Coherent Corp

NYSE:COHR

Earnings Call Transcript 2018-Q2

[Operator]

Good day, ladies and gentlemen, and welcome to the II-VI Incorporated Fiscal Year 2018 Second Quarter Conference Call. [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.

[Mary Raymond, executive]

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 being recorded on Thursday, February 1, 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 undertake any obligation to update these statements to reflect events subsequent to today. With that, let me turn it over to Dr. Chuck Mattera. Chuck?

[Vincent Mattera, executive]

Thank you, Mary Jane, and thanks to everyone for joining us this afternoon. It was a strong quarter for II-VI across 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 3 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 of consumer, automotive and EUV lithography contributed 70% over the quarter's growth over the prior year.

3D sensing production and development efforts this quarter proceeded on plan and were a highlight. 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.

Silicon carbide was also strong in the quarter. Our 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 in 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 strong, especially in Europe and China. Our CO2 laser optics business remains strong with a 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 in communications grew 8% sequentially. Datacom was nearly 19% of our total communications revenue, driven largely by our success in 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 new Tax Cut 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 reevaluated during Q3 and Q4 because their final resolution is dependent on the FY '18 year end position in earnings and/or cash in our businesses around the world.

The new bill accounts for a reduction of EPS of $0.24 per share and all but 16% of our tax rate in the quarter. Our Q2 tax expenses largely for the withholding tax for expected cash repatriation from our non-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'd 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 Electronic Show in early January. Giovanni?

[Giovanni Barbarossa, executive]

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 market we sell. Broadly speaking, they're falling to the categories of innovations in advanced material processing, and application-specific thin-film coating technologies, including some for the life sciences market.

With respect to advanced material processing, this week, we introduced our freeform 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 atomically precise surface finishes. These allow our customers to design application-specific beam-shaping systems to improve the efficiency of laser processing heads.

We launched smaller and lighter scan lenses that enable faster processing of micro materials by combining zinc sulfide and fused silica optics.

Scan lenses for carbon monoxide lasers, or CO lasers, were also introduced. CO lasers operate at a wavelength of 5 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 displays used in consumer electronics products.

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 colorimetry 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 incidence angle mirrors for LiDAR applications. These new mirrors enable folded laser beam geometries that are essential to achieving compact LiDAR designs, and are able to operate in extreme operating conditions.

We introduced ultraviolet fluorescence filters for a new generation of biomedical instruments that use new fluorochromes. In addition, we unveiled our new laserhead 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.

Such high measurement sensitivity for flow cytometers is critical for clinicians who need to accurately identify residual traces of target cells or markers. Next on our schedule is the optical fiber communications conference in March, where you can expect truly a more exciting product announcements from II-VI.

With that, I will hand it over to Gary.

[Gary Kapusta, executive]

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 3 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. Those efforts resulted in the majority of our locations, achieving ISO 9001:2015 qualifications in our Dallas, Texas facility, receiving its ISO 13485 registration for the design and manufacture of FDA-approved biomedical assemblies. This latter very special ISO certification marks its successful implementation of the specific requirements to support the design and manufacture of medical devices and systems for FDA-approved equipment. It's an important milestone as we continue to build our life sciences business. All of these efforts have been instrumental, and are being able to ramp significant growth on several front this year.

Secondly, we have united our procurement efforts worldwide. With procurement goals for both cost reduction and on-time delivery, this has particularly aided the ramp and helped maintain or improve margins across the company.

And 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 offices into 1 central customer operations 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 '17 and are important to progressing them along the ranges that we set for the fiscal year '18 as a whole that are included in our investor presentation.

With that, I'd like to turn the call back to Mary Jane.

[Mary Raymond, executive]

Thanks, Gary. And hi to 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 results. That page details by segments, 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 of 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 and Q2 FY '17. This is due to our significant ramp of several products serving our end markets, 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 up 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 acquisitions 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 Photonics segment, and the U.K. fab has been integrated into the Laser Solutions segment.

With respect to the segment operating margins, Laser Solutions 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 mark -- the $400 million mark for the first time. This consists of $151 million in Performance Products, $131 million in Photonics and $122 million in Laser Solutions. The backlog contains orders that will ship 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 plans that rolled off now for being fully expensed.

We expect the annual expense for 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 sales 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 had other income of $2 million, primarily from equity earnings from our technology investments, including our recent $52 million in a 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 was $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 is $254 million and our net debt position is $272 million. 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 final EPS calculation method by March 31. And when we do, we'll 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 patterns, and the continued acceleration of capacity expansion for several product lines. This is also all at today's currency rate.

