Good day and thank you for standing by. Welcome to the II-VI Incorporated Fiscal Year 2022 Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Mary Jane, Chief Financial Officer. Please go ahead.

Thank you and good morning. I'm Mary Jane Raymond, the Chief Financial Officer here at II-VI Incorporated. Welcome to our earnings call today for the third quarter of fiscal year 2022. With me today on the call are Dr. Chuck Mattera, our Chair and Chief Executive Officer; and Dr. Giovanni Barbarossa, our Chief Strategy Officer and the President of the Compound Semiconductor segment. This call is being recorded on Tuesday, May 10, 2022. Our press release and our updated investor presentation are available on the Investor Relations tab of our website, ii-vi.com. As a reminder, our remarks today may contain forward-looking statements. These remarks are given in the context of today only. They are subject to various risk factors and are subject to change, possibly materially. We do not undertake any obligation to update these statements to reflect the events subsequent to today, except as required by law. A list of our known material risk factors can be found in our Form 10-K for the year ended June 30, 2021, along with our subsequent filings to the SEC. Our remarks today do not constitute an offer to sell, nor do they constitute a solicitation of an offer to buy any securities. No offering of securities shall be made except by means of a prospectus meeting the requirements of Section 10 of the United States Securities Act of 1933 as amended. Finally, with respect to today's call, we will also present some non-GAAP measures for which the reconciliations to GAAP are found at the end of each document that includes those measures such as the press release or the investor presentation. With that, let me turn the call over to Dr. Chuck Mattera. Chuck?

