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Edited Transcript of COHR earnings conference call or presentation 29-Jan-19 9:30pm GMT

Q1 2019 Coherent Inc Earnings Call

SANTA CLARA Feb 11, 2019 (Thomson StreetEvents) -- Edited Transcript of Coherent Inc earnings conference call or presentation Tuesday, January 29, 2019 at 9:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Bret M. DiMarco

Coherent, Inc. - Executive VP, General Counsel & Corporate Secretary

* John R. Ambroseo

Coherent, Inc. - President, CEO & Director

* Kevin S. Palatnik

Coherent, Inc. - Executive VP & CFO

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Conference Call Participants

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* Blayne Peter Curtis

Barclays Bank PLC, Research Division - Director & Senior Research Analyst

* Brian K. Lee

Goldman Sachs Group Inc., Research Division - VP & Senior Clean Energy Analyst

* Patrick Ho

Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector

* James Andrew Ricchiuti

Needham & Company, LLC, Research Division - Senior Analyst

* Lawrence Scott Solow

CJS Securities, Inc. - MD

* Mark S. Miller

The Benchmark Company, LLC, Research Division - Research Analyst

* Mehdi Hosseini

Susquehanna Financial Group, LLLP, Research Division - Senior Analyst

* Nikolay Todorov

Longbow Research LLC - Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to Coherent's First Quarter Fiscal Year 2019 Financial Results Conference Call hosted by Coherent, Inc. (Operator Instructions)

As a reminder, this call is being recorded. I would now like to introduce Bret DiMarco, Executive Vice President and General Counsel. You may begin your conference.

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Bret M. DiMarco, Coherent, Inc. - Executive VP, General Counsel & Corporate Secretary [2]

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Thank you, Connor, and good afternoon, everyone. Welcome to today's conference call to discuss Coherent's results from its first quarter of fiscal year 2019. On the call with me are John Ambroseo, our President and Chief Executive Officer; and Kevin Palatnik, our Executive Vice President and Chief Financial Officer.

I would like to remind everyone that some information provided during this call may include forward-looking statements including, without limitation, statements about Coherent's future events, anticipated financial results, business trends and the expected timing and benefits, if any, of such trends.

These forward-looking statements may contain such words as project, outlook, future, expects, will, anticipate, believes, intends or referred to as guidance. These forward-looking statements reflect beliefs, estimates and predictions as of today, and Coherent expressly assumes no obligation to update any such forward-looking statements. These forward-looking statements are only predictions and are subject to substantial risks, uncertainties and assumptions that are difficult to predict and may cause actual results, performance or achievement to materially differ from those expressed or implied by these forward-looking statements.

Factors that could cause or contribute to such differences include, but are not limited to, risks associated with global demand; acceptance and adoption of our products; the worldwide demand for flat panel displays and adoption of OLED for mobile displays; the pricing and availability of OLED displays; the demand for and use of our products in commercial applications; our ability to generate sufficient cash to fund capital spending, operations or debt repayment; our successful implementation of our customer design wins; our ability to successfully rectify execution issues on a going-forward basis; our and our customers' exposure to risks associated with worldwide economic conditions, particularly China; our customers' ability to cancel long-term purchase orders; the ability of our customers to accurately forecast their own end markets; our ability to accurately forecast future periods; continued timely availability of products and materials from our suppliers; our ability to timely ship our products and our customers' ability to accept such shipments; our ability to have our customers qualify our products; worldwide government economic policies, including trade relations between the U.S. and China and China monetary policy; our ability to integrate the business of Rofin and other acquisitions successfully; manage and integrate our expanded operations and achieve anticipated synergies; and other risks identified in the company's SEC filings.

For a detailed description of risks and uncertainties, which could impact these forward-looking statements, you should review Coherent's periodic SEC filings, including its most recent Form 10-K, Form 10-Q and Forms 8-K, including the risks identified in today's financial press release.

I will now turn the call over to John Ambroseo, our President and Chief Executive Officer.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [3]

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Thanks, Bret. Good afternoon, everyone. We are currently experiencing a diverse set of market conditions. The materials processing market in China is facing increasing pressure due to a number of factors. The business outside of China is a different story. The flat panel business is in line with industry expectations. The trends in SEMI, API and instrumentation are generally positive. We are adjusting our customer engagement and investments accordingly.

Against the challenging backdrop, overall semi -- I'm, sorry overall microelectronics bookings posted low double-digit growth on a sequential basis. Several factors contributed to this result. While general Semicap spending is slowing, fab utilization remains high, which translated into very strong service renewals. This included leading-edge nodes for high-performance logic and memory production as well as legacy nodes for IoT and automotive devices.

Some of the lasers used in legacy nodes have either reached end-of-life or are very difficult to support due to a lack of parts. In anticipation of this, we've developed several solid-state alternatives that dramatically reduce utility costs due to a thousandfold increase in electrical efficiency. Demand for these replacement units has been understandably good.

