Back to GetFilings.com

Table of Contents

FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

For the quarterly period ended September 30, 2004

For the transition period from              to              .

Commission File Number: 0-16195

II-VI INCORPORATED

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: 724-352-4455

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

At November 1, 2004, 14,542,941 shares of Common Stock, no par value, of the registrant were outstanding.

Table of Contents

II-VI INCORPORATED

INDEX

2

Table of Contents

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

II-VI Incorporated and Subsidiaries

Consolidated Balance Sheets (Unaudited)

($000)

- See notes to consolidated financial statements.

3

Table of Contents

II-VI Incorporated and Subsidiaries

Consolidated Statements of Earnings (Unaudited)

($000 except per share data)

- See notes to consolidated financial statements.

4

Table of Contents

II-VI Incorporated and Subsidiaries

Condensed Consolidated Statements of Cash Flows (Unaudited)

($000)

- See notes to consolidated financial statements.

5

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

Note A - Basis of Presentation

The consolidated financial statements for the three month periods ended September 30, 2004 and 2003 are unaudited. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation for the periods presented have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Corporation’s annual report on Form 10-K for the year ended June 30, 2004. The consolidated results of operations for the three month periods ended September 30, 2004 and 2003 are not necessarily indicative of the results to be expected for the full year.

Note B - Contract Receivables

The components of contract receivables, which are a component of accounts receivable, net, were as follows ($000):

Note C - Inventories

The components of inventories were as follows ($000):

6

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited), Continued

Note D - Property, Plant and Equipment

Property, plant and equipment at cost consist of the following ($000):

Note E - Goodwill and Intangible Assets

The gross carrying amount and accumulated amortization of the Company’s intangible assets other than goodwill as of September 30, 2004 and June 30, 2004 were as follows ($000):

7

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited), Continued

Note E - Goodwill and Intangible Assets, Cont’d.

Amortization expense recorded on the intangible assets was $177,000 and $131,000, for the three months ended September 30, 2004 and 2003, respectively. Included in the gross carrying amount and accumulated amortization of the Company’s customer lists component of intangible assets is the effect of the foreign currency translation of the portion relating to the Company’s German and Switzerland majority-owned subsidiaries. At September 30, 2004, the estimated amortization expense for existing intangible assets for each of the five succeeding fiscal years is as follows:

Note F - Debt

The components of debt were as follows ($000’s):

8

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited), Continued

The Company has a 300 million Yen loan. The loan matures on September 25, 2007. Interest is at a rate equal to the Japanese Yen base rate, as defined in the loan agreement, plus 1.49%. The Japanese Yen base rate was 0.07% at September 30, 2004 and 0.06% at June 30, 2004.

Note G - Earnings Per Share

The following table sets forth the computation of earnings per share for the periods indicated. Weighted average shares issuable upon the exercise of stock options that were not included in the calculation because they were antidilutive were immaterial for all periods presented ($000 except per share data):

Note H - Comprehensive Income

The components of comprehensive income were as follows for the periods indicated ($000):

9

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited), Continued

Note I - Segment Reporting

The Company reports its segments using the “management approach” model for segment reporting. The management approach model is based on the way a company’s management organizes segments within the company for making operating decisions and assessing performance. Reportable segments are based on products and services, geography, legal structure, management structure or any other manner in which management segregates a company.

The Company’s reportable segments offer similar products to different target markets. The segments are managed separately due to the production requirements and facilities that are unique to each segment. The Company has the following reportable segments: Infrared Optics, which is the Company’s II-VI infrared optics and material products businesses; Near-Infrared Optics, which is the Company’s VLOC subsidiary and the Suzhou, China near-infrared operations; and Military Infrared Optics, which is the Company’s Exotic Electro-Optics subsidiary. The Compound Semiconductor Group, (formerly “Other”) is primarily the aggregation of the Company’s eV PRODUCTS division, the Company’s Wide Bandgap Materials (WBG) group and the Company’s Advanced Material Development Center (AMDC) group, which is responsible for the corporate research and development activities and remaining corporate activities, primarily corporate assets, capital expenditures and depreciation and amortization.

