Coherent: Laser Focus Is Required (NYSE:COHR)

In the summer of 2021 I offered some thoughts on shares of Coherent Corp. (NYSE:COHR) which were still called that II-VI at the time. Shares had seen a tough half year, as II-VI was perhaps too aggressive in trying to acquire Coherent, as the lack of discipline in M&A and softening operating performance was both disappointing and concerning.

With shares down 40% from the highs, appeal was luring, but the risks were too large for me to get involved.

A Recap

In the summer of 2021, it became evident that II-VI was beating peers Lumentum Holdings Inc. (LITE) and MKS Instruments, Inc. (MKSI) in its quest to acquire Coherent. That said, with aggressive bidding in taking place, the question was if II-VI was really the winner after it offered $6.4 billion to acquire Coherent, a deal to be financed 50/50 with regard to cash and stock.

II-VI at the time saw shares trading at $100 per share, as the company commanded a $12 billion equity valuation, equal to roughly 4 times sales of $3.1 billion and 25 times operating earnings. Coherent was much smaller with $1.3 billion in sales, as the initial $6.4 billion offer valued the company at nearly 5 times sales. Moreover, Coherent shows slower growth and lower margins, making me quite upbeat on the pricing attached to the firm.

At the time of the deal, I believed it could go two ways, either it was a great long term strategic play, or the debt taken on at a good point in the cycle might really haunt the company for a long time, and with the benefit of hindsight the latter situation appears to be the case.

Since the deal announcement in March 2021, shares of II-VI fell from $90 to $60 in August, in part because the company increased the cash component during spring (in a move which would add more debt to II-VI) while hiking the deal tag further to $287 per share. The final deal called for a $7 billion valuation, including at $5.4 billion cash component, quite a bit different from the original deal of course.

By August, II-VI posted annual sales at $3.1 billion and $601 million in operating earnings, as the company has built up a small cash position ahead of the deal closing. I was worrying that the organic business saw no growth in the upcoming fiscal 2022.

Net debt was pegged at $5.2 billion, for a roughly 5 times leverage ratio, as the 138 million pro forma share count valued equity at $8.3 billion at $60 per share. With a pro forma enterprise valuation around $13.5 billion, it was evident that quite some value has gone up into smoke, with II-VI still commanding an $11 billion valuation at the start of the year. Pegging earnings power around $3.60 per share, valuations have been reset in a big way at $60, yet leverage made me cautious, certainly as the core business saw some operational challenges.

Coming Down

Since the summer of 2021, Coherent Corp. shares have traded above the $60 mark until June 2022, but fell to $30 in the fall of that year. With the exception of a small recovery to the forties in February, shares have fallen further, trading at their lows at $27 per share.

The deal for Coherent finally closed in July 2022, and the company was actually renamed Coherent upon that deal. In August of the year, the company posted its fiscal 2022 results, which did not include a contribution from Coherent of course. Full year sales rose in a modest fashion (on an organic basis) to $3.3 billion, on which flattish adjusted earnings of $3.72 per share were reported. Net cash was further built up to $282 million ahead of the deal.

In November, when shares traded near their lows in the $30s, Coherent posted first quarter sales of $1.35 billion with adjusted earnings reported at $1.04 per share. Net debt came in at $3.7 billion, looking quite manageable with EBITDA trending at a rate of $1.4 billion per annum.

Second quarter sales of $1.37 billion looked solid, albeit that adjusted earnings fell to $0.95 per share and the backlog fell a bit to $2.9 billion. Moreover, the company guided for third quarter results to soften further, with sales seen between $1.32 and $1.37 billion, and adjusted earnings seen between $0.75 and $0.90 per share.

In May, it was painful to see the company miss on its results by a wide margin, with revenues only coming in at $1.24 billion, on which adjusted earnings of $0.58 per share were reported. Moreover, there is a near $40 million pre-tax stock-based compensation adjustment excluded in these numbers, equal to nearly $0.30 per share. Net debt came down to $3.5 billion, as pressure on earnings make that EBITDA trends at $1.1 billion and change, pushing up leverage ratios to more than 3 times. Net debt is much lower than expected upon the deal announcement, but this comes after Coherent has accepted $2.2 billion in mezzanine equity from Bain as well, of course.

And Now?

With 139 million shares outstanding, and these shares trading at $27 and change, the Coherent Corp. market value has shrunken to $3.8 billion. Including net debt of $3.5 billion, the resulting $7.3 billion enterprise valuation actually more or less coincides with the price paid for Coherent, as a testament of how much shareholder value has gone up into smoke, although the enterprise valuation rises to $9.5 billion if we include mezzanine equity.

Moreover, sales multiples have collapsed to less than 2 times here as earnings multiples are not that indicative here amidst the huge pressure on (adjusted) earnings, with realistic earnings only trending at a dollar and change here.

For me, the situation is not about current earnings multiples, but for Coherent to make it through this episode without incurring dilution or having to take other painful measures. Moreover, now quick avail is in sight as fourth quarter sales are seen at just a midpoint of $1.15 billion, with adjusted earnings seen only between $0.33-$0.43 per share.

Hence, there is not a great deal of room for operating missteps here, as the latest Coherent Corp. performance and outlook looks soft. That said, valuation have been discounted in a huge manner, and while debt can be painful, the company should be able to survive if the fourth quarter is the lowest point in the cycle, which of course is a big if. That said, we have seen green shoots elsewhere, as this could be a prime beneficiary for a recovery. While the Coherent Corp. situation looks appealing, this situation is only interesting for investors with an above-average tolerance for risk.