The API market experienced even higher sequential growth, signaling that oversupply in microvia is ebbing. Orders also rose for PCB cutting and redistribution layer structuring. The final contribution came from the solar market. We booked a record order for ultrafast lasers used in thin-film scribing against an incumbent supplier. The end customer expects to further expand capacity over the next 4 quarters.

The FPD market can best be characterized by its constancy and continuous innovation. Samsung continues to dominate the mobile display market with roughly a dozen other firms trying to close the gap. We recently surveyed the Chase Group regarding their R&D commitments and projected timing for future investments. There appears to be little to no change in appetite or desire. Timing is subject to improvement in manufacturing yields and funding whether from government or handset manufacturers.

With a fair amount of future investment coming from China, we've been inquiring whether the country's economic slowdown will affect government support of display manufacturers. The answers vary but mostly the funding will be available when they need it.

During last quarter's earnings call, I mentioned that we were negotiating the cancellation of an ELA order. We reached resolution with the customer during our fiscal Q1. While we -- our overall ongoing business framework is confidential, we can disclose that a onetime $7 million upfront fee is included in our first fiscal quarter results. The balance of the business considerations will be recognized over time and will be incorporated into our quarterly guidance.

The Korean government has been closely watching investment and advancement in OLED technology by Chinese display companies. It is probably particularly frustrating that some of the technology developments have been aided by Korean expats employed by Chinese competitors. As a result, we understand that the Korean government is considering designating the Korean OLED equipment industry as a core technology of Korea. If this happens, it would restrict Chinese manufacturers' abilities to purchase Korean equipment or invest in Korean equipment companies. There are certain techniques, like lamination, where Korean vendors have a leadership position. Much of the other equipment in an OLED fab can be sourced outside Korea, so an embargo might slow but would not ultimately stop Chinese display manufacturers.

FPD service has been stable for the past few quarters, even though customers have reduced their service inventories. This would suggest utilization rates have been good.

There are a large number of OLED-equipped devices on display at CES this year, ranging from tablets to rollable TVs. Mobile computing displays represent an interesting opportunity for the industry since they consume a total surface area similar to the handset market. Some of the companies exhibiting these devices include Samsung, HP, Dell, ASUS and Lenovo. Shipments should commence in the next few months. If consumer adoption is strong, OLED capacity will likely have to be added to support surface area growth.

OLED and 8K TVs were also in abundance at CES. The most impressive demo was rollable OLED TVs from LG, which won numerous awards. Availability of rollable units may come later this year with a price tag that could exceed $20,000.

MicroLEDs also made an appearance predominantly in very large formats up to 219 inches based upon an 8 by 8 inch tile architecture. The image quality was impressive as was the size. When commercially available, these displays would be ideal for cinemas and signage. Our microLED was on display in the Samsung booth. It was a 75-inch unit and had 4K resolution. Apparently, you could own one for the price of an average single-family home.

The strong bookings trend in instrumentation OEM components continued in Q1. Bioinstrumentation customers are seeing solid demand from key applications like cytometry, and cite double-digit growth in emerging markets as one of the reasons. Light engines, the combinations of lasers and wavelength-switchable delivery systems, represent an increasing amount of our bioinstrumentation business. Customers can exploit the capabilities of and appreciate the reliability and ease of integration of our light engines, leading a major player to recognize us with their annual innovation award.

Medical OEM customers are also enjoying favorable conditions. Orders were up for dental and urology products. Demand was stable for aesthetic and ophthalmic lasers. Stable demand in aesthetic is particularly encouraging since it relies on discretionary consumer spending and can be seen as a loose proxy for consumer confidence in the Americas and Europe.

Orders for aerospace and defense applications grew by 45% year-over-year. The largest contributions came from U.S.-based directed energy projects and space-based telescope applications. The activity in both areas is on the rise, and we are well positioned as a U.S.-based manufacturer.

It was a predictably challenging quarter for the materials processing business as the combination of tariffs, rising Chinese consumer debt and eroding Chinese consumer confidence and spending are taking a toll on the Chinese economy. The Chinese government has to strike a delicate balance between reining in debt and providing stimulus, which has been previously effective in driving demand for the big-ticket items like autos and appliances.

In addition to these macro factors, a price war in certain fiber lasers continues to further exacerbate the challenges for the laser industry in China. There are some bright spots, however. Our focus on automotive applications is yielding results. We received significant orders for electromobility projects in Asia and Europe. The automotive market continues to perform well, and we expect bookings to grow for battery, powertrain and body-in-white projects over the remainder of FY '19.

We are also pleased by a bookings increase in medical device manufacturing, including a record 10% contribution from China. The Chinese medical device industry is expected to grow by as much as 25%, so this may provide a partial offset for the broader Chinese materials processing market.

The question on everybody's mind is what will 2019 look like. The risk associated with China has increased over the past quarter as we learn more about the evolving underlying situation, particularly their domestic challenges. Based upon these and other factors, it would be understandable to have a more dour outlook.

On the opposite side of the ledger, there are a number of things that could happen, any one of which could send markets upwards. For example, we could have an end to the trade conflict, leading to improved consumer confidence. The Chinese government could institute a stimulus package that encourages investment and/or consumption without piling on debt. And someone other than Samsung could make a breakthrough in OLED yields, which accelerates investment in new capacity. Some of these are more likely than others, all would have a market impact and all contribute to the uncertainty regarding the outlook for 2019, which makes full year forecasting very difficult. And as a result, we are not issuing full fiscal year guidance. We will focus on quarterly forecasting for the foreseeable future.

I'll now turn the call over to Kevin Palatnik, our Chief Financial Officer.

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [4]

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Thanks, John. Today, I'll first summarize fiscal first quarter 2019 financial results, then move to the outlook for fiscal Q2. I'll discuss primarily non-GAAP financial results and ask that you refer to today's press release for a detailed description of our GAAP results as well as a reconciliation between GAAP and non-GAAP financial results. The non-GAAP adjustments relate to stock-based compensation expense, amortization of intangible assets, restructuring costs, purchase accounting adjustments, the related tax adjustments and tax adjustments for stock-based compensation.

The full text of today's prepared remarks and trended GAAP and non-GAAP supplemental financial information will be posted on the Coherent Investor Relations website. A replay of this webcast will also be made available for approximately 90 days following the call.

Fiscal first quarter 2019 financial results for the company's key operating metrics were: total revenue of $383.1 million, non-GAAP gross margin of 42.6%, non-GAAP operating margin of 20%, adjusted EBITDA of 23.1% and non-GAAP EPS of $2.09.

Total revenue for the fiscal first quarter was $383.1 million. As expected, microelectronics and materials processing sales decreased sequentially by approximately $66 million and $20 million, respectively, primarily due to lower excimer shipments into the FPD market and decreased shipments of tools and diode components in the materials processing market.

Our revenue mix by market for fiscal Q1 was microelectronics, approximately 47%; materials processing, 27%; OEM components and instrumentation, 17%; and scientific and government, 9%.

Geographically, Asia accounted for approximately 55% of revenues in the fiscal first quarter; the U.S., 22%; Europe, 19%; and the rest of world, 4%. Asia includes 2 territories with revenues greater than 10% of total sales. We had 1 customer in South Korea related to large flat panel display manufacturing that contributed more than 10% of our fiscal first quarter revenues.

Other product and service revenues for fiscal first quarter of 2019 were $118 million or approximately 31% of total sales. Other product revenue consists of spare parts, related accessories and other consumable products and was approximately 28% of sales. Revenue from services and service agreements was approximately 3% of sales. Total service revenues were sequentially flat as our key integrators continue to focus on conserving cash by keeping their service stock to lower threshold amounts.

Fiscal first quarter non-GAAP gross profit, excluding stock-based compensation costs, intangibles amortization, restructuring and purchase accounting, was $163 million. Non-GAAP gross profit was impacted sequentially by volumes, product mix and warranty costs, partially offset by the onetime cancellation fee, resulting in non-GAAP gross margin of 42.6% for fiscal Q1.

Non-GAAP operating expenses decreased sequentially by approximately $10 million, primarily due to deferred compensation liability decreases as well as the increased number of holidays and vacation taken in December, the end of our fiscal Q1.

While we experienced a significant operating expense decrease sequentially, it was not enough to offset lower non-GAAP gross profit, resulting in non-GAAP operating margin of 20% for the fiscal first quarter. Adjusted EBITDA was 23.1% in fiscal Q1.

Turning to the balance sheet. Nonrestricted cash, cash equivalents and short-term investments were approximately $320 million at the end of fiscal Q1, an increase of approximately $9 million compared to the end of last quarter. During the quarter, we repurchased shares totaling approximately $25 million and borrowed $40 million against our line of credit. We did not make any voluntary payments against our term loan. The outstanding amount of the term loan in USD is approximately $422 million.

International cash was $219 million, or approximately 68% of the total cash and short-term investment balance. Approximately 37% of total cash and short-term investments is denominated in dollars.

Accounts receivable DSO was 78 days compared to 69 days in the prior quarter. The increase related to large collections that occurred in early January 2019 rather than in December of 2018. The net inventory balance at the end of fiscal first quarter was approximately $493 million, an increase of $6 million from the prior quarter. And capital spending for the quarter was approximately $23 million or 6% of total sales.

Now I'll turn to our outlook for our second fiscal quarter 2019. Revenue for fiscal Q2 is expected to be in a range of $360 million to $380 million. We expect fiscal Q2 non-GAAP gross margin to be in the range of 37.5% to 40.5%. Non-GAAP gross margin excludes intangibles amortization of approximately $12.5 million and stock compensation cost estimated at $1.3 million.

Non-GAAP operating margin for fiscal Q2 is expected to be in a range of 12.5% to 15.5%. This excludes intangibles amortization estimated at a total of $15.1 million and stock compensation expense of a total of approximately $8.7 million. Other income and expense is estimated to be an expense in the range of $5 million to $6 million. We do not include transaction gains and losses related to future changes in foreign exchange rates in our OI&E outlook.