The Infrared Optics segment is divided into the geographic locations in the United States, Singapore, China, Germany, Switzerland, Japan, Belgium and the United Kingdom. An Executive Vice-President of the Company directs the segment, while each geographic location is directed by a general manager, and is further divided into production and administrative units that are directed by managers. The Infrared Optics segment designs, manufactures and markets optical and electro-optical components and materials sold under the II-VI brand name and used primarily in high-power CO₂ lasers.

The Near-Infrared Optics segment is located in the United States and China. The Near-Infrared Optics segment is directed by a general manager. The Near-Infrared Optics segment is further divided into production and administrative units that are directed by managers. The Near-Infrared Optics segment designs, manufactures and markets near-infrared and visible-light products for industrial, scientific and medical instruments and laser gain material and products for solid-state YAG and YLF lasers at the Company’s VLOC subsidiary.

The Military Infrared Optics segment is located in the United States. The Military Infrared Optics segment is directed by a general manager with oversight by a Corporate Vice-President. The Military Infrared Optics segment is further divided into production and administrative units that are directed by managers. The Military Infrared Optics segment designs, manufactures and markets infrared products for military applications under the Exotic Electro-Optics brand name.

The Compound Semiconductor Group is located in the United States. The Compound Semiconductor Group segment is directed by a Group Vice-President. The Company’s eV PRODUCTS division manufactures and markets solid-state x-ray and gamma-ray sensor materials and products for use in medical, security monitoring, industrial, environmental and scientific applications. The Company’s WBG group manufactures and markets single crystal silicon carbide substrates for use in solid-state lighting, wireless infrastructure, RF electronics and power switching industries. The Company’s AMDC group directs the corporate research and development initiatives.

The accounting policies of the segments are the same as those of the Company. Substantially all of the Company’s corporate expenses are allocated to the segments. The Company evaluates segment performance based upon reported segment earnings or loss, which is defined as earnings before income taxes, interest and other income or expense. Inter-segment sales and transfers have been eliminated.

10

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited), Continued

Note I - Segment Reporting, Cont’d.

The following table summarizes selected financial information of the Company’s operations by segment ($000’s):

11

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited), Continued

Note J - Derivative Instruments

SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended, establishes accounting and reporting standards for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value.

The Company from time to time purchases foreign currency forward exchange contracts, primarily in Japanese Yen, that permit it to sell specified amounts of these foreign currencies expected to be received from its export sales for pre-established U.S. dollar amounts at specified dates. These contracts are entered into to limit transactional exposure to changes in currency exchange rates of export sales transactions in which settlement will occur in future periods and which otherwise would expose the Company, on the basis of its aggregate net cash flows in respective currencies, to foreign currency risk.

The Company recorded the fair value of contracts with a notional amount of approximately $5.1 million and $3.3 million as of September 30, 2004 and June 30, 2004, respectively. These amounts were recorded in Prepaid and other current assets as of September 30, 2004 and in Other accrued liabilities as of June 30, 2004 on the Consolidated Balance Sheets. The Company does not account for these contracts as hedges as defined by SFAS No. 133 and records the change in the fair value of these contracts in the results of operations as they occur. The change in the fair value of these contracts increased net earnings by $77,000 and decreased net earnings by $137,000 for the three months ended September 30, 2004 and September 30, 2003, respectively.

To satisfy certain provisions of its credit agreement (see Note F), on March 9, 2004 the Company entered into a one-year interest rate cap with a notional amount of $5.6 million replacing an interest rate cap that expired on March 6, 2004. These agreements were entered into to limit interest rate exposure on one-half of the remaining outstanding balance of the Company’s term loan under the credit agreement. The floating rate option for the cap agreement is the one-month LIBOR rate with a cap strike rate of 2.00%. At September 30, 2004 the one-month LIBOR rate was 1.84%. The Company has elected not to account for these agreements as hedges as defined by SFAS No. 133 but instead recorded the unrealized change in the fair value of these agreements as an increase or decrease to interest expense in the results of operations. The effect of the interest rate cap on net earnings for the three months ended September 30, 2004 was insignificant.

12

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited), Continued

Note K - Stock-Based Compensation

The Company uses the intrinsic value approach of APB Opinion No. 25 for stock options granted to officers and key employees. All options granted under the plan had an exercise price equal to the fair market value of the underlying common stock on the date of grant.

In accordance with the disclosure requirements of SFAS No. 148, the following pro forma information adjusts previously reported net earnings, basic earnings per common share and diluted earnings per common share to reflect the fair value recognition provisions of SFAS No. 123.

The pro forma adjustments were calculated using the Black-Scholes option pricing model under the following weighted-average assumptions in each period:

In March 2004, the FASB issued an Exposure Draft titled “Share-Based Payment an amendment of FASB Statements No. 123 and 95”. The Exposure Draft would require the recognition of compensation expense over the vesting period for all share-based payments, including stock options, based on the fair value of the payment at the grant date. Although the Exposure Draft and its eventual effective date are still subject to revision, the proposed effective date of the Exposure Draft is for fiscal years beginning after June 15, 2005. Once finalized, the Company will adopt the provisions of the Exposure Draft upon its effective date.

13

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

Note L - Warranty Reserve

The Company records a warranty reserve as a charge against earnings based on a percentage of sales utilizing actual returns over the last twelve months.

The following table summarizes the change in the carrying value of the Company’s warranty reserve as of and for the three months ended September 30, 2004 and as of and for the year ended June 30, 2004 ($000).

Note M - Investment in 5N Plus, Inc.

The Company has a 33% equity ownership interest in 5N Plus, Inc. which is a supplier to the Company. 5N Plus, Inc. is based in Montreal, Canada. The investment is accounted for under the equity method of accounting and is shown as Investment on the accompanying Consolidated Balance Sheets.

At September 30, 2004 and June 30, 2004, the Company had outstanding notes receivable of approximately $0.4 million from equipment and supply agreements with 5N Plus, Inc. Payments on these notes are made quarterly with interest calculated at the Canadian Prime Rate plus 1.5% on the unpaid balance.

The Company’s pro rata share of the earnings from this investment and the interest received from these agreements did not have a material effect on the Company’s results of operations for the three months ended September 30, 2004 and 2003.

Note N - Acquisition of Certain Coherent Assets

On September 11, 2003, the Company entered into an agreement to acquire certain assets, equipment, intellectual property and rights from Coherent, Inc. (Coherent) relating to Coherent’s business of growing and fabricating materials used for ultra-violet (UV) filters. UV filters assist aircraft in the early detection of missile threats. Under the terms of this asset purchase the Company paid $2.0 million to Coherent. The major assets acquired were equipment ($0.9 million), inventory ($0.3 million) and a patent for crystal growth ($0.8 million).

14

Table of Contents

II-VI Incorporated and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited), Continued

Note O - Acquisition of II-VI LOT Suisse S.a.r.l.

During the quarter ended December 31, 2003, the Company reached an agreement with LOT – Oriel Laser Optik Technologies Holding GmbH and LOT – Oriel Laser Optik GmbH & Co. KG of Darmstadt, Germany (collectively LOT) to establish a new European entity, II-VI LOT Suisse S.a.r.l. (II-VI LOT Suisse) to distribute infrared optics in Switzerland. Prior to this acquisition, the distribution of the Company’s products in Switzerland was handled by LOT for over 25 years. II-VI and LOT created II-VI LOT Suisse to better service the needs of customers in Switzerland. The Company purchased a 75% controlling interest in II-VI LOT Suisse for approximately $1.8 million. The major assets acquired were inventory of approximately $0.8 million and intangible assets consisting of customer lists and related information of approximately $1.0 million that are being amortized over a ten-year useful life. At any time after December 1, 2006, the Company has a call option to purchase the remaining interest in II-VI LOT Suisse and LOT has a put option to require the purchase of the remaining interest in II-VI LOT Suisse. The price of the remaining interest is determined by a fixed formula based on the average sales of II-VI LOT Suisse for the three fiscal years prior to the exercise of the option.