Thanks Mary Jane. Good morning everyone and thank you for joining. This past quarter and indeed the past couple of years have been exceptional in every conceivable way. While we continue to face unprecedented and dynamic challenges, relentless dedication to operational excellence is paying tremendous dividends. Our one II-VI team around the world continues to rise to the occasion every day and performs with extraordinary effort, resilience, determination, and success. In addition to our focus on operational excellence, our strategy of participating in markets underpinned by large mega market trends continues to lead to long-term transformative and sustainable growth. An unwavering commitment to our customers who serve these markets is creating deeper intimacy and even more opportunities for growth. From a financial point of view, in short, we delivered another exceptional quarter, with $828 million of revenue, a 6% increase year-over-year and above the top end of our guidance. Our customers clearly want even more of what we offer. This was evident by the tremendous surge in demand as our global sales team again booked a record quarter, with an amazing $1.2 billion of new orders. This represents an increase of 48% compared to a year ago. And our backlog of $2.1 billion grew 88% year-over-year with a substantial increase in bookings contributed by both segments. Looking at the quarter in more detail, we continued our disciplined cost controls and productivity improvements, which contributed to our solid non-GAAP earnings per share, that was at the top end of our guidance. Driven by strength in our datacom networking business for large enterprises, as well as for hyperscale data centers and supercomputing clusters that underpin the cloud and the metaverse, Photonic Solutions increased revenue to $568 million or 12% compared to last year. Our growth was led mostly by datacom, which was 40% of our business in Q3. Datacom grew 15% sequentially and 26% year-over-year. Most of our datacom revenue comes from transceivers and of those just under half are now 200G and above with 800G now just beginning to ramp meaningfully. I'm thrilled with the momentum that we've built since we acquired the transceiver platform more than two and a half years ago. As we envisioned at that time, it has become an outstanding engine of growth for our business. The datacom business is driven by the growing footprint of cloud computing, sustained by large scale investments that our customers continue to pour in. Computing is moving to the cloud to a degree that is profoundly transforming many industries. It is enabled by high-speed optical networks carrying data to and from consumer devices at the edge of the network, and that are themselves increasing in computer power and sensing capabilities. We are witnessing the convergence of communications computing and consumer electronics, which is at the core of the mega trends driving our growth. As you know, II-VI plays a leading role in the buildout of the global optical communications network. As a result, our broad portfolio of products remains in high demand and is growing. Currently, our ability to ship such products is highly constrained by the availability of semiconductors. Over time, we expect these constraints to ease. In the meantime, we continue to work hard in collaboration with our supply chain partners and our customers to mitigate the impact of these shortages, including focused product, technology, and manufacturing innovation efforts. We continue to advance our telecom transceiver technology, and we are also executing on a multi-site capacity expansion plan, including significant capital investments to enable our future growth. We fully expect the super cycle to continue in the face of broader economic challenges impacting other industries and these capacity expansion capital investments position us very well as the worldwide supply chain pressure eases. In Coherent transceiver technology, we continue to make great progress. In April, Windstream announced the completion of the industry's first 400G ZR+ interoperability trials enabled by our plugable transceivers, which impressed with its industry-leading output power, thanks to its underlying indium phosphide device technology. Earlier today, we announced that we are first to market with a new node on blade platform that integrates an entire ROADM node into a single subsystem based on a unique wavelength, selective switch amplifier and high-resolution channel monitored technologies. This new platform promises to transform ROADM networks by enabling them to be more compact, consume less power, be more flexible and enable lower-cost networks. Connected to the access network is the vast Internet of Things where an increasing number of sensors can sense the world around them. Optical sensing and consumer electronics is especially exciting with the coming of extended reality in the metaverse. These are also driving new use cases for our broad portfolio of products and the Compound Semiconductor segment that includes semiconductor lasers, driver electronics, metal lenses, high index wave guides, and advanced materials. In 3D sensing for smartphones on the heels of a substantial increase in share over the last two years, we are on track to achieve design ends with new customers. While our revenues and consumer electronics were down in Q3 as expected due to seasonality, it was offset by the explosive revenue growth in semiconductor capital equipment and industrial markets that include silicon carbide. In the SemiCap market, global shortages in semiconductors have become a meaningful opportunity for us as well. Revenues in SemiCap grew 34% year-over-year. The tens of billions of dollars that the industry is investing to build new fabs are driving the increased demand for immersion lithography tools, as well as the most advanced semiconductor fab technology, such as EUV lithography. We are aware of our responsibility as an extremely important part of this supply chain. And so, we are investing in manufacturing capacity to keep up with the pace of demand. Our revenue in industrial grew 13% year-over-year, fueled by silicon carbide. Our silicon carbide wafer finishing line in Fuzhou is now operating at full capacity and our vision of establishing a leadership position in wide-bandgap electronics is on track. Thanks to our customer engagements that are expanding rapidly in the U.S., Europe, and Asia, we are becoming increasingly embedded in the global automotive supply chains as the transition to electric vehicles paves the highways with green and clean transportation networks. Now, I would like to conclude with a few comments specifically about our supply chain and our pending merger with Coherent. First on the supply chain. Revenues in the third quarter were $65 million lower due to the supply chain constraints. Our Q4 guidance anticipates the gap growing to about $100 million as the rate of demand accelerates even faster than our increased rate of supply. In fact, we expect that our full demand for semiconductors will continue to outstrip our supplier's capability, at least through this calendar year, even as AI capacity. I would like to acknowledge all of the hard work by our one II-VI, our suppliers, and our customers in mitigating the impact of unprecedented supply chain challenges. Thanks to our close collaboration with our strategic supply chain partners, extensive coordination with our customers, and the strong dedication of our global operations teams, we continue to effectively manage our way through these complex challenges. Regarding the Coherent acquisition, we have completed our major integration planning tasks. As you have seen by now, we refiled the U.S. Hart-Scott-Rodino clearance on May 2nd and continued to have cooperative discussions with the center. We anticipate closing the acquisition before the end of June. Like the II-VI people, the Coherent team is truly exceptional. It has been a pleasure to work with them as we planned our future together. We really look forward to the combination and the opportunities to unlock value. With that, let me turn it over to Dr. Giovanni Barbarossa. Giovanni?

Thank you, Chuck and good morning everyone. We are pleased to report that we continue to make progress with our silicon carbide based devices for power electronics and our engagements with customers in the U.S. and Asia are expanding rapidly. We sampled our first automotive qualified MOSFET devices, and we're working relentlessly to secure our first design wins. We've also begun shipments on gallium nitride on silicon carbide devices for wireless applications. Our substrate sales were robust for both power and communications applications. They were about 70% and 30% of the substrate sales in the quarter, respectively. Sales for power electronics increased 17% sequentially. Our expansion in capacity for the manufacturing of indium phosphide based devices, including EMLs and DMLs for datacom telecom is proceeding according to plan to support both internal and external customers. As a result of this expansion, we expect to start generating incremental revenue from our newly expanded sites in the second half of the calendar year. During the quarter, we sustained a high level of production for the 980 nanometer pump product line to support the current demand and the strong forecast for holden and amplified products in the second half of the calendar year. Revenue in the industrial market grew 13% year-over-year. And after market sales for laser components reached an all-time record in Q3 in North America, while sales in March were an all-time record globally, indicating a high level of laser usage in the installed base, a good proxy for industrial activity overall. In Q3, we experienced again, what we believe is evidence of a multiyear demand cycle for semiconductor capital equipment, enabled by our differentiated composite materials and diamond based products. Tens of new wafer fabs being built around the world are driving our customers to request incremental output and to continue to expand our manufacturing capacity, which generated record bookings and revenues last quarter. We are proud to be doing our part to help the semiconductor electronics industry to increase production worldwide as part of a global effort to eliminate the integrated circuit shortage. While our consumer business sales were typical for a seasonally low Q3, the qualification of all new products is on track. We expect strong revenue growth in the second half of the calendar year, as a result of the incremental investments in technology and capital expenditures we have been making to scale new platforms for new applications. Clearly, our results this quarter demonstrate that our strategically diversified product portfolio offers long-term resilience to market dynamics and generates multiple vectors of growth in fast-growing segments of the markets we sell. With that, let me turn it over to Mary Jane Raymond.