We expect our fiscal Q2 non-GAAP tax rate to be in the range of 25% to 26%. And finally, we're assuming weighted average outstanding shares of approximately 24.5 million for the fiscal second quarter.

I'll now turn the call back over to the operator for a Q&A session.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Jim Ricchiuti with Needham & Company.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [2]

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Just a question with respect to the decision to move to quarterly guidance only. Is -- can you talk about which verticals you've seen the biggest change in terms of your outlook that you had been providing relative to the current guidance? I mean, it sounds like you had a reasonably good bookings quarter in certain verticals. I'm just trying to get a sense of where you're seeing the weakness.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [3]

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Jim, it's John. I would say -- I would answer it a little bit differently. I would say that there's enough macroeconomic uncertainty that any one of a number of things could happen that could send things sideways. I mean, just in the last few weeks, as an example, the President talked about tariffs on foreign manufactured automobiles. Now if that happens, it -- and I have no way of predicting whether it will happen, but if it were to happen, the wrench that, that throws into the works is pretty significant. And just given some of these very big topics or issues that are being bandied about, trying to understand how all of them or any of them might impact the forecast is challenging.

If you look at our markets -- now to drill down to your question a little bit. If you look at the markets, certainly the one that faces the greatest unknowns right now is materials processing. And that said, there's a lot on China, obviously, given its importance to that market. The other markets less so, but it really is macroeconomic factors that has us concerned rather than specific factors within any of the markets.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [4]

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That's helpful. And if I heard you correctly, I think you said that microelectronics bookings grew double digit, did I hear that correctly?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [5]

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On a sequential basis, yes.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [6]

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On a sequential basis. And you sound like you had some reasonably good bookings strength in other verticals. Can you talk a little bit about the sustainability of microelectronics bookings, putting aside the display portion of the business for a moment? Just in light of -- we're hearing mixed things there.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [7]

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Sure. I'm happy to expand to the extent that I can. I think if you look -- and I'm going to repeat myself a little bit here. If you look at our Semicap business as an example, we probably did better on a demand basis and possibly on a revenue basis than some of the other players in that market. Now part of that is tied to the fact that utilizations remain high, as I mentioned. And a good portion of our revenue within that space is related to service, so that ties [there] quite well. And the demand in legacy nodes continues to be strong. People are trying to recommission old products or old equipment. And that's led to a refresh cycle, which, fortunately, we had anticipated and positioned ourselves to take advantage of.

I would be remiss if I tried to convince you that the semicap market overall is buoyant. I think we've just done better than many of the other companies in the space just because of alignment that we have right now. Do we expect it to continue that way? I think there are parts of the business that will continue to be strong. Whether there will be sustained demand for leading-edge nodes is a greater question. A lot of the investment right now seems to be service related and getting legacy lines up.

With respect to the advanced packaging market, which more or less mirrors the semicap market, it was in a bit of the doldrums over the last year. There was some overcapacity that took place. It appears that, that's finally winding its way down. And certainly, announcements from U.S. carriers about initial 5G deployment is good. But as I mentioned in previous calls, the first phase of 5G will have a little bit of a benefit because it's more of the same. It's the second phase of 5G that really drives a more substantial upgrade. And as far as we can tell, that's still a couple of years away.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [8]

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Okay. Just a quick question. Kevin, can you say how much of a headwind that legacy Rofin ERP issue that you had in Europe was in the quarter?

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [9]

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In the current quarter, 0. We addressed that issue last quarter from a process standpoint, from a management perspective. That has been rectified.

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Operator [10]

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Your next question comes from the line of Patrick Ho with Stifel.

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Patrick Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [11]

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John, maybe first off, in terms of the display business and your longer-term outlook of the OLED industry. Given some of the concerns and the signs from the high-end smartphone market and a potential extending of the replacement cycle for these high-end smartphones, has your long-term outlook over the next 3 to 5 years changed in the OLED display market, how it may potentially impact the longer-term growth prospects of that business?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [12]

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So if you look at it over the longer term, no, I don't think our thinking has changed very much there. If you go back to comments that we made over several years, we said the best possible outcome is one customer leads the way for an extended period of time. Others then break the code and have to invest to start to take market share. It looks like we're much smarter than we probably are because that's the way things are playing out right now. But the longer term really is predicated on breaking into new format sizes. And that's why we were really encouraged what we saw at CES, where so many frontline manufacturers were displaying OLED-equipped either tablets or laptops and were actually talking about shipment dates rather than saying, hey, we have this in our portfolio. And that would suggest that some investment will have to take place if that becomes a meaningful part of the market.

In the short term, they can probably use some of the capacity that's already in place, at least for small quantities. But if it becomes a bigger part of the market, obviously, it's going to pull things along. And the reason we think that's likely to happen is when you look at how people use those devices, whether it's streaming or gaming, high-quality video is a pretty big deal. And given the intensity -- or the power intensity of displays, it all fits very well with the advantages or the story behind OLED. So no, our long-term outlook hasn't changed. Yes, there are some short-term dynamics in the handset market that need to be overcome.

