale and $4.4 million of stock compensation and $3.8 million of acquired amortization in the operating expenses.
Excluding these items our gross margin would be 39.2% and our operating margin would be 14.8%. The Company have other income of $2 million primarily from equity earnings from our technology investment including a recent $52 million in the company that provides proprietary materials and devices processing and is reported in our performance product segment.
Capital expenditures this quarter were $40 million. The Q2 FY'18 tax rate was 68% approximately 16% attributable to our normal operations and 52% attributable to the new tax legislation. We expect the tax rate to be 31% for the full year and between 17% and 21% for Q3 and Q4.
The reported EPS in this quarter with $0.15 a share and $0.39 without the effects of the new tax bill compared to $0.37 a share in Q2 FY'17. Our cash $254 million and our next debt position is 272. We did not repurchase any shares this quarter.
Our Q2 results include $0.04 a share for our convertible debt. The company will select its file EPS calculation method by March 31 and when we do, will publish the calculation schedule including a pro forma recast of Q1 and Q2 on a comparable basis if that’s necessary.
Turning to our outlook, the outlook for the third fiscal quarter ending March 31, 2018 is revenue of $270 million to $285 million and GAAP diluted earnings per share of $0.33 to $0.40 inclusive of all investments and the effects of financing.
This wider range provides for a number of dynamics in this upcoming quarter, including Chinese New Year. The timing of contract negotiation and customer buying pattern and the continued acceleration of capacity expansion for several product lines.
This is also all at today’s currency rates. For comparison to last third quarter of fiscal year 2017 the results for the third quarter ended March 31, 2017 revenue of $245 million and GAAP diluted earnings per share of $0.35.
Now as we turn to the Q&A for this call, just remember that our actual results may differ from these forecast in the future, due to a variety of factors, including, but not limited to changes in product mix, customer orders, competition and general economic conditions.
I will also remind you that our answers to your questions today may contain certain forward-looking statements which are based on our best knowledge today only, and for which actual results may differ materially.
In addition to the Q&A, in addition during the Q&A, we will abide by our obligations to protect our customers confidential information and as a result, will only answer your questions to the extent allowable or required.
Andrew, you may open the line for questions.
Thank you. [Operator Instructions] Our first question comes from the line of Jim Ricchiuti - Needham & Company. Your line is now open.
Hi, thank you. Good afternoon. Just going back to your last call when you talked about the sequential ramp in revenues and I think at the high end you hit that target that $20 million sequential ramp, but I think what you said back then was that the initial ramp in 3-D sensing would be a meaningful contributor to that ramp. Was that the case, can you talk a little bit about the truck whether it is meeting your expectations?
We said that year-over-year 70% of the growth came from the three markets, consumer, automotive and Datacom, and vessels were the most meaningful component across the board.
Okay, that’s helpful. And another question I just want to ask and I’ll jump back in the queue. What kind of visibility do you have in this part of the business, and more broadly, if I could, just in the industrial business? Can you talk a little bit about that?
So, I would say if we take industrial. The industrial business tends to have somewhat better visibility because it tends to be a little bit more setting market. I would say 3D-sensing probably is a little bit more like optical communications where the visibility is not always very clear necessarily goes away planned.
Okay. Thank you.
Sure.
Thank you. Our next question comes from Mark Miller with The Benchmark Company. Your line is now open.
Hey, Mark.
Hi. Congratulations on the record sales, the bookings were good. Just a question. In terms of the, there's been some recent people on the global telecom market who were saying the first half will be fairly moving somewhat soft but then strengthening the second half.
You've been doing well, bright and shiny, you've been doing better; a lot of people saying that. I'm just wondering what your outlook is for the global market, telecom market this year, back in only there is there going to be study throughout the year.
Yes, well actually or as I just commented on optical. We show generally we give the guidance by end market but also optical is the one I think that's the most subject to change. So, we have done well in the optical market this year.
It's been steady, we've worked hard at that but I don’t know that we would probably give much more than that since it's subject to change pretty much at any point in time.
Okay. Is that the driver for the low and high end of your revenues is at the most uncertain thing right now on your forecast, was dragging with 15 million?