Thank you, Giovanni. Good morning. The end market and geographic breakdown of our $828 million of revenue can be found on the fourth page of the investor presentation. Our Q3 non-GAAP gross margin was 40.6%. The non-GAAP operating margin was 20.8%. The results include approximately $7.5 million of progress payments on development programs being partially supported by customers. Supply chain costs and COVID costs, a total of $14.5 million are not excluded to arrive at non-GAAP results. At the segment level, the non-GAAP operating margins were 14.4% for Photonics and 34.7% for Compound Semiconductors. Our record backlog of $2.1 billion consists of $1.57 billion for Photonics and $560 million for Compound Semiconductors. As we have stated, this increase in backlog is a function of demand, partly from the industrial, semiconductor capital equipment and communications markets. GAAP operating expenses, SG&A plus R&D were $215 million in Q3, excluding $10 million of amortization, $17 million of stock compensation, $13 million in startup costs, and $12 million of M&A and integration costs. Non-GAAP OpEx was $163 million or 20% of revenue. Quarterly GAAP EPS was $0.28, and non-GAAP EPS was $0.95 after tax non-GAAP adjustments of $80 million in total. The increase in the non-GAAP adjustments compared to last quarter includes a whole quarter of interest and fees of $33 million related to the debt used to finance the Coherent transaction. The diluted share count for the GAAP results was 117 million shares, and for non-GAAP, the share count was 126 million shares. The GAAP and non-GAAP EPS calculations are in the ending tables of our press release. Pretax interest was $43 million. This includes $10 million of our underlying interest and $33 million of interest in fees on the debt for the Coherent transaction. Cash flow from operations in the quarter was $36 million, and free cash flow was a use of cash of $59 million, including CapEx of $94 million and a build of strategic inventory of $60 million in the quarter, totaling $183 million for the first nine months of the fiscal year to support our growth and customer requests to accelerate deliveries from the backlog. For FY 2022, we now expect CapEx to be at or above the top end of our range of $325 million to $375 million, driven by our expansion in silicon carbide and indium phosphide. We paid down $16 million of our debt in Q3, and our net cash position is $288 million. The company's liquidity at March 31 was $3.1 billion. The effective tax rate in the quarter was 22%, and we expect the tax rate to be between 18% and 20% for fiscal year 2022. Turning to the outlook for Q4 fiscal year 2022. Our outlook for revenue for the fourth fiscal quarter ending June 30th, 2022 is expected to be $840 million to $880 million and earnings per share on a non-GAAP basis of $0.85 to $1. The share count is 126 million shares for the whole of the guidance range. The EPS calculation, including the dividend treatment, is detailed in Table 8 of the press release for the low, mid, and points of the guidance. This is at today's exchange rate and an estimated tax rate of 19%. For the non-GAAP earnings per share, we add back to the GAAP earnings pretax amounts of $19 million and amortization $17 million, stock comp $48 million, and transaction integration startup and other related costs. The actual dollar amount of non-GAAP items, the tax rate, the exchange rates, and the share counts are all subject to change. Before we go to the Q&A, just as a reminder, our answers today may contain certain forecasts from which our actual results may differ due to a variety of factors, including, but not limited to changes in mix, customer changes, supply chain shortages, both upstream and downstream, competition changes in regulations, COVID-19 protocols, and global economic conditions. We welcome your questions and expect to end this call not later than 10 o'clock this morning. You may open the line for questions. Thank you.

Our first question comes from the line of Ananda Baruah from Loop Capital. Your line is now open.

Hi, good morning everyone. Congratulations on the strong execution and great results. I have a couple of questions. Chuck, in the press release and your prepared remarks, you mentioned a tremendous surge in demand. Could you provide some context on whether this surge was stronger than you anticipated 90 days ago? Additionally, any insights into the linearities you experienced throughout the quarter would be appreciated, and then I have a quick follow-up. Thank you.

Thanks Ananda. Good morning. Yes, indeed. It was stronger than we forecasted, and it accelerated throughout the quarter.