I would, however, again reiterate the position in the handset market. Even without handset growth, there's still roughly 2/3 of the handset market that does not have OLED displays and would probably benefit from them or like access to them if there were more than one reliable vendor or more than one reliable manufacturer out there. And that's why, going back to one of my first comments, we need somebody to close the gap.

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Patrick Ho, Stifel, Nicolaus & Company, Incorporated, Research Division - MD of Technology Sector [13]

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Great. That's helpful, John. And maybe as my follow-up question for Kevin in terms of gross margins. Obviously, product and market mix is a key variable in your gross margins. Is that the biggest influence in your March quarter outlook? Or are there other moving pieces that are impacting gross margins at least for the March quarter?

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [14]

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Yes. Patrick, with regards to Q2 or the March quarter, actually, volumes plays a larger variable. We saw a pretty significant volumes drop into our fiscal Q1. So effectively, the WIP and the finished goods that were manufactured that roll into Q2 for shipments, they carry much higher costs. And that's a big determinant of the gross margins that we guided for Q2.

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Operator [15]

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Your next question comes from the line of Brian Lee with Goldman Sachs.

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Brian K. Lee, Goldman Sachs Group Inc., Research Division - VP & Senior Clean Energy Analyst [16]

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Maybe first off, John, you mentioned larger form factors. You also specifically called out the rollable TV from LG Display -- or LG Electronics at CES. And there's chatter across the industry of Samsung potentially reentering OLED TVs with a QD variant. So just wondering if you can talk maybe at a high level longer term about your positioning here, if there's visibility to resolutions in TVs specifically increasing to the point where your [ELA] technology would not be needed.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [17]

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I'm sorry, you broke up a little bit there. I think what you're asking is our views on TV and whether our technology might be applicable. Is that -- does that capture it?

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Brian K. Lee, Goldman Sachs Group Inc., Research Division - VP & Senior Clean Energy Analyst [18]

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Yes, in a nutshell. As some of these resolutions move up to 4K, and I think there were a handful of 8K variants out at CES as well. If that's sort of your window of opportunity at some point to start supplying ELA technology.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [19]

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So I'm going to refer back to comments that I've made in prior calls. For the TV market, a 4K device for TV is viewed by many as a benchmark, but the reality is it's less than a couple hundred PPI. So compared to a smartphone, it's actually a much more simple display. The reason to use annealing in TV is really about refresh rate because the traditional electronics will limit how fast you can refresh. And if you consider an OLED is capable sort of out of the box at a thousand times faster refresh rate than an LCD, you're leaving a key advantage or a key benefit on the sidelines. So any conversation around using any form of annealing would really be on refresh rates and being able to surpass what is currently in the market.

Even if you look at the specs around the LG TVs and the images from those TVs is beautiful, especially the color gamut, as you would expect from an OLED, but the refresh rates are nothing to get too excited about. And when we start to think about either 8K or very large screens, both of those put even more and more demands on the refresh rate. So I've said it, I think, 6 times now, I hope that I've left the impression that it's an important technical aspect.

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Brian K. Lee, Goldman Sachs Group Inc., Research Division - VP & Senior Clean Energy Analyst [20]

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Fair enough. No, that's helpful. Maybe just a second question on stimulus. It sounds like you're comfortable the funding will be there based on some of the work you've done. But curious if you have a specific view on OLED subsidies in the region, if there's any indication of those losing support in any provinces and then just how sustainable you think those could be in the current economic malaise that, that region see.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [21]

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Sure. So if we look at it from the national perspective, display technology is part of the 5-year plan. Typically, the government has stuck to its guns with respect to the things that are in the 5-year plan. We've questioned customers whether they see any change in position there. They claim not. When you drill down to the regional governments, I think you could have -- you potentially could have more variation there. And again, when we ask customers about that, they say they believe the funding is going to be there. It will remain to be seen, when rubber hits the road, if that is indeed the case. We have no reason to doubt the customer, but we've realized it's a very fluid situation in China, and things could change. But clearly, the commitment to being a major player in display is there. And if OLED starts to penetrate some of these other verticals, such as laptops and tablets and then becomes a bigger part of TV, it leaves the Chinese manufacturers who currently dominate LCD production in the dust. I guess, the question that I would pose to you in reply, how likely is the Chinese government going to allow that to happen?

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Operator [22]

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Your next question comes from the line of Blayne Curtis with Barclays.

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Blayne Peter Curtis, Barclays Bank PLC, Research Division - Director & Senior Research Analyst [23]

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Just want to go back to the Q2 guidance. If you -- I was trying to discern between your 2 segments there, if you could provide any color. You're down 3% overall. Just trying to understand, the material processing continued to slide into March. And then the second question was just kind of understanding your commentary on gross margin. Sounded like overall volumes, but obviously, you had higher gross margins back when your business was at a similar revenue rate. So I'm just trying to understand that and then kind of any perspective. I know you're not giving full year guide anymore, but any perspective on the recovery if your revenue does stay at this level.