For comparison to last third quarter of fiscal year '17, the results for the third quarter ended March 31, 2017, with 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 forecasts 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'll 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, we'll only answer your questions to the extent allowable or required. Andrew, you may open the line for questions.

[Operator]

[Operator Instructions] Our first question comes from the line of Jim Ricchiuti with Needham & Company.

[James Ricchiuti, analyst]

I'm 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 3D sensing would be a meaningful contributor to that ramp. Was that the case? Can you talk a little bit about that, Chuck? Whether it's meeting your expectations?

[Vincent Mattera, executive]

We said that year-over-year, 70% of the growth came from the 3 markets: consumer, automotive and datacom. And VCSELs were the most meaningful component across the board.

[James Ricchiuti, analyst]

Okay, that's helpful. And another question I just want to -- 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?

[Mary Raymond, executive]

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 steady market. I would say 3D sensing probably is a little bit more like optical communications where the visibility is not always very clear and necessarily goes the way planned.

[Operator]

Our next question comes from Mark Miller with The Benchmark Company.

[Mark Miller, analyst]

Congratulations on the record sales. The bookings were good. Just a question, in terms of the -- there's been recent people on the global telecom market who were saying the first half will be fairly -- will be somewhat soft but then strengthening in the second half. You've been doing well. In fact, in China, you've been doing better, a lot of people in that segment. I'm just wondering what your outlook is for the global market, telecom market this year? Back-end loaded or is it going to be steady throughout the year?

[Mary Raymond, executive]

Yes. Well, actually, I just commented on optical. We don't generally 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.

[Mark Miller, analyst]

Okay. Is that the driver for the low and high end of your revenues? Is that the most uncertain thing right now in your forecast? What's driving the $50 million?

[Mary Raymond, executive]

I would say that it's a good part of it if for no other reason, then the Chinese New Year effect. That not only affects what we produce, it more importantly affects 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 patterns, a variety of things that could make Q3 a little bit more uncertain than other quarters.

[Operator]

Our next question comes from the line of Tim Savageaux with Northland Capital.

[Timothy Savageaux, analyst]

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 imagine that's still principally driven by optical communications, but -- and you mentioned, I guess, some sequential growth in China. I'm not sure if that was orders or revenue. But if you could kind of characterize that strength in Photonics orders by end market or whether there are any major geographic drivers there.

[Mary Raymond, executive]

So first of all, just to answer your question on the sequential growth in optical China, it wasn't revenue. So with respect to orders picking up, I think as Chuck commented on, datacom was strong in the quarter and is remaining strong. 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 has been very strong and continues to be.

[Operator]

Our next question comes from Richard Shannon with Craig-Hallum.

[Richard Shannon, analyst]

I know that you typically don't ask in precisely the way that I'm asking a question, but I just wanted to get a sense of, in terms of your 3 big revenue buckets that you report on, how you're expecting the trends to go into the March quarter. I know in the midpoint of your guidance is just negative sequentially. But I'm wondering if there's any changes within those 3 buckets that are markedly different than that average.

[Mary Raymond, executive]

I would say that -- again, we don't really give the color by product line. But first of all, just to maybe put the answer in the context of your question there. We're seeing reasonably good strength and growth in industrial. We've seen that now for several quarters. Optical, first of all, is the most difficult to forecast and also, we'll see a little bit of an effect of 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, and continued momentum, I think from our growth markets. So that's probably what we can tell you.

[Richard Shannon, analyst]

Okay, that's fair enough. I'll follow up on the commentary around your growth markets. I think in response to a previous question, Chuck you had mentioned that much of the growth in the growth markets is coming from VCSELs. And obviously, you have 2 big markets, so 3D sensing and datacom. Your datacom results have been very strong the last few quarters. So I wonder if you care to quantify or qualify any more precisely what you -- where that growth is coming from.

[Mary Raymond, executive]

We're not going to break down the VCSEL shipments by end market. I think it's fair to say they were good across all the end markets we sell VCSELs.

[Richard Shannon, analyst]

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 that you expect the second half of your fiscal '18 to grow 50% year-on-year versus same period the year before, is that correct?

[Vincent Mattera, executive]

That's correct.

[Mary Raymond, executive]

Yes.

[Richard Shannon, analyst]

Okay. And that's a -- that's encompassing both wireless and power side?

[Vincent Mattera, executive]

Correct.

[Mary Raymond, executive]

Right.