Chuck, regarding the backlog, we are seeing significant strength in new orders and substantial growth in backlog. I recall that in the latter half of last year, the backlog became a key topic of discussion. You provided some insights into why you believed the backlog was of high quality. If I remember correctly, you mentioned that you were enhancing your shipping capabilities to align with production. As a result, you were confident in the quality of the backlog. Can you discuss the current quality of the backlog now that it has grown so much, and how you feel about it? That's all from my side. Thank you.

First of all, thanks Ananda. Yes. First of all, on the one hand with the supply chain shortages accelerating. Many of our customers have increased the visibility that they are giving us in order to allow us to put longer-term orders on our suppliers. So that's the first thing. And then, when we receive those longer-term orders, we do verify with them what they are expecting in terms of deployments on their side. We particularly do that if there is a capital investment required because we wouldn't put the capital in if we thought we were just building for somebody's inventory, not to be deployed. Beyond that, of course, we also watch the backlog. We watch the dates to see if the dates are moving. That is a very early sign. We obviously look at debookings very, very carefully and debookings are reported every day. There aren't that many of them. And then finally, in cases where we have inventory as part of an agreement that's gone on for years, it's a normal practice to have some of our inventory sitting at the customer site. We watch that area that's typically referred to as a cage. We watch the cage to be sure that we understand whether that inventory is actually moving, and those are the main signs that we use. But the main reason that the backlog is growing, as I indicated, is really demand. In order to give the correct picture of demand to the supply chain, many of our customers have worked collaboratively with us to have longer dated visibility.

That's really helpful, Mary Jane. Thank you guys so much. Appreciate it.

And then just before we go to the next question, I just want to let you all know Chuck will be with us until about 10 minutes of 10 and then Giovanni, I will be here through till 10 o'clock, but let's go to the next question.

Thank you. Our next question comes on the line of Paul Silverstein from Cowen. Your line is now open.

Guys, I apologize if you said, and I missed it. But what was the margin impact from supply chain in March? And what are you expected to be in June? I heard your comment about revenue.

So, the supply chain costs this quarter were about $8.5 million. The COVID costs were about $6 million, so that's the composite of this $14.5 million. So it's about a little over one percentage point.

And that's what you're expecting …

I'm sorry.

That's what you're expecting for June.

I would say that it's probably not less than that. It could be higher, but it's probably not less than $8.5 million.

Mary Jane, virtually every company in networking and communication equipment and optical components this quarter mentioned an adverse impact on margins in the range of 200 to 300 basis points. Some companies fared better, while others fared worse. What are your thoughts on the margins, considering the significant cost increases over the past 90 days? Where do you see your margin structure heading over the next year?

First of all, comparing supply chain costs across companies in our sector might yield different figures, even though those providing the numbers are likely accurate. In our situation, we've shared the actual excess costs incurred to obtain parts beyond their usual prices. Other firms might include lost revenue from undelivered shipments and the resulting margin impact, which is significant. If we factored that in for ourselves, it could account for an additional basis point or two. So, when comparing different numbers, it's essential to verify the specifics. Regarding margins, demand remains exceptionally strong. Although there are variables that can affect us, and we're not completely past the supply chain issues or potential temporary plant shutdowns due to COVID, which were more significant than we anticipated in the first quarter. Even if we manage to ship, customers might face challenges receiving products. Overall, I'm confident that the hard work of our teams globally will help us see margins gradually improve. However, as we've noted before, each day presents new challenges in the supply chain, and we expect this to continue through the remainder of the year.

And Mary Jane, just to clarify, you're not expecting a meaningful adverse impact in June.

I don't know that we aren't. I mean, we could have an adverse impact in June. I mean, first of all, again, just normal things in the margins such as mix could affect it. But I would say that we will do what we did this quarter, which is fight very hard because I probably gave the same answer last quarter when we reported that. Yes. I mean, I didn't think necessarily the margin we were on was the absolute floor. I think we're just going to work very, very hard to try and offset that, which is why I say it's hand to hand combat every day.

All right. I appreciate the response. Thank you.

Thank you. Our next question comes from the line of Mark Miller from Benchmark Company. Your line is now open.

Congratulations on another great quarter. I was wondering about the impact of the supply chain, specifically which major components are affected. Is it mainly ROADMs and what else?

The main part that is short is integrated circuits. And the primary end product for us that's being affected. Yes, this is in the ROADM area. Though this quarter, we did have some impacts in the transceiver area.

Okay. Backlog, is it pretty linear? Is it backend loaded backlog? And what about the margin profile? The backlog is similar to what you're seeing.