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [24]

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Yes. So Blayne, from a gross margin standpoint, again, we produced 42.6% non-GAAP in Q1. We're guiding 37.5% to 40.5% for Q2. So there are several impacts related to that decrease. The single largest one, though, has to do with volumes. And with volumes, you don't absorb as much as your overhead and, call it, your fixed costs, so that your higher inventory costs that are built in the prior quarter, WIP and finished goods that gets shipped in the following quarter, they just carry higher costs and less meaningful margins. There are other things, warranties, duties related to importing of goods go higher with higher cost. Ancillary costs that increase which impacts gross margin, but the single largest has to do with volumes, volume degradation.

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Blayne Peter Curtis, Barclays Bank PLC, Research Division - Director & Senior Research Analyst [25]

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And just any commentary on the segments into March between material processing and microelectronics would be helpful.

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [26]

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Yes. Again, Blayne, I think John kicked it off. It's tough to get into the verticals, especially with material processing, given its relationship into China and all the uncertainty and doubt with China. So anything we'd say probably would be wrong. So we're just not going go into the verticals. We'll stay at the top with the $360 million to $380 million guide.

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Operator [27]

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Your next question comes from the line of Mehdi Hosseini with SIG.

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Mehdi Hosseini, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [28]

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Have a couple of follow-ups. Kevin, your days of inventory spiked during the December quarter. It's almost like a multiyear high. What is the mix here and the reason for the sequential increase?

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [29]

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So Mehdi, I mentioned DSO of the AR, accounts receivable, on the call. Were you specifically on DSO of inventory or AR?

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Mehdi Hosseini, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [30]

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No. Days of inventory.

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [31]

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Okay. So in inventory, inventory did rise a little bit quarter-on-quarter. And as you know, revenues came down. We talked about cancellations. John talked about cancellations upfront. All of that materials has already been ordered, so that will impact your metric days of inventory outstanding. But those were the largest drivers, if you will.

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Mehdi Hosseini, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [32]

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So would the majority of the sequential increase be the finished goods?

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [33]

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So if you break down our inventory, it's about 1/3 materials -- raw materials, 1/3 WIP and 1/3 finished goods. It's somewhat equally distributed. But again, related to volumes, it drives costs. If we have cancellations that's going to carry the inventory longer and as we look into our fiscal Q2, again, the guide was down a little bit, that's going to mean you're going to burn off inventory that much longer, which increases days of inventory outstanding.

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Mehdi Hosseini, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [34]

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Okay. That's very clear. And then last quarter, you talked about adjusting your cost structure. What's the update there? And what's been the traction?

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [35]

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No change. We said last quarter, for the year, we would reduce OpEx by $10 million to $15 million. A few good surprises in Q1 that effectively go away in Q2. For instance, the holiday and vacations. As you know, the December quarter between Thanksgiving holiday and vacation-taking and the December Christmas holidays, both holiday and vacation taken, we don't have that benefit as we look into Q2. That will drive OpEx up a little bit. And then it is on the press release, you can see the piece parts, where we got a $2 million benefit in period expense with OpEx in the December quarter related to our deferred comp plan. That will increase and decrease depending on the overall market. In periods of decrease, we get a credit to expense. In periods of increase, we get a debit to expense. So we did get a benefit from that, and there's an expectation that, that will go away as well, also driving period expense.

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Mehdi Hosseini, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [36]

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Okay. And then just one quick follow-up for John. I remember a year or 2 ago, you were actually capacity constrained and you were beginning to add capacity for OLED application. And I'm assuming that capacity is in place but not utilized. Is that fungible? Can you reallocate that capacity to other parts of the company or product portfolio that's growing faster?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [37]

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So Mehdi, the capacity that we put in place, there were 3 aspects. One was on the service side, which is being utilized because the installed base is higher than it was when we made that investment. So we're utilizing that capacity. On the system side, we didn't add any physical space. We added test equipment, so really a minimal impact there. And then the third area was on optics polishing or optics fabrication enrichment, and we have dramatically grown our non-FPD business, particularly for ground-based and space-based telescopes. So again, we're utilizing the capacity there. It's for a different end market.

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Operator [38]

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Your next question comes from the line of Larry Solow with CJS Securities.

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Lawrence Scott Solow, CJS Securities, Inc. - MD [39]

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Most of my questions have been answered. Just a couple, John, follow-up. Just outside of materials processing, it sounds like more positives than negatives. But if you just had to isolate those segments where there's hopefully less uncertainty, have things -- your outlook basically stable, some pluses and minuses or a constant from last couple of quarters?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [40]

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Again, Larry, if you look at the 4 end markets, microelectronics, we are enjoying some tailwinds in some of those submarkets. I can't say that there are any surprises around flat panels. It's about where we expected it to be. The instrumentation space has been on a good run, it continues to be on a good run. The materials processing market, I think we've flogged that one to death. And then the scientific market, it's stable to slightly up. It's not a big enough piece of the business to cast a swing vote. But I would say in general, 3 of the 4 end markets are doing well. The largest application space is in a down year. We've talked about that for a while, and materials processing is where the turbulence is.