I would say that it's a good part of it if for no other reason than the Chinese New Year effect. That not only effects what we produce as more importantly effects what customers might buy. But I would say there's a lot of things going on and I try to give a color on them.
Certainly, optical and Chinese New Year but also customer negotiation, customer buying pattern, a variety of things that can make Q3 a little bit more uncertain than other quarters.
Thank you.
Sure.
Thank you. Our next question comes from the line of Tim Savageaux with Northland Capital. Your line is now open.
Hi, Tim.
Hi, good afternoon and I apologize for the voice here, getting over a little cold. I wanted to ask about the strength in orders on the Photonics side and at least on a sequential basis. From what you've seen recently in, I imagined that's still principally driven by optical communications.
But and you mentioned I guess some sequential growth in China, much of that was orders a revenue. But if you could kind of characterize that strength in Photonics orders by end-market or where there any major geographic drivers there. Thanks.
So, first of all just to answer your question on the sequential growth in optical, China was in revenue. So, with respect to orders picking up, I think as Chuck commented on Datacom was strong in the quarter and is remaining strong. And but keep in mind from a Photonics point-of-view, the other part that drives the whole of the Photonics segment is industrial.
And that is has been very strong and continues today.
Thank you. Our next question comes from Richard Shannon with Craig-Hallum. Your line is now open.
Hi, Richard.
Hi, Chuck, Mary. Hi, Chuck Mattera, how are you. Thanks for taking my questions.
Hi. Hello, Richard.
Hi, good afternoon. I know that you typically don’t ask in precise the way that I'm asking to ask the question. But just want to get a sense of in terms of your big your three big revenue buckets that you report on in how are you expecting the trends to go into the March quarter.
I know, in the midpoint of your guidance is just negative sequentially but wondering if there's any changes within those three buckets that are markedly different than that average?
I would say that, again we openly give the color by product line but first of all just to maybe put the answer on the context of your question there. It was seeing reasonably good strength in growth and industrial. We've seen that now for several quarters. Optical, first of all is the most difficult to forecast and also will see a little bit of an effective Chinese New Year.
And then in the growth markets that we have, the growth in each one of them may differ from Q2, but generally speaking we expect to see some decent growth not necessarily sequentially it continues momentum I think from a growth market. So, that's probably what we can tell you.
Okay. That's right off. I'll follow-up on the commentary regarding to your growth markets. I think in response to the previous question, Chuck you'd mentioned that much of the growth in the growth market it's coming from VCSELs. So, now obviously have two big markets, are the 3D-sensing and Datacom.
Your Datacom results had been very strong last few quarters. I wonder if you care to quantify or qualify any more precisely what you where that growth is coming from.
We're not going to break down the VCSELs shipments by end-market. I think it's fair to say they were good across all the end-markets we sell VCSELs.
Okay. That is fair enough. A quick follow-up or a quick question on silicon carbide. I want to make sure I caught that comment correct. Did I hear you say do you expect the second half of your fiscal '18 to grow 50% year-on-year versus the same period a year before? Is that correct?
Yes.
That's correct.
Okay. And that's encompassing both wireless and power side?
Correct.
Right.
Okay. I guess, last question from me, when you purchase the ANADIGICS and EpiWorks assets a couple of years ago, you set out some milestones soon after that. They kind of finished with calendars '17. I wonder if you want to check if you can offer any other milestones that we should look at for this calendar year about your progress development capacity, customer wins et cetera.
I would say this, Richard, as I said in my prepared comments. I will progress through the quarter and then right up to the end of the calendar year; were a highlight.
But I'm not prepared today to set long range targets for technology; for products; for utilization; other than to say we will be working across all three of those fronts to continue our penetration into the market and will take it step-by-step, quarter-by-quarter and we will continue to carry on and point our capability to the markets to be able to support and enable customers along the way.
Okay, fair enough. I appreciate those stats, all the questions from me. Thank you, very much.
Thanks.
Thank you. Our next question comes from James Kisner with Loop Capital Markets. Your line is now open.
Thanks, guys.
Hi, James.
Nice quarter. I think I also want to dig in the outlook a little bit. So, you guys, you're talking about Chinese New Year, presumably you had II-VI some pressure in China in the last two March quarters and you were up sequentially in this quarter.
I was just trying to understand if there's something different this time around or perhaps the street of this quarter come somewhat at the expense of the March guide. Could you maybe clarify that a little bit?
No. I'd think actually we probably have the answer on our hands from the last two years. Right, we saw some pressing on demand and capacity through a good part of fiscal year '16 and we did in '17. But right about this same quarter, in other words the quarter that commenced January 1st was about the time last year that we started to hear about flowing in China.
So, the fact that we are seeing a little bit less visibility from customers compared to what we might have had in the prior two March 31 quarters I think is not either the least but unusual or surprising and probably kind of to be expected.
Okay. Thanks for that. In just gross margin, I think I heard you right, I think it was -- if I heard you right, the gross margin was a little bit depressed driven by the ramp of new products. I don’t know if you can quantify that, it was a 100 basis points, if I heard that right.
Do you expect that, listen to that that head win to abate from margins kind of tick back up into the 40% or into some point in the future. Just, I don’t know you don’t guide it but I had to ask it.
Yes, sure. But first of all, we're not going to change the range we have out on our gross margin guidance for the year-end, first of all. But second of all, I would say that the thing just to keep in mind because we mentioned other few times in the script, we have quite a few areas of good growth where we are out of capacity.
Silicon carbide, our products in -- CO2 and low power CO2 lasers were ramping VCSELs at this point which you obviously all know. EUV, were out of capacity in two different types of product lines for that product. So, we do expect it to abate certainly and I would say probably at any point in time we're always ramping something.
But what is very exciting for us this year is that we're ramping so many at the same time.
Okay, that's helpful. I have just a couple of housing questions too. The tax, I get the repetition tax impact, what about the future corporate tax rate on a non-GAAP basis, there is a preset same old cut to U.S. taxes here. I know this is an offsetting tax on foreign income but is there any change to your interpretation for this non-GAAP tax rate?
Well, so I gave you a range of 17 to 21 for Q3 and Q4. For '19, I think you got -- obviously remember this, we're 630 year-end. Some provisions of the bill are evaluated at the year-end. So, I'm not, we are not in a position at this point to try and forecast what we think the say the FY'19 tax rate is going to be.
But I would say that managing the tax rate, taking advantage of various incentives no matter where we operate is a responsibility of every general manager we have and they have a history of doing that well. So, I would expect them to continue that.
But I think until we're clear on the next two quarters, the bill will probably not going to say much more about an actual vein.
Okay, great. Last one. Some dilution from IPI and you gave -- I think you said it was $0.02. That was for the guidance if I heard you right? What is that items that's pretty good trajectory versus where you saw before a $0.05 dilution this last quarter.
Is that the kind of retro you expect is that you trade to the keep being, is it ahead of schedule or is that kind of no longer be dilutive and in another quarter or what do you think?
So, first of all my comment about the $0.02 is the actuals in this quarter.
Oh, well.
And -- yes, the actuals in this quarter. What part-and-parcel with the question we had earlier about Datacom, we've seen some nice growth in our Datacom products across the board which include the price that are made of IPI. So, that obviously is a help to it potentially being different than the range but I'm not going to necessarily forecast this specifically and just still probably say we keep it above the $0.03 or $0.05 going forward.
It combine just again with the variability in the third quarter, this is one of those markets that could be subject to some of this buying. I don’t know that where we confirm that would be $0.02 necessarily every other quarter from here.
Okay, thank you.
Okay.
Thanks.
Our next question comes from Troy Jensen with Piper Jaffray. Your line is now open.
Hi, thanks and congrats for the nice quarter.
Hi, Troy.
Hello, Mary Jane. These are two questions quick. Revenues for the Photonics section were flat sequentially but the operating margins were down 230 BIPs. I'm curious if that was your gross margins or is it OpEx or was there any acquisition related dilution in that?
Actually, I hate to give you a little bit of math here but the bigger issue really was the last quarter was particularly high. It was up a couple certainly more than a 100, maybe a 150, I don’t quite exactly remember, for an inventory pickup on the revaluation of the inventory.
And we had called that out because --.
That's right.
I had not, yes, I had not expected to see the margin for Photonics stay at '17. So, if you just take that into consideration, I think the Photonics team has continued to do a great job, holding their revenue steady and holding their margins and continuing to work on improvements.
Okay.
Yes, I would add, Troy. Good afternoon, Troy. I would add one of the major areas of capacity expansion that we have underway this FY'18 is in our thin-film filter based products. And we have an awful lot of activity happening in addition to the acquisition of new thin-film coaters.
Training of people, establishment of lines, qualifying our capability. We have an awful lot happening in the first half of the year. And we ramped it up here in the second quarter. We begin to -- we will we should begin to see the benefit of those investments, maybe the tail end of the third quarter and into the fourth quarter of this year.
We're working hard to pick it up.
Okay, perfect. And then Chuck, I got to follow-up here for you. So, I'm curious if you've taken any time to dive into the new China five-year plan. It sounds like their intentions are just sort of some more optical components domestically.
When I looked through the plan, I didn’t see much for their intentions to get into pumps and amps. But just curious if you think this has any implication for your customers or am I wrong on the lack of the getting into the pumps and amps business?
Well, let's see Troy, it's a great question. Here is what I would say. We are in close contact with our customers in China as you know as we are everywhere else in the world. And even in the most recent tour, in meeting and talking with customers even in the last few weeks or so.
It's really difficult to see any impact at all on the ongoing commercial relationship. We're in the process of talking about short-term longer-term forecast, short-term needs, longer-term needs. It just feels like the ordinary course of business for us.
And that's just because they're not focus on pumps and amps and focus on getting source domestically for other components or?
I don’t know but I do believe that they are satisfied with the service that they get from II-VI and all other conversations that we're in, they generally tilt toward how we can do more.
Alright, understood. Thanks, and I'd be at look this year.
Thank you.
Thanks.
Our next question comes from Dave Kang with B. Riley FBR. Your line is now open.
Hi, Dave.
Thank you, good afternoon. My first question is regarding -- hi, regarding IPI in U.K. dilution. So, I may have missed it but did you give a timeframe for when they'll breakeven?
So, we have said that we were targeting to breakeven by the end of this year. That'll depend a lot on whether or not we need further capacity expansion or we decide to accelerate that. That's probably the case.
Okay. And then, my follow-up would be on the VCSELs. So, I guess your you don’t want to break out between end markets but between Datacom and consumer, can you at least tell us which is bigger and how much is the total VCSELs revenue, just roughly speaking?
So, a couple of things. We don’t breakdown the if it's the revenue by each product. I'd say that particularly if you focus on the growth. We've sold VCSELs for Datacom in the past. So, in the quarter, a lot of the VCSELs revenue would have been for newer applications but that's probably the extent to what we can say.
Okay. And my last question would be just on your outlook for third quarter. Can you at least give us some or tell us what your assumptions are by your key markets or segments the way you break it up between industrial, Photonics and performance?
I would say, not really. I think what I did say here was that we expect to see industrial perhaps more set even optical, though keep in mind part of the industrial business that's contributing to our growth as in China.
So, the whole Chinese New Year affect and ends up affecting really both of those segments. Performance products is a little bit less subject to that particular and a sort of a factor for Q3 but probably has a more in there with the number of customer negotiations in the timing of that, that we'll see here in Q3.
Alright, thank you.
Sure.
Thank you. Our next question comes from Vishal Shah with Deutsche Bank. Your line is now open.
Yes, hi.
Hi, Vishal.
Thanks for taking my question. Hi. So, I wanted to just expand on the comment you made on silicon carbide. It sounds like the market is pretty tight. Can you talk about what you're seeing in terms of your conversations with ongoing with customers around just longer term agreement that you were able to sign multiyear contract.
And also, what are your longer term capacity expansion plans. I know you are adding capacity but how do you see CapEx in that business as you go through this year and potentially next year?
Let me just address the second question first. First of all, I sometimes remind people of this that for the optical communications business in 2013, actually 2016. We expanded the business 35% on those three major product lines and never said a word about it.
So, we will I think the thing you should think about us is we try to pick end markets that we think have longevity and therefore we could be looking at capacity expansion continually especially as Chuck said earlier, we continue to focus on yields and production methods and handling methods throughout the whole production line.
I would say that silicon carbide's probably a decent chunk of our CapEx this year but I don’t know that it is necessarily out weighted to other growth markets that we have. And then with respect to longer term agreements, do you want to take that one, Chuck?
Yes. I guess, I would say that here's a trend, Vishal. Recently, I would say the last few quarters we're seeing maybe fewer orders much larger average size. And so, we have large customers who are coming maybe in the past they would have been placing smaller sized orders more frequently as part of their qualification schedules perhaps as part of their early ramps.
But and in many cases, we're either seeing orders or we're engaged in discussion about future orders whose average sizes are substantially greater than what they have been let's say a year or so ago. It's a sign that to us that the demand the near term demand is real.
And in our discussions with them, we are working and hoping to be able to get to a place where we have really much longer term commitments. And I think that's a general direction that we're pushing. In the meanwhile we are pleased with the fact that the larger orders are coming and more customers are coming to us to be engaged in those kinds of discussions.
That's helpful, thank you. Just one other question on pricing. Openly there is a industry pricing has to come down in order for silicon carbide to be used much more broadly. Can you talk about how you think the pricing environment is in the near term, is pricing stable or are you seeing some price reductions with your customers and also how do you think you can manage margin through this ramp.
Do you think your margins can remain where they are or you think there's some margin compression potentially possible as you ramp volumes. Thank you.
Okay, Vishal. I'd like to take, I'll take both of them. First of all, with the right of pricing, we're very much aware that there have been other reports in the industry about capacity expansions. They're widely published, widely understood. I really don’t want to make any comment regarding pricing.
And so, that's number one. What was your second question with regard to your margins?
Yes.
Yes. With regard to margins, of course the equation includes pricing. But we regard the margins, we will continue to work hard to sustain and improve the margins and first and foremost we need to be able to improve our yield at true point and our overall operational efficiency.
And we're so focused on that. It's just that you'll see a little bit of a lag because when we add capacity, cost effectively we add a large number of furnaces in one tranche. And so, there is a little bit of a lag by the time we have it turned on, proven, and then be able to generate the revenue, there is a little bit of a drain on the operating margin.
But then, we're moving quickly to be able to fill and get back up to the targeted level. And it's a combination of things. Order coverage, maximizing the mix, and these larger orders from bigger customers are really part of the equation as well. So, we like that a lot.
Great, thank you.
[Operator Instructions] Our next question comes from Jim Ricchiuti from Needham & Company. Your line is now open.
Chuck, with respect to the last comment you made about larger orders from larger customers, is this a broader trend that you're seeing within the business. Is this a change in strategy, is this customers that are now recognizing your capabilities or is this something that you're actively pursuing and that you have been pursuing and you're seeing the benefits of it now?
I think it's a great question, Jim. Let me say that in many cases including a couple of them that I have in mind, as I talk about larger orders. We've been engaged with many of these customers for a long time.
The qualification periods for example for electronics, for automotive applications, is a long cycle. So, you need to be engaged with them. But I would say across the board, if I one of the biggest changes in II-VI in the last few years is that our capabilities, our technology platforms, our product portfolios, our investments in our road map are in line with many larger customers than we did business with maybe three four years ago.
And I think that we are attracting much larger OEMs by virtue of our differentiated technology, our overall strategy and our motive operation. And I think this is just part of a long game that we're playing as I said taking it step by step but it’s one of the most exciting things for me about the growth of the company.
Okay, thank you. That’s helpful.
Thank you Jim.
And I’m showing no further questions. I would not like to turn the call back to Chuck Mattera for any further remarks.
I’ll take that for Chuck. Let me take this opportunity to thank my colleagues on this call and all of you who joined us today, we appreciate your attendance and the change in our time to accommodate Photonics West. This ends our call today. We look forward to updating you on our results for the third quarter and the outlook for the fourth quarter when we have our third quarter conference call that is now scheduled for our normal time slot on Tuesday May 1, 2018. Have a good day and thanks again for joining us.
Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may all disconnect. Everyone have a great day.