I would say that the margin profile is similar to what we've mentioned. Regarding the timing of the backlog, we have more scheduled for the third and fourth quarters than we might have seen last year, but overall, the backlog usually tends to be more concentrated in the first and second quarters right after this reporting period.

Okay. What about transceiver margins? Are you seeing some progress there, or have they been fairly stable?

Well, considering the significant progress the company has made on transceiver margins over the past three years, I believe they are now being influenced by supply chain shortages as well.

Thank you.

Sure.

Thank you. Our next question comes on the line of Richard Shannon from Craig-Hallum. Your line is now open.

Well, great. Thanks for taking my questions. Mary Jane, maybe the first one for you. Looking at the operating margins for compound semis, both before and after the adjustments for startup costs are pretty impressive here. Maybe if I can look at it even exclude or including the startup costs that you're reporting in the press release. You did about 29% in the just reported quarter with revenues that aren't record and those margins are well above what you've reported in the last few quarters, even with the investments going on here. Can you describe what's going on here? Is this mostly from gross margins, or other dynamics coming in here? And what does this say about the future margin structure for this segment?

We have discussed the improvement in margins overall. It's been noted that in growth areas like silicon carbide and the sensing market, along with the resurgence of the industrial market, Giovanni's segment has shown the best potential for margin expansion. This trend is reflected in the recent quarter, where the industrial market continues to be a strong margin area. The sensing market is benefiting from ongoing efficiencies implemented during the off-season, along with advancements in silicon carbide and indium phosphide, which contribute to higher margins in the compound semiconductor sector compared to the corporate average. It is important to recognize that strong gross margins are essential, as they set the foundation for overall profitability. Additionally, Chuck highlighted that effective cost control is beneficial for both segments.

Okay. Perfect. That's great Mary Jane. My follow-up question's on 3D sensing. I'm not sure if Giovanni or Chuck remarks were suggesting a better than seasonal pattern here in this back half of the year, but maybe you can discuss what you're thinking there, even the throwing in thoughts on share position would be great, please.

Thank you for the question, Richard. If we continue to secure new design wins and introduce additional applications and products, it positively impacts seasonality. Essentially, if we remain limited to our current design wins, we face seasonal fluctuations. However, by expanding our market presence with significant new design wins, we anticipate strong growth in the latter half of the year, which will enhance or at least mitigate this seasonality. While it remains seasonal in relative terms, we're raising the bar by launching new products for various applications, as I mentioned in my earlier comments.

Okay. Can you discuss whether those are with the current or new customers, Giovanni?

No. Sometimes as you know, we don't even know what application is because they don't tell us, but we expect it's only sensing for sure, not necessarily 3D sensing. So, I would talk about sensing in general, including 3D sensing.

Okay. Perfect. That's all for me. Thank you.

Thank you. Our next question comes from Samik Chatterjee from JP Morgan. Your line is now open.

Hi, thank you for taking my questions. I’d like to start with an update on your facilities in China. I recall that during the last call there was mention of a COVID outbreak and some inefficiencies at the facilities, even though there wasn't a direct impact. Can you provide an update on the current situation there? I'm interested in hearing about any changes in efficiencies as well. I have a follow-up question after that. Thank you.

Samik, good morning. Thanks for your question. This is Chuck. As it relates to the situation in China, as you know, we have a great team in China and they have done an extraordinary job here since the situation changed in the last month or two. We've been moving forward with very little impact to no impact in our factories in China. At our design center in Shanghai, we've had some impact, but even in the case where people have been working from home, we've been allowed to have people go into the facility and we're right on track for the milestones that we laid out for the quarter. Our employees have done an extraordinary job. And if you ask me, has there been an impact, I would say for all intents and purposes? No.

Good. For my follow-up, I know Mary Jane mentioned the composition and growth of the backlog. Industrial is a significant part of that. However, when you talked about automotive, specifically regarding the opportunities you are seeing and the backlog from both materials processing and silicon carbide, could you elaborate on that?

So, Samik, is your question, what are the components of the backlog?

No. Sorry. What are you seeing in relation to backlog from the automotive markets?

We don't usually break down the backlog by specific end markets. Generally speaking, from an industrial perspective, it is increasing across all markets that involve cutting, welding, and embracing. We have other components that are utilized in some of these end markets, but we haven't really categorized the backlog by specific industries.

Our automotive share is currently less than 10% of the total company footprint. Therefore, you can expect that most of the backlog is related to datacom and telecom, as well as some in semi-cap equipment and industrial. Datacom and telecom are definitely the main components.

Got it. Thank you. Thanks a lot for clarification.

Thank you. Our next question goes to the line of Dave Kang from B Riley. Your line is now open.

Thank you. Good morning. First question on 3D S, just wondering customer concentration is the lead customer over maybe 90% of 3D S revenue. And how should we think about fiscal 2023 growth?

Okay, Dave. Good morning, Dave. Thanks for the question. So, I would say that our leading customer is definitely the majority of the 3D sensing revenue. But I want to make sure that we expand that general market to sensing moving forward, because I think we are seeing more and more sensing applications in proximity presence, depth, skin sensing, and so forth. So, the market is growing beyond 3D, and of course, 3D is still a large portion of it. But I would like to kind of move on from 3D to a much larger market, which is the sensing market for us. And yes, our leading customer will be the majority of that for in the next few quarters. Yeah.

Got it. And then, regarding CapEx, how should we think about for next fiscal year?

I would imagine that we would expect to see next fiscal year also being a year of investment. So, if we think about this year in that kind of $350 million or $375 million range, I think it's probably not less than that going forward. At least that's our current view at the present moment. It could be higher as well. I mean, I think it could be $400 million. And of course, keep in mind as the company progresses in this possibly larger that's speaking just to the II-VI based platform, not the combined company that we potentially could have by then.

Got it. Thank you.

Sure.

Thank you. Our next question comes from the line of Jim Ricchiuti from Needham. Your line is now open.

All right. Thank you. Just a question on the booking strength that you saw. The book-to-bill, obviously very high. Can you give any color on the book-to-bill Photonics versus the Compound Semi?

Sure. The book-to-bill was good in both of our segments. As Chuck said in his remarks, both of the segments contributed to the increase in the book-to-bill for the company for the quarter. As Giovanni did mention, the fact that probably numerically speaking the largest increase in the backlog was in datacom and telecom, but generally speaking proportionately, both of them were very strong.

On the industrial side, you mentioned an increase of 13% driven primarily by silicon carbide, which performed well. Is it still approximately 5% of revenues? Giovanni, you referenced some of the aftermarket activity, but in general, what trends are you observing in that segment of the business?

Thanks for the question, Jim. Our industrial definition covers a wide range of applications, including those driven by lasers, specifically fiber lasers, such as welding and cutting. For instance, we set records in bookings for our cutting heads. Silicon carbide, which is primarily used for power electronics in industrial applications, is a key component in this area. We differentiate based on how customers plan to utilize the wide-bandgap materials. Overall, our industrial sector, particularly in the manufacturing of durable goods, remains very strong. We continue to leverage our scale in pump production and optics, especially in China. Additionally, our battery welding applications are still robust. While we may not be at record numbers just yet, we anticipate achieving new records in the second half of the year for battery welding.

Okay. Thank you.

Thank you. Our next question comes from the line of Simon Leopold from Raymond James. Your line is open.

Thanks for taking the question. First, just I wanted to clarify Giovanni's comments on the sensing growth in the second half of the year, whether that was a reference to first half over second half or whether that was year-over-year or both of those. And then, the question I wanted to ask was particularly on the 200 gig and above rates for data center transceivers. I want to get an understanding of whether or not those in particular are supply chain constrained, and how big is your hyperscale exposure as a percent of total revenue today? Thank you.

Thank you for the question, Simon. To address your first question, it pertains to both year-over-year comparisons and the divide between the first half and second half of the calendar year. Regarding your second question, the majority of our supply chain challenges are centered around telecom rather than datacom, although there are some issues in the datacom sector as well. As for your third question about our presence in the web scale market, I would note that approximately one-third of total datacom is dominated by one or two hyperscaler companies. Another third comprises various cloud service providers, roughly 20 to 30 customers, while the remainder consists of a broader base of around two to three hundred customers, primarily small enterprise clients. This outlines the distribution of our datacom numbers.

That's very helpful. Thank you.

Thank you.

Thank you. Our next question comes from the line of Harsh Kumar from Piper Sandler. Your line is now open.

I have a question for Giovanni. You mentioned that you're sampling your first MOSFET device for automotive, which is exciting. Can you share any information on the level of interest in design wins or sampling that you are observing? Also, I'd like to ask Mary Jane or Chuck to provide some insights regarding guidance, specifically how you view your two segments and any additional details you can offer on those.

Well, with respect to second one, I think both. I would expect both segments to contribute positively to the growth in the upcoming fourth quarter. Over to you.

Yeah. Obviously there's a new market for us, so we have no design wins at this point in time. So, everything that, we'll be able to accomplish will be in a way a market gain for us. So, we are looking forward to that. We definitely increased with the qualified power usage to engage customers and increase our chances. So, there was the first step, which was announced last time last quarter. And this quarter, we're saying, well, now we are sampling in the hands of our automotive makers, which again, it's pretty exciting considering that we are a newcomer. So, yeah, I think it all goes without saying that the reason they're interested is because of our performance and the quality we are demonstrated deriving from, as you know, mostly from photonics applications. So, given our collaboration with GE, which were really the original market for those designs. So, it's really great exchange with these automotive makers, and we hopefully will get the design win sometime soon.

Great guys. Congratulations. Thank you.

Thank you. Our next question comes from Meta Marshall with Morgan Stanley. Your line is now open.

Thank you. I have a couple of questions. To start with, Mary Jane, you've been successful in achieving operational efficiency, possibly even surpassing your guidance, while capital expenditures seem to be aligned with your plans for silicon carbide investments. I'm trying to understand if we should anticipate an increase in operational expenses as you begin utilizing those facilities, or if you're continuing to discover efficiencies with the investments you planned in that area. I also have a follow-up question.

Overall, we are progressing with the investments we had planned. Regarding operating expenses, I anticipate they will likely trend upward. Initially, we indicated they could reach up to 23, but I had mentioned from the start that it might settle between 21 and 21.5, which is actually quite significant. However, we will continuously seek operational efficiencies. I didn't expect to see $14.5 million this quarter due to COVID and supply chain issues, but we did. This is impacting our margins. The figures we can manage are in our operating expenses, and that's where our focus is. The Directors sent out by Chuck, Giovanni, and Sunny Sun are primarily concentrating on General and Administrative expenses. Nonetheless, our CTO and Giovanni are dedicated to ensuring that we're maximizing our R&D spending efficiently, which has always been a key feature of our company.

Great. As a follow-up, could you provide an update on the select price increases you mentioned last quarter? How did those negotiations go, and when can we expect to see their impact, or can we quantify it? Thanks. That's all from me.

Thank you, Meta. This is Chuck. It's going very well. And we're beginning to see the effect of it in this quarter for those conversations and those negotiations that were settled two or three quarters ago. So, we're in the process of continuing this. We've been selective about it in terms of our priority and in terms of the value equation that we offer the customers. The conversations have gone very, very well. And when you look at the size of our backlog, on the other hand, we have agreements and contracts and purchase orders that we're committed to certain pricing that are part of this backlog that we reported today. So, as it's working out and working its way through, I expect the impact to accelerate over the next, let's call it next three to four quarters.

Great.

Thank you. Our next question comes from Vivek Arya with Bank of America. Your line is now open.

Thanks for taking my question. I'm curious, Mary Jane, how should we think about gross margins heading into fiscal 2023 relative to what you're expecting this year? What would be the moving pieces and interplay between your segment mix? And where I'm particularly interested, and as the depreciation from this rising CapEx. So just, high-level puts and takes of how we should think about gross margins going into the next year?

I think the gross margins are projected to be in the range of 38 to 42. While it's not impossible for them to reach a 39 at some point, I would expect ongoing efforts to improve the gross margin in any given quarter. The key factors affecting the gross margin in the Photonics segment include alleviating supply chain shortages of integrated circuits, which benefit the ROADM products, known for their higher value within Photonics. Regarding Compound Semiconductors, growth in newer areas like sensing and silicon carbide, along with ongoing strength in the industrial and semiconductor capital equipment sectors, where we provide components, positively impacts the margin. These are the main considerations. As for CapEx, most is tied to a seven-year depreciation cycle, but at least $50 million is likely more infrastructure-related, following a depreciation cycle of about 10 to 15 years.

Got it. Very helpful. And then, for my follow-up, I'm curious about what your ambitions are longer term in the silicon carbide space, because there is a very large competitor who is investing $500 million or $600 million annually in their substrate capacity, building out a new fab and so forth. And there are a ton of incumbents on the device side. So, you are coming at it from a very strong IP base, but I'm curious that in terms of just your ambitions about market share and so forth, how will this play out over the next two to three years?

Thank you for the question. We have significant work ahead, and we are investing a billion dollars over the next five years. As I mentioned earlier, we are reevaluating our presence in the device market. It's impressive that automotive manufacturers are currently testing our device components. This indicates substantial potential for us to increase our market share. The market is expansive, extending over the next 50 to 100 years, allowing space for many players, and we will need to focus on differentiation. Having a competitive silicon carbide substrate platform will be essential for us to remain price competitive. We've made considerable progress, have sampling products ready, and anticipate some design wins shortly. This all positions us for growth in the coming years. The market is not only large but will continue to grow, providing ample opportunity for us as well.

So, we have about five minutes left, and there's three of you in the queue. So, we'd like to try to get all three you in.

