Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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Forward-Looking Statements

Certain statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are forward-looking statements. Forward-looking statements are also identified by words such as “expects,” “anticipates,” “believes,” “intends,” “plans,” “projects” or similar expressions. Actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including those potential risks set forth in Item 1A, of this Annual Report on Form 10-K, which are incorporated herein by reference.

Overview

II-VI Incorporated (“II-VI,” the “Company,” “we,” “us” or “our”), a worldwide leader in engineered materials and optoelectronic components, is a vertically integrated manufacturing company that develops innovative products for diversified applications in the industrial materials processing, optical communications, military, consumer electronics, semiconductor equipment, life science and automotive applications . The Company produces a wide variety of application-specific photonic and electronic materials and components, and deploys them in various forms, including integration with advanced software.

The Company generates revenues, earnings and cash flows from developing, manufacturing and marketing engineered materials and optoelectronic components and devices for precision use in industrial materials processing, optical communications, consumer electronics, semiconductor equipment, life sciences and automotive applications. We also generate revenue, earnings and cash flows from government funded research and development contracts relating to the development and manufacture of new technologies, materials and products.

Our customer base includes OEMs, laser end-users, system integrators of high-power lasers, manufacturers of equipment and devices for the industrial, optical communications, military, semiconductor, medical and life science markets, consumer, U.S. government prime contractors, various U.S. Government agencies and thermoelectric integrators.

As we grow, we are focused on scaling our Company and deriving the benefits of vertical integration as we strive to be a best in class competitor in all of our highly competitive markets. The Company may elect to change the way in which the Company operates or is organized in the future to enable the most efficient implementation of its strategy.

Critical Accounting Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) 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 1 of the Notes to our Consolidated Financial Statements contained in Item 8 of this Annual Report on Form 10-K describes the significant accounting policies and accounting 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 estimates are those related to revenue recognition, inventory valuation, business combinations, impairment of goodwill and indefinite-lived intangible assets, accrual of income taxes and accounting for share-based compensation. Management believes these estimates 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.

Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the related disclosure. In addition, there are other items within our consolidated financial statements that require estimation, but are not deemed critical as described above. Changes in estimates used in these and other items could have a material impact on the consolidated financial statements.

Revenue Recognition

Revenues for product shipments are realizable when we have persuasive evidence of a sales arrangement, the product has been shipped or delivered, the sales price is fixed or determinable and collectability is reasonably assured. Title and risk of loss passes from the Company to its customer at the time of shipment in most cases, with the exception of certain customers for whom customer’s title does not pass and revenue is not recognized until the customer has received the product at its physical location.

The Company’s revenue recognition policy is consistently applied across the Company’s segments, product lines and geographical locations. Further, for the periods covered herein, we did not have post shipment obligations such as training or installation, customer acceptance provisions, credits and discounts, rebates and price protection or other similar privileges. Our distributors and agents are not granted price protection. Our distributors and agents, who generate less than 10% of consolidated revenue, have no additional product return rights beyond the right to return defective products covered by our warranty policy. We believe that our revenue recognition practices are consistent with Staff Accounting Bulletin 104 and that we have adequately considered the requirements of Accounting Standards Codification 605 Revenue Recognition. Revenues generated from transactions other than product shipments are contract-related and have historically accounted for approximately 1% of the Company’s consolidated revenues.

Inventory

The Company generally records an inventory adjustment as a charge against earnings for all products on hand for more than 12 to 24 months, depending on the products that have not been sold to customers or cannot be further manufactured for sale to alternative customers. An additional charge may be recorded for products on hand that are in excess of product sold to customers over the same periods noted above. If actual market conditions are less favorable than projected, additional inventory adjustments may be required. The Company’s inventory adjustments have historically been proven to be materially correct based upon actual write-offs incurred.