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Lawrence Scott Solow, CJS Securities, Inc. - MD [41]

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Right. And without one of these potential remedies that you mentioned, whether it be some kind of trade deal or stimulus in China, without giving guidance, you normally get sort of an improvement in the back half. You're not getting sequential improvement in Q2, which you normally get with -- any way you can sort of picture what you frame the back half of the year, if nothing changes and sort of we remain in a similar negative, but constant macroeconomic environment?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [42]

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Yes. Larry, again, it's a great question. Certainly understand why you're asking it. However, since I just said that we were going to stick to quarterly guidance, it really would be flying in the face of that if I were then to turn around and make comments about the second half of the year. So I'm going to have to pass on that one.

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Lawrence Scott Solow, CJS Securities, Inc. - MD [43]

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Fair enough. I just threw that out there. How about just on a -- just a housekeeping question. The $7 million fee -- cancellation fee, was that accounted for -- does that all flow to the bottom line? How is that sort of accounted for? And is that in the GAAP EPS number? I assume so, but...

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [44]

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Your assumption is correct.

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Lawrence Scott Solow, CJS Securities, Inc. - MD [45]

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Okay. Last question, share repurchases; doesn't look like there was any activity in the quarter. Is that right?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [46]

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Share repurchases.

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [47]

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Oh, yes, so Larry, you'll see in my prepared remarks as it gets posted, but we did $25 million worth of share repurchases.

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Operator [48]

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Your next question comes from the line of Mark Miller with Benchmark Company.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [49]

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I just wanted to ask about 2 trends that are a little puzzling. Your SEMI business was strong, yet as you noted, people have been talking about double-digit declines in the industry. I believe you said that was due to service. Any more color you can give us? And do you think that's going to continue?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [50]

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So on the utilization side, the numbers have remained pretty good. We don't watch them day to day. We look for the regular updates that come from the various tracking agencies. I think the downturn that everybody is pointing to really is capacity expansion because we were on a memory craze for several years. And that has righted itself based on how memory pricing has changed just in the last 2 or 3 quarters. And then we were -- and when I say we, I mean the industry, was expecting China sovereign investment to close some of that gap. That hasn't happened as quickly as was expected. And the questions behind that is it cash conservation, is it because they're struggling to get the processes to work, is it somehow retaliatory for tariffs? Don't know. But we do recognize that our business right now is an outlier compared to the rest of the semi industry. And we think we understand the reasons for it. And it really has to do with how we're aligned on the service side and what we've been doing on the legacy end.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [51]

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The other question I had was about your other revenues which were flat, it looks like, sequentially. That's kind of puzzling, too, at least if we would think of in service. And I forgot if you mentioned service specifically, but especially with the reports that some of the smartphone manufacturers or suppliers are being hit with 10% to 20% reductions in expected supply from some of the major smartphone suppliers.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [52]

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How do I explain that without violating any customer information? The -- I'm struggling a little bit here, Mark, because I want to be very careful about what I disclose. I would say that while production has slowed for installed devices or shippable devices, you still have an aspect of R&D -- ongoing R&D by a number of players. And even though they might not be recognizing revenue, they're -- they still have to run the fabs and run the equipment, and that drives service revenue in the absence of unit sales.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [53]

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Okay. Just one last question for me. You said that fiber pricing -- laser pricing remains aggressive. Is it mainly still in the 1 to 3 kilowatts? Or is that starting to spread to higher powers? A couple of firms have introduced higher-power lasers. I'm just wondering if that's still confined to lower 1 to 3 kilowatt power ranges.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [54]

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What we saw in the December quarter was in the 1 to 3, 1 to 4 is where the battleground has been. We would expect that to extend to higher powers as people enter that space.

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Mark S. Miller, The Benchmark Company, LLC, Research Division - Research Analyst [55]

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Okay. Just curious because I heard some conflicting things. Sorry for the additional question. In terms of supplying 10 kilowatt fiber lasers, how many people are truly supplying 10 kilowatt fiber lasers or are some just talking about it? I was told there were just 2 people out there who are really supplying. I was skeptical about that, so...

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [56]

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I think it's probably fair to say that there are a limited number of players that can supply 10 kilowatt reliable fiber lasers. There are lots of companies that will ship a 10 kilowatt fiber laser.

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Operator [57]

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Your next question comes from the line of Nick Todorov with Longbow.

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Nikolay Todorov, Longbow Research LLC - Analyst [58]

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Can you give us an update on the FPD consumables inventory at your customers? Do you expect this kind of a low inventory management to continue through 2019 or you think that digestion [went] at some point?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [59]

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I think that the customers will continue to keep an aggressive posture on inventory as a cash conservation method. And we're in a position where we can supply on relatively short notice. They're aware of that, so they're trying to strike the right balance.

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Nikolay Todorov, Longbow Research LLC - Analyst [60]

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Okay. And can you talk about the level of activity around FPD outside of Korea? And I mean, to the extent possible, can you share with us when do you expect the trough in terms of customer activities and inquiries to occur? Or maybe that has already occurred. I was just curious if you can address that.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [61]

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Again, Nick, I completely understand the reason for the question, but that really plays into a sort of a longer-term outlook, and we're -- we've said that we're going to stick to a short-term outlook. And I'll just go back to the comments I made. Without being specific around the timing of any orders with any specific customer, I would say the level of activity remains to be positive. We still -- as I've said now for a couple of quarters in a row, we need someone else to break through on the yield front, and that should be a very nice elixir for the marketplace.

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Nikolay Todorov, Longbow Research LLC - Analyst [62]

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Okay. And in the materials processing, in the last call, you mentioned about -- you talked about aggressive pricing environment in China. Can you give us an update if you've seen anything incremental on that front?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [63]

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I don't know that it's got incrementally worse. There was a pretty significant step-down in average pricing in the 1 to 3, 1 to 4 kilowatt market several months ago, and it remains at that level. And a lot of that pricing is around -- is for high-volume customers. Customers that are buying one-offs are not getting the same level of pricing as customers that are buying hundreds of lasers, but they're certainly trying to use the pricing for 100 off to drive the pricing for one-off.

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Nikolay Todorov, Longbow Research LLC - Analyst [64]

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Okay, got it. And lastly, Kevin, can you tell us what was cash flow from operations in the quarter?

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [65]

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Sure, $51 million in quarter.

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Nikolay Todorov, Longbow Research LLC - Analyst [66]

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Okay. And any way you can talk about free cash flow in the year? Do you expect essentially working capital to become a cash tailwind for the year?

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [67]

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Yes. Sorry, Nick, as we've said a couple of times now, in terms of going out for the full year, we're not going to do that. Too much turbulence ahead of us, so we're going to keep it to just the current quarter.

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Operator [68]

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Your next question comes from the line of Jim Ricchiuti with Needham & Company.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [69]

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Kevin, can you say what the materials processing business looked like outside of China? I mean, in total, it looks like it was down about 19% year-over-year. I don't know if that's accurate or not. But ex China, how did that business look?

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Kevin S. Palatnik, Coherent, Inc. - Executive VP & CFO [70]

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Yes. Frankly, China is where all the turbulence is, and we did see some pushouts in quarter related to that impacting the quarter. As I look around the rest of the world, U.S. was okay, Europe was okay, but just okay. A lot of the materials processing activity is in China, so that sort of sets the stage for the whole vertical. The other pieces or the other geos are relatively minor in relation.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [71]

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Yes. That makes sense. And John, you alluded to some wins in solar and not sure how significant they are. You also, I think, in the press release talked about some Tier 1 auto wins. So how do we think about that? Are these -- do these have the potential to be meaningful down the road? Or are they meaningful -- some of these wins, are they meaningful now? And how much follow-on potential is there?

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [72]

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So the solar win provided -- provides a nice short-term pop. I mean, it's not going to move full year results, but it's a nice onetime pop. The customer is in a position to place orders in the next 12 months, and that will really depend on how the market performs and how we perform in the application in a full deployment mode. I mentioned the auto ones not because they're big revenue contributors today, but because they have the potential to contribute significant revenue over the next several years. Once you get designed into these applications, repeat business comes on a pretty regular basis. And some of these applications, particularly around battery production and electric propulsion or electric motors, these are our large-scale operations. So if we continue to perform well, as we've done so far, it's going to be an attractive piece of business.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [73]

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Okay. No, that's helpful. And just last question from me is just we are seeing some signs of slowing elsewhere outside of China. So I'm wondering what your -- as you look, for instance, at Europe and you hear some signs of further weakness in automotive and potentially some slowing in the U.S., what -- how would you characterize the demand outlook outside of China if you're able to? And again, not going out that far, I understand you're not giving guidance.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [74]

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Yes. So I think the thing to bear in mind with a number of these applications, and I think this is true for the industry, not just Coherent, is that we're playing a role or -- I should say -- maybe that's too strong. We're participating in disruption. So the move to electric vehicles away from internal combustion engines, this is generally a growth area regardless of what the overall number looks like because electric vehicles are capturing more and more share as you move along. So you can't just look at it and say, okay, what's the automotive market going to do? You have to look at relevant share within the market for the technologies where we're playing to see what kind of an impact they're going to have. And clearly, just look at the news about environmental concerns and other things, you can well understand why electric vehicles are going to capture more and more share as we move forward. And I think that's a generally positive trend for our industry because we provide so much critical production equipment.

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Operator [75]

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And at this time, we have no further questions in the queue. I will turn the call back over to John Ambroseo for any closing or additional remarks.

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John R. Ambroseo, Coherent, Inc. - President, CEO & Director [76]

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Great. Thanks, Connor. I'd like to thank everybody for participating in today's call, and we will certainly look forward to updating you in a few months' time. Have a good day.

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Operator [77]

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This concludes today's conference call. You may now disconnect.