Thank you. Our next question comes from Sidney Ho with Deutsche Bank. Your line is open.

Good morning. This is Sidney. Thank you for taking my question. My first question is about supply constraints. In the past, you mentioned that the transceivers and ROADMs business has been highly constrained. Are you observing any changes this time regarding specific products or end markets that have been mostly affected?

I think what we've said is that it's ROADMs that are particularly constrained and commencing this quarter, we are seeing more on the transceiver side.

That's helpful. Thank you. And then, my follow-up is regarding your investments in silicon carbide, then in indium phosphide, improved indium in previous quarters. You also mentioned that you expect these expansions to sort of materialize towards the mid fiscal 2023. And can you provide an update on the progress of these expansions, and have supply chain disruptions had any impact on the timeline of these ramps? Thank you.

For silicon carbide that we said the product is probably coming to market actually in 2024 and at the present moment, supply chain is not affecting those.

Thank you. Our next question comes from Christopher Rolland with Susquehanna. Your line is open.

Hi there, and congrats on the strong results and guidance here. My question is around the hyperscale datacom business. Would love to know is this kind of broad-based cloud, or these more AI applications? And what is the technology involved here? Are we beginning to see kind of the inflection for PAM 4 or is this something else? Thank you.

Yes, there is strong demand across the board. I wouldn't say there’s a clear distinction between cloud and AI. It's hard to draw a line between the two. PAM remains the preferred moderation format, increasing the number of bits per board, which will continue to drive down the cost per bit transmitted. We are competitive in this area, and considering the market growth rate alongside our reported growth, we are clearly regaining a significant share of the market, which is benefiting the overall company growth.

Thanks Giovanni. My second one's around 3D sensing. So, your competitor talked about having majority share and then moving to a 50-50 split, but we haven't seen that in your numbers yet. And I know you said it's a backend loaded year, of course, with seasonality. But do you think we could get back to perhaps a quarter whether September or December in which you guys are doing north of $100 million quarterly with this 50-50 split?

Well, I don't know what the split is. I could be different in 50-50. But what I want to emphasize is the fact that, ultimately we are playing in the sensing market. And again, 3D is only part of that. So, maybe even for 3D, we may have close to 50-50 split, may not be the same for the sensing market. So, I will look into that. I already said earlier that we expect strong growth in the second half of the calendar year. And as I said, driven by new products for new applications, we think that is going to definitely offset the share to a larger number for us. I suspect, but we'll see.

Thanks guys. Congrats.

Thank you. Our last question comes from Tom O'Malley with Barclays. Your line is now open.

Hey, guys. Thanks for sneaking me in. I appreciate it. Giovanni, this is more of just a clarification. I think you said this quarter, that datacom as a percentage of com was 40%, and then it was at 15% quarter-over-quarter. I think last quarter you said it was 60%. Did I hear that wrong? Could you just level set us on what datacom was as a percentage of com last quarter?

First of all, Giovanni's comment that it was 40% is 40% of the whole company, not for datacom.

Yeah. I think, Tom, the comment on the 50%, I think there was about the high-speed the 200, 400, 800, that now represent 50% of the total transceiver datacom business, right? So, we are shifting from, let's say, 100G being more than 50% to 100G and below being more than 50% to 100G and below being less than 50%, therefore the higher speed, the higher data rate transceiver now they are close to 50%. So, it's kind of a shift in mix. Yeah.

Gotcha. Yeah. No, the 40% is a function of the total business. Makes a lot more sense. Then just the follow-up. Just on the stuff that's below 200G speeds. I think Mary Jane called out that there was a lot of on the transmission side, a little more supply chain charges. How would you kind of characterize overall demand there? Just given the fact that it sounds like a lot of people can't get product. Has that continued to improve throughout the year, or is that seeing any pockets of weakness? That'd be really helpful. Thank you again.

The demand is very strong. However, we are facing some supply chain challenges, particularly with the ROADM telecom, and now we are also experiencing some issues in the transceiver area. Typically, the volumes are higher for lower speed products. We believe the improvement could be between $75 million to $100 million better than our guidance, which would have been $100 million higher if not for the supply chain issues. Datacom accounts for the largest share of our revenue as a single market, and most of that $100 million impact is related to transceivers.

Thanks again for sneaking me on guys. Appreciate it.

No problem.

Thank you. This does conclude today's question-and-answer session. I would like to hand the call back to Mary Jane for any closing remarks.

Thank you very much everyone for joining us this morning, and we'll talk to you all soon. So, have a good day. Bye-bye.

Thank you. This does conclude today's conference. You may now disconnect.