Business Acquisitions

The Company accounts for business acquisitions by establishing the acquisition-date fair value as the measurement for all assets acquired and liabilities assumed. Certain provisions of U.S. GAAP prescribe, among other things, the determination of acquisition-date fair value of consideration paid in a business combination (including contingent consideration) and the exclusion of transaction and acquisition-related restructuring costs from acquisition accounting.

Goodwill and Indefinite-Lived Intangibles

The Company tests goodwill and indefinite-lived intangible assets for impairment annually, and when events or changes in circumstances indicate that goodwill or indefinite-lived intangible assets might be impaired. Other intangible assets are amortized over their estimated useful lives. The determination of the estimated useful lives of other intangible assets and whether goodwill or indefinite-lived intangibles are impaired requires us to make judgments based on long-term projections of future performance. Estimates of fair value are based on our projection of revenues, operating costs and cash flows of each reporting unit, considering historical and anticipated results and general economic and market conditions and their projections. The fair values of the reporting units are determined using a discounted cash flow analysis based on historical and projected financial information as well as market analysis. The annual goodwill impairment analysis considers the financial projections of the reporting unit based on our most recently completed long-term strategic planning processes and also considers the current financial performance compared to our prior projections of the reporting unit. Changes in our internal structuring, financial performance, judgments and projections could result in an impairment of goodwill or indefinite-lived intangible assets. As of June 30, 2018, no reporting units are at risk for impairment, as the fair value of the reporting units substantially exceeds the carrying values.

The Company has the option to perform a qualitative assessment of goodwill prior to completing the quantitative assessment described above, to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill and other intangible assets. If the Company concludes that this is the case, it must perform the quantitative assessment. Otherwise, the Company will forego the quantitative assessment process and does not need to perform any further testing. The Company did not use the optional qualitative assessment during the years ended June 30, 2018 and 2017.

As a result of the purchase price allocations from our acquisitions, and due to our decentralized structure, our goodwill is included in multiple reporting units which are the same as the Company’s operating segments. Due to the cyclical nature of our business, and the other factors described in the section on Risk Factors set forth in Item 1A of this Annual Report on Form 10-K, the profitability of our individual reporting units may periodically be affected by downturns in customer demand, operational challenges and other factors. These factors may have a relatively more pronounced impact on the individual reporting units as compared to the Company as a whole, and might adversely affect the fair value of the individual reporting units. If material adverse conditions occur that impact one or more of our reporting units, our determination of future fair value might not support the carrying amount of one or more of our reporting units, and the related goodwill would need to be impaired. Based upon our annual quantitative goodwill and indefinite-lived intangible assets impairment tests, the Company did not record any impairments of goodwill or indefinite-lived intangible assets for the fiscal year ended June 30, 2018.

0.25% Convertible Senior Notes

Our 0.25% convertible senior notes are accounted for in accordance with ASC 470, Accounting for Convertible Debt Instruments That May be Settled in Cash upon Conversion (Including Partial Cash Settlement). ASC Subtopic 470-20 requires the issuer of convertible debt that may be settled in shares or cash upon conversion at the issuer’s option, such as these notes, to account for the liability (debt) and equity (conversion option) components separately. The value assigned to the debt component is the estimated fair value as of the issuance date of a similar debt instrument without the conversion option. The amount of the equity component is calculated by deducting the fair value of the liability component from the principal amount of the convertible debt instrument. The resulting debt discount is amortized as additional non-cash interest expense over the expected life of the notes utilizing the effective interest method. Although ASC 470 has no impact on our actual past or future cash flows, it requires us to record non-cash interest expense as the debt discount is amortized.

Income Taxes

The Company prepares and files tax returns based on its interpretation of tax laws and regulations and records estimates based on these judgments and interpretations. In the normal course of business, the Company’s tax returns are subject to examination by various taxing authorities, which may result in future tax, interest and penalty assessments by these authorities. Inherent uncertainties exist in estimates of many tax positions due to changes in tax law resulting from legislation, regulation and/or as concluded through the various jurisdictions’ tax court systems. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution. The amount of unrecognized tax benefits is adjusted for changes in facts and circumstances. For example, adjustments could result from significant amendments to existing tax law and the issuance of regulations or interpretations by the taxing authorities, new information obtained during a tax examination, or resolution of an examination. The Company believes that its estimates for uncertain tax positions are appropriate and sufficient to pay assessments that may result from examinations of its tax returns. The Company recognizes both accrued interest and penalties related to unrecognized tax benefits in income tax expense.