[Richard Shannon, analyst]

Okay. I guess, last question from me. When you purchased the ANADIGICS and EpiWorks assets a couple of years, you set out some milestones soon after that. They kind of finished the -- with calendar '17. I wondered if you want to -- Chuck, if you can any offer any other milestones that we should look at for this calendar year about your progress, development capacity, customer wins, et cetera.

[Vincent Mattera, executive]

I would say this, Richard. As I said in my prepared comments, our 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 3 of those fronts to continue our penetration into the market. And we'll 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.

[Operator]

Our next question comes from James Kisner with Loop Capital Markets.

[James Kisner, analyst]

So you guys, I mean, you're talking about Chinese New Year -- I mean, presumably, you had this decent exposure China in the last 2 March quarters and you were up sequentially in this quarter. I'm just trying to understand if there's something different this time around or perhaps the strength of this quarter comes somewhat at the expense of the March guide. Could you maybe clarify that a little bit?

[Mary Raymond, executive]

No. I think, actually, we probably have the answer on our hands from the last 2 years, right? I mean, 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 1 was about the time last year that we started to hear about slowing in China. So the fact that we're seeing a little bit less visibility from customers compared to what we might have had in the prior 2 March 31 quarters, I think, is not either the least bit unusual or surprising and probably kind of to be expected.

[James Kisner, analyst]

Okay. And just gross margin, I think I heard you right, I think you were -- 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, if it was 100 basis points or if I heard that right. And do you expect that headwind to abate and for margins to kind of tick back up into that 40% where [ you hinge ] at some point in the future? Just -- I know you don't guide it, but I have to ask it.

[Mary Raymond, executive]

Yes, sure. Well, first of all, we're not going to change the range that 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 it a 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; we're ramping VCSELs at this point, which you obviously you all know; EUV, we're out of capacity in 2 different types of product lines for that product. So it -- 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.

[James Kisner, analyst]

Okay, that's helpful. And just a house -- a couple of housekeeping questions. So I mean, the tax, I get to repatriation tax impact. What about the future corporate tax rate on a non-GAAP basis, I mean, there's a pretty substantial cut to U.S. tax this year, I know there's an offsetting tax on foreign income, but has there any change to your expectation for the non-GAAP tax rate?

[Mary Raymond, executive]

Well -- so I gave you range of 17% to 21% for Q3 and Q4. For '19, I mean, I think you guys will obviously remember this, we're a 6/30 year-end. Some provisions of the bill are evaluated at the year-end. So we are not in a position at this point to try and forecast what we think, 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 2 quarters in the bill, we'll probably not going to say much more about an actual rate.

[James Kisner, analyst]

Okay, great. Last one. Just on the dilution from IPI and the U.K. fab. I think you said it was $0.02, that's was for the guidance, if I heard you right. What is it -- and I guess that's pretty good trajectory versus where you thought before, $0.05 dilution this last quarter. I mean, is that the kind of trajectory you'd expect. Is it -- you expect it to keep being -- is it ahead of schedule? Is that going to be no longer going to be dilutive in another quarter? Or what do you think?

[Mary Raymond, executive]

So first of all, my comment about the $0.02 is the actuals in this quarter. And -- yes, the actuals in this quarter. 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 products that are made at IPI. So that, obviously is a help to it potentially being different than the range, but I'm not going to necessarily forecast the specific range. I'd still probably say we keep it about the $0.03 or $0.05 going forward, combined, 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 would confirm it would be 2% necessarily every other quarter from here -- $0.02, sorry.

[Operator]

Our next question comes from Troy Jensen with Piper Jaffray.

[Troy Jensen, analyst]

So 2 questions, quick. Revenues for the Photonics section were flat sequentially, but the operating margins were down 230 bps. I'm curious if that was gross margins, was it OpEx, was there any acquisition-related dilution in that?

[Mary Raymond, executive]

Actually, I hate to give you a little bit of math here, but the bigger issue really was that last quarter was particularly high. It was up a couple -- certainly more than 100, maybe 150, I don't exactly remember, for an inventory pickup on the revaluation of the inventory. And we had called that out because I had not yet -- yes, I had not expected to see the margins for Photonics today at '17. So if you just take that into consideration, I think the Photonics team has continued to do a great job holding their revenues steady, and holding their margins and continuing to work on improvement.

[Vincent Mattera, executive]

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've began to -- 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.

[Troy Jensen, analyst]

Okay, perfect. And then Chuck, if I can get a follow-up here for you. So I'm curious if you've taken any time to dive into the new China 5-year plan. It sounds like their intentions are to source more optical components domestically. When I looked to the plan, I didn't see much further intentions to get into the pumps and amps. But just curious, if you think this has any implications for your customers or am I wrong on the lack of them getting into the pumps and amps business?

[Vincent Mattera, executive]

Well, let's see, Troy. It's a great question. Here's 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.

[Troy Jensen, analyst]

And is that just because you're not focused on pumps and amps, and focused on getting sourced domestically for other components or...

[Vincent Mattera, executive]

I don't know. But I do believe that they are satisfied with the service that they get from II-VI. In all of the conversations that we're in, they generally tilt toward how we can do more.

[Operator]

Our next question comes from Dave Kang with B. Riley FBR.

[Dave Kang, analyst]

My first question is regarding IPI and U.K. dilutions. So I may have missed it, but did you give a time frame for when they'll breakeven?

[Mary Raymond, executive]

So we had said that we were targeting to break even by the end of this year. That will depend a lot on whether or not we need further capacity expansion when we decide to accelerate that. That's probably the case.

[Dave Kang, analyst]

Okay. And then my follow-up would be on the VCSEL. So I guess you're -- 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 VCSEL revenue, just roughly speaking?

[Mary Raymond, executive]

So a couple of things. We don't break down the revenue by each product. I would say this, particularly if you're focused on the growth, we've sold VCSELs for datacom in the past. So in the quarter, a lot of the VCSEL revenue would have been for newer applications, but that's probably the extent to what we can say.

[Dave Kang, analyst]

Okay. And my last question would be just on your outlook for third quarter. Can you at least give us or tell us what your assumptions are by your key markets or segments, the way you break it up between industrial, Photonics and performance?

[Mary Raymond, executive]

I would say -- not really. I mean, what I think I did say here was that we expect to see industrial perhaps more steady than optical. Though keep in mind, part of the industrial business that's contributing to our growth is in China. So the whole Chinese New Year effect ends up affecting really both of those segments. Performance Products is a little bit less subject to that particular and are sort of a factor for Q3, but probably has more to do with the number of customer negotiations and the timing of that, that we'll see here in Q3.

[Operator]

Our next question comes from Vishal Shah with Deutsche Bank.

[Vishal Shah, analyst]

So I wanted to just expand on the comments you made on silicon carbide. It sounds like that market was pretty tight. Can you talk about what you see in terms of your conversations ongoing with customers around just the longer-term agreement? Are you able to sign multiyear contracts? And also, what are your longer-term capacity expansion plans? I know you're adding capacity, but how do you see CapEx in that business as you go through this year and potentially next year?

[Mary Raymond, executive]

Well, 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 -- excuse me, 2016, we expanded the business 35% on our 3 major product lines and never said a word about it. So it's -- 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 full 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's necessarily out-weighted to other growth markets that we have. And then with respect to longer-term agreements, did you want to take that one, Chuck?

[Vincent Mattera, executive]

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 that would have been placing smaller size orders more frequently as part of their qualification schedules, perhaps as part of their early ramps. But in many, many cases, we're either seeing orders or we're engaged in discussions 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, that's the general direction that we're pushing. In the meanwhile, we are pleased with the fact that the larger orders are coming and more and more customers are coming to us to be engaged in those kinds of discussions.

[Vishal Shah, analyst]

That's helpful. Just one other question on pricing. Clearly, there's a -- the 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? Was pricing stable, or are you seeing some price reductions with your customers? And also, how do you think we 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?

[Vincent Mattera, executive]

Okay. Vishal, I'd like to take -- I'll take both of them. First of all, with regard to 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 margins? Yes, with regards to margins, of course, the equation includes pricing, but with regard to 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 yielded throughput 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 1 tranche. And so there is a little bit of a lag by the time we have it turned on, proved in, 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. You have 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.

[Operator]

[Operator Instructions] Our next question comes from Jim Ricchiuti from Needham & Company.

[James Ricchiuti, analyst]

Chuck, with respect to the last comment you made about larger orders from larger customers, is this a broader trend that you 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?

[Vincent Mattera, executive]

I think it's a great question, Jim. But 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, 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 roadmap are in line with many larger customers than we did business with maybe 3, 4 years ago. And I think that we are attracting much larger OEMs by virtue of our differentiated technology, our overall strategy and our mode of 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.

[Operator]

And I'm showing no further questions. I would now like to turn the call back to Chuck Mattera for any further remarks.

[Mary Raymond, executive]

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.

[Operator]

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.