Note P - Legal Proceedings

During the quarter ended September 30, 2003, the Company was awarded a jury verdict in the amount of $0.8 million in a trade secret lawsuit which it had initiated. In addition, the Company was initially entitled to punitive damages and reimbursement of its attorneys’ fees and costs at the discretion of the court. On April 27, 2004, the court denied the award relating to punitive damages and reimbursement of its attorneys’ fees and costs. The Company has appealed certain of the decisions by the lower court. As such, the Company has not made any adjustments to its financial position or results of operations for this contingent gain.

15

Table of Contents

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This Management’s Discussion and Analysis contains forward-looking statements as defined by Section 21E of the Securities Exchange Act of 1934, as amended, including the statements regarding projected growth rates, markets, product development, financial position, capital expenditures and foreign currency exposure. Forward-looking statements are also identified by words such as “expects,” “anticipates,” “intends,” “plans,” “projects” or similar expressions.

Actual results could materially differ from such statements due to the following factors: materially adverse changes in economic or industry conditions generally (including capital markets) or in the markets served by the Company, the development and use of new technology and the actions of competitors.

There are additional risk factors that could affect the Company’s business, results of operations or financial condition. Investors are encouraged to review the risk factors set forth in the Company’s most recent Form 10-K as filed with the Securities and Exchange Commission on September 13, 2004.

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America and the Company’s discussion and analysis of its financial condition and results of operations requires the Company’s management to make judgments, assumptions, and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note A of the Notes to Consolidated Financial Statements in the Company’s most recent Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates.

Management believes the Company’s critical accounting policies are those related to revenue recognition, allowance for doubtful accounts, warranty reserves, inventory valuation, valuation of long-lived assets including acquired intangibles and goodwill, accrual of bonus and profit sharing estimates, accrual of income tax liability estimates, workers compensation accrual for our self insurance program, and accounting for stock-based compensation. Management believes these policies to be critical because they are both important to the portrayal of the Company’s financial condition and results of operations, and they require management to make judgments and estimates about matters that are inherently uncertain.

As of September 30, 2004, there have been no significant changes with regard to the critical accounting policies disclosed in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended June 30, 2004.

Introduction

We generate revenues, earnings and cash flows from developing, manufacturing and marketing high technology materials and derivative products for precision use in industrial, medical, military, security and aerospace applications. We also generate revenue, earnings and cash flows from external customer and government funded research and development contracts relating to the development and manufacture of new technologies, materials and products.

Our customer base includes original equipment manufactures, laser end users, system integrators of high-power lasers, manufacturers of equipment and devices for industrial, security and monitoring, digital radiography, U.S. government prime contractors and various U.S. government agencies.

16

Table of Contents

Results of Operations

Net earnings for the first quarter of fiscal 2005 were $5,959,000 ($0.40 per share-diluted) on revenues of $40,507,000. This compares to net earnings of $3,114,000 ($0.21 per share-diluted) on revenues of $34,094,000 in the first quarter of fiscal 2004. Increase in net earnings is partially attributed to a 19% increase in revenues for the first quarter of fiscal 2005 compared to the same quarter last fiscal year. Stronger revenues were realized in all of the Company’s reporting segments led by Near-Infrared Optics and Compound Semiconductor Group which increased revenues 30% and 28%, respectively, compared to the same quarter last fiscal year. The Company’s addressable markets continue to strengthen across all reporting segments. The Company is projecting revenues to increase approximately 10% to 15% for the fiscal year 2005 compared to fiscal year 2004. In addition to the increase in revenues, improved operating results from the Infrared Optics, Military Infrared Optics and Compound Semiconductor Group which are a result of operating efficiencies as well as lower selling, general and administrative expenses and the lower effective tax rate have also contributed to the increased net earnings in the first quarter of fiscal 2005 compared to the same quarter last fiscal year.

Bookings for the first quarter of fiscal 2005 increased 9% to $37,532,000 compared to $34,582,000 for the same period last fiscal year. Bookings are defined as customer orders received that are expected to be converted to revenues over the next twelve months. For long-term customer orders, the Company does not include in bookings the portion of the customer order that is beyond 12 months due to the inherent uncertainty of an order that far out in the future. Near-Infrared and Compound Semiconductor Group bookings showed the strongest increase, 53% and 20%, respectively, compared to the same period last fiscal year. The Infrared Optics bookings increased 3% from the first quarter of last fiscal year. As further discussed in the Infrared Optics analysis, bookings from customers in Switzerland will now occur on a more continual basis since the formation of II-VI LOT Suisse S.a.r.l., a majority owned subsidiary of the Company. When LOT Suisse was an independent distributor for the Company, a significant twelve-month contract was booked in the first quarter of each fiscal year, including the first quarter of last fiscal year. Excluding bookings from Switzerland for both periods of approximately $587,000 and $3,783,000 for the quarters ended September 30, 2004 and 2003, respectively, the infrared optics bookings for fiscal 2005 increased over 20% as compared to the same quarter of last fiscal year. Bookings for contract research and development for the first quarter of fiscal 2005 of $1,450,000 increased 11% compared to $1,312,000 for the same period last fiscal year. Increased contract bookings were received in the Compound Semiconductor Group and Near-Infrared Optics during the first quarter of fiscal 2005 compared to the same period last fiscal year.

Bookings, revenues and segment earnings (loss) for the Company’s reportable segments are discussed below. Segment earnings is a non-GAAP financial measure and differs from income from operations in that segment earnings excludes certain operational expenses included in other expense – net as reported. Management believes segment earnings to be a useful measure as it reflects the results of segment performance over which management has direct control. See also Note I to the Company’s consolidated financial statements.

17

Table of Contents

Bookings for the first quarter of fiscal 2005 for Infrared Optics increased 3% to $22,986,000 from $22,324,000 in the first quarter of last fiscal year. Because infrared optics customers in Switzerland are serviced by the Company’s majority-owned subsidiary II-VI LOT Suisse S.a.r.l., the bookings recorded from that part of the world will occur on a more continual basis. When LOT Suisse was an independent distributor for the Company, a significant twelve-month contract was booked in the first quarter of each fiscal year, including the first quarter of last fiscal year. For the first quarter of fiscal 2005, infrared optics bookings increased over 20% as compared to the same quarter of last fiscal year when bookings from Switzerland of approximately $587,000 and $3,783,000 for the quarters ended September 30, 2004 and 2003, respectively, are removed from both periods. Original Equipment Manufacturers (OEM’s) continue to strengthen across all markets serviced. Demand is expected to remain strong for the near-term as manufacturing companies worldwide continue to invest in laser equipment to increase productivity and lower costs.

Revenues for the first quarter of fiscal 2005 for Infrared Optics increased 16% to $23,065,000 from $19,906,000 in the first quarter of last fiscal year. This increase was primarily attributable to increased shipment volume to both OEM and aftermarket customers. The Infrared Optics business continues to strengthen worldwide led by II-VI Japan and II-VI LOT GmbH which increased their revenues 18% and 10%, respectively, from the first quarter of last fiscal year.

Segment earnings for the first quarter increased 38% to $7,535,000 from $5,451,000 in the first quarter of last fiscal year. The improvement in segment earnings for the current fiscal three month period as compared to the same period of the last fiscal year was due to a combination of increased sales volume, a build-up of the infrared optic worldwide inventory levels, an increased level of manufacturing at the Company’s Asian facilities in Singapore and China, and productivity improvements occurring at our various manufacturing facilities. In addition, the first quarter of fiscal 2005 included the incremental margin generated by our II-VI LOT Suisse S.a.r.l. subsidiary. The first quarter of last fiscal year did not include the incremental margin as this acquisition did not occur until December 2003.

18

Table of Contents

Bookings for the first quarter of fiscal 2005 for Near-Infrared Optics increased 53% to $7,055,000 from $4,610,000 in the first quarter of last fiscal year. The overall increase in bookings was experienced in all product lines and was driven by a market share gain in the YAG laser market, by continued growth in the medical laser market and by several increased military production orders. Bookings are anticipated to remain strong in the near-term as the Near-Infrared Optics group continues to gain market share.

Revenues for the first quarter of fiscal 2005 for Near-Infrared Optics increased 30% to $7,747,000 compared to $5,951,000 in the first quarter of last fiscal year. This increase in revenues was attributed to revenues from the UV Filter product line, a new product offering of the Company. During the first quarter of fiscal year 2005, increased customer delivery requirements of the UV Filter product line drove the revenue increase. In addition, increased shipments of standard optics and crystal products used in the medical and military markets contributed to the revenue increase.

Segment earnings for the first quarter of fiscal 2005 decreased 14% to $466,000 from $544,000 in the first quarter of last fiscal year. This decrease in segment earnings was attributed to higher production costs, expenses incurred during the ramp-up of the UV Filter business.

Bookings for the first quarter of fiscal 2005 for Military Infrared Optics decreased 8% to $5,642,000 as compared to $6,105,000 in the first quarter of last fiscal year. The overall decrease in bookings was primarily due to timing differences in receipt of core military orders.

Revenues for the first quarter of fiscal 2005 for Military Infrared Optics increased 13% to $6,411,000 compared to $5,682,000 in the first quarter last fiscal year. Contributing to the increase in the revenues for the quarter ended September 30, 2004 was the continued progress of the segment’s sapphire window assembly which recorded revenues of approximately $1.3 million for the first quarter of 2005, an increase of approximately 65% from the first quarter of the prior fiscal year. Core military revenues increased approximately 10% compared to the prior year due to increased demands for military infrared optics used or damaged in the Iraq war.

Segment earnings for the first quarter of fiscal 2005 increased to $281,000 compared to segment loss of $6,000 for the same period last fiscal year. The improvement in segment earnings for the three month period of the current fiscal year as compared to the last fiscal year was primarily due to losses recognized in the prior fiscal period from activities performed on a fixed price percentage of completion contract. During the prior fiscal year, the Company received a “stop-work order” relating to this contract as the U.S. Government cancelled the entire program relating to the Comanche Helicopter Defense initiatives. During the first quarter of fiscal 2005, the contract termination was settled.

19

Table of Contents

The Company’s Compound Semiconductor Group (formerly “Other”) includes the combined operations of the Company’s eV PRODUCTS division, the Company’s Wide Bandgap Materials (WBG) group and the Company’s Advanced Material Development Center (AMDC) group.

Bookings for the first quarter of fiscal 2005 for the Compound Semiconductor Group were $1,849,000 as compared to $1,543,000 in the first quarter of last fiscal year. The increase in bookings was partially due to the increase in product bookings from the WBG group. The increase in WBG Group product bookings reflect continued success at penetrating the OEM marketplace with competitive products.

Revenues for the first quarter of fiscal 2005 for the Compound Semiconductor Group were $3,284,000 compared to $2,555,000 in the first quarter of the last fiscal year. The higher revenues for the three month period were primarily attributed to the WBG group which recorded approximately $1.6 million of product and contract revenue. The amount represents an increase in revenues of over 100% from the first quarter of last fiscal year. Revenues for the first quarter of fiscal 2005 for the Group’s eV PRODUCTS division decreased slightly from the first quarter of last fiscal year. Sharply lower demand than expected for our bone mineral densitometry radiation sensor products from our major customer contributed to this decrease.

The segment loss for the first quarter of fiscal 2005 of $546,000 decreased from the segment loss of $1,265,000 in the first quarter of the prior fiscal year. The decrease in the loss for the three month period was attributable to improved incremental gross margin on increased revenues of these operations.

Overall

Manufacturing gross margin, which is defined as net sales less cost of goods sold, for the first quarter of fiscal 2005 was $17,410,000 or 46% of net sales compared to $13,987,000 or 44% of net sales for the same period last fiscal year. The increased margin resulted in part from a build-up of the worldwide inventory levels, specifically in the Infrared Optics segment. The increased sales volume for the current quarter as compared to the same period last fiscal year and the increase in the amount of manufacturing performed at the Company’s Singapore and China facilities all impacted gross margins favorably.

Contract research and development gross margin, which is calculated as contract research and development revenues less contract research and development expenses, for the first quarter of fiscal 2005 was $375,000 or 14% of research and development revenues compared to a gross margin of $50,000 or 2% of research and development revenues for the same period last fiscal year. The increase in the contract research and development gross margin for the three months ended September 30, 2004 compared to contract research and development gross margin for the same period last fiscal year was due to losses recognized in the prior fiscal year from activities performed on a fixed price percentage of completion contract in the Military Optics segment. The contract research and development revenues and costs are a result of development efforts in the Near-Infrared Optics and the Military Infrared Optics segments as well as activities in the eV PRODUCTS division and the WBG group for the current quarter. Contract research and development gross margin is a result of cost plus fixed fee, cost reimbursement and percentage of completion contract activities.

20

Table of Contents

Company-funded internal research and development expenses for the first quarter of fiscal 2005 were $1,048,000 or 3% of revenue and was consistent with the same period last fiscal year of $1,087,000 or 3% of revenues. Company funded internal research and development expenses combined with externally funded research and development expenses for the first quarter of fiscal 2005 were $3,356,000 or 8% of revenue compared to $3,078,000 or 9% for the same period last fiscal year.

Selling, general and administrative expenses for the first quarter of fiscal 2005 were $9,001,000 or 22% of revenues compared to $8,226,000 or 24% of revenues for the same period last fiscal year. The increase for the three month period as compared to the same period last fiscal year reflect increased salary expenses for the Company’s worldwide profit driven bonus program. In addition, the selling, general and administration expenses of II-VI LOT Suisse S.a.rl. which was acquired during the second quarter of the prior year contributed to the increase. The selling, general and administrative expense in the same quarter last year reflected legal and professional fees of approximately $700,000 to defend and protect our trade secrets and intellectual properties.

Interest expense for the first quarter of fiscal 2005 was $63,000 compared to $134,000 for the same period last fiscal year. The lower interest expense reflects a 33% reduction in the overall debt levels of the Company at September 30, 2004 as compared to the same period last fiscal year as well as capitalized interest on a specific construction project at the Company’s Pennsylvania facility.

Other income for the first quarter of fiscal 2005 was $491,000 compared to other income of $91,000 for the same period last fiscal year. These income items included foreign currency gains, earnings from our one-third interest in 5NPlus, Inc. and other income items. Other income was partially offset by the minority interests in our majority-owned subsidiaries in Germany and Switzerland and other expense items.

The Company’s year-to-date effective income tax rate is 27% compared to an effective income tax rate of 33% for the same period in fiscal 2004. The decrease in the effective tax rate as compared to the effective tax rate in effect for the previous year is the result of an expected shift in the mix of taxable earnings to lower tax rate jurisdictions as well as a lower tax rate on the Singapore operations based on a new tax program offered to II-VI Singapore by the Singapore government.

Liquidity and Capital Resources

Historically, our primary source of cash has been provided through operations. Other sources of cash include proceeds received from the exercise of stock options, as well as through long-term borrowings. Our historical uses of cash have been for capital expenditures, purchases of businesses and payment of principal and interest on outstanding debt obligations. Supplemental information pertaining to our sources and uses of cash is presented as follows:

Historically, during the first quarter of each fiscal year, cash generated from operations is at its lowest amount or is negative due to the pay-out during that period of the Company’s worldwide bonuses accrued from the previous fiscal year. In the first three months of fiscal 2005, cash used in operations was approximately $1.8 million. This primarily resulted from a decrease of approximately $4.4 million of accrued bonuses. In addition, an increase in working capital requirements (accounts receivable, inventories and accounts payable) of approximately $4.4 million were used in operations.

21

Table of Contents

Net cash used in investing during the first quarter of fiscal 2005 of approximately $4.1 million was primarily from property, plant and equipment expenditures. Net cash provided by financing activities of $638,000 included $725,000 of proceeds from the exercise of stock options offset by $87,000 of net payments on borrowings.

The Company had available $14.8 million under its line of credit option of the credit facility as of September 30, 2004. The Company is obligated to pay $1.9 million on the first day of each fiscal quarter until the term loan portion of the credit facility, which was $7.5 million as of September 30, 2004, is repaid. At September 30, 2004, $12.3 million remained outstanding on the credit facility. Our current credit facility is scheduled to expire in August 2005 and we expect to have a new credit facility in place by that time. Beginning with the quarter, September 30, 2004, all borrowings on the credit facility have been classified as short-term debt and will continue to be reported in this manner until a new facility is obtained.

The Company is expanding its thin film coating and administrative offices at its Saxonburg, Pennsylvania facility. Estimated total costs of the expansion project is approximately $9.6 million and will be funded from cash generated from operations.

Our cash position, borrowing capacity and debt obligations are as follows:

The Company believes cash flow from operations, existing cash reserves and available borrowing capacity will be sufficient to fund its working capital needs, capital expenditures, scheduled debt payments and growth for fiscal 2005.

22

Table of Contents

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Foreign Exchange Risks

The Company is exposed to market risks arising from adverse changes in foreign currency exchange rates and interest rates. In the normal course of business, the Company uses a variety of techniques and derivative financial instruments as part of its overall risk management strategy primarily focused on its exposure to the Japanese Yen. No significant changes have occurred in the techniques and instruments used other than those described below.

The Company also has transactions denominated in Euros and Pounds Sterling. Changes in the foreign currency exchange rates of these currencies did not have a material impact on the results of operations for the quarter ended September 30, 2004.

In the normal course of business, the Company enters into foreign currency forward exchange contracts with its banks. The purpose of these contracts is to hedge ordinary business risks regarding foreign currencies on product sales. Foreign currency exchange contracts are used to limit transactional exposure to changes in currency rates. The Company enters into foreign currency forward contracts that permit it to sell specified amounts of foreign currencies expected to be received from its export sales for pre-established U.S. dollar amounts at specified dates. The forward contracts are denominated in the same foreign currencies in which export sales are denominated. These contracts provide the Company with an economic hedge in which settlement will occur in future periods and which otherwise would expose the Company to foreign currency risk. The Company monitors its positions and the credit ratings of the parties to these contracts. While the Company may be exposed to potential losses due to risk in the event of non-performance by the counterparties to these financial instruments, it does not anticipate such losses. The Company entered into a low interest rate, 300 million Yen loan with PNC Bank in September 2002 in an effort to minimize the foreign currency exposure in Japan. A change in the interest rate of 1% for this Yen loan would have changed the interest expense by approximately $7,000 and a 10% change in the Yen to dollar exchange rate would have changed revenues in the range from a decrease of $401,000 to an increase of $492,000 for the quarter ended September 30, 2004.

For II-VI Singapore Pte., Ltd. and its subsidiaries, the functional currency is the U.S. dollar. Gains and losses on the remeasurement of the local currency financial statements are included in net earnings. Foreign currency remeasurement gains were $191,000 and $100,000 for the quarters ended September 30, 2004 and 2003, respectively.

For all other foreign subsidiaries, the functional currency is the local currency. Assets and liabilities of those operations are translated into U.S. dollars using period-end exchange rates; while income and expenses are translated using the average exchange rates for the reporting period. Translation adjustments are recorded as accumulated other comprehensive income within shareholders’ equity.