Management evaluates the realizability of deferred tax assets for each jurisdiction in which it operates. If the Company experiences cumulative pretax income in a particular jurisdiction in a three-year period including the current and prior two years, management normally concludes that the income tax assets will more likely than not be realizable and no valuation allowance is recognized, unless known or planned operating developments, or changes in tax laws, would lead management to conclude otherwise. However, if the Company experiences cumulative pretax losses in a particular jurisdiction in a three year period, management then considers a series of factors in the determination of whether the deferred tax assets can be realized. The Company has recorded valuation allowances against certain of its deferred tax assets, primarily those that have been generated from net operating losses in certain foreign taxing jurisdictions and acquired U.S. carryforwards. In evaluating whether the Company would more likely than not recover these deferred tax assets, it has not assumed any future taxable income or tax planning strategies in the jurisdictions associated with these carry-forwards where history does not support such an assumption. Implementation of tax planning strategies to recover these deferred tax assets or future income generation in these jurisdictions could lead to the reversal of these valuation allowances and a reduction of income tax expense.

Share-Based Compensation

The Company recognizes share-based compensation expense over the requisite service period of the individual grantees, which generally equals the vesting period. The Company utilizes the Black-Scholes valuation model for estimating the fair value of share-based equity expense, using assumptions such as the risk-free interest rate, expected stock price volatility, expected stock option life and expected dividend yield. The risk-free interest rate is derived from the average U.S. Treasury Note rate during the period, which approximates the rate in effect at the time of grant related to the expected life of the options. Expected volatility is based on the historical volatility of the Company’s common stock over the period commensurate with the expected life of the options. The expected life calculation is based on the observed time to post-vesting exercise and/or forfeitures of options by our employees. The dividend yield is zero, based on the fact the Company has never paid cash dividends and has no current intention to pay cash dividends in the future.

Fiscal Year 2018 Compared to Fiscal Year 2017

The Company aligns its organizational structure into the following three reporting segments for the purpose of making operational decisions and assessing financial performance: (i) II-VI Laser Solutions, (ii) II-VI Photonics, and (iii) II-VI Performance Products. The Company is reporting financial information (revenue through operating income) for these reporting segments in this Annual Report on Form 10-K.

The following table sets forth select items from our Consolidated Statements of Earnings for the years ended June 30, 2018 and June 30, 2017 ($ in millions except per share information):

		Year Ended								Year Ended
		June 30, 2018								June 30, 2017
						% of								% of
						Revenues								Revenues
Total revenues		$	1,158.8				100.0	%		$	972.0				100.0	%
Cost of goods sold			697.5				60.2				583.7				60.1
Gross margin			461.3				39.8				388.3				39.9
Operating expenses:
Internal research and development		117.2					10.1				96.8				10.0
Selling, general and administrative			208.8				18.0				176.0				18.1
Interest and other, net			13.1				1.1				(3.3	)			(0.3	)
Earnings before income tax			122.2				10.5				118.8				12.2
Income taxes			34.2				3.0				23.5				2.4
Net earnings		$	88.0				7.6	%		$	95.3				9.8	%
Diluted earnings per share		$	1.35							$	1.48

Executive Summary

Net earnings for fiscal year 2018 were $88.0 million ($1.35 per-share diluted), compared to $95.3 million ($1.48 per-share diluted) for the same period last fiscal year. The decrease in net earnings during current fiscal year from fiscal year 2017 was primarily driven by provisions under the Act and the Company’s related actions. Under the Act, the Company’s effective tax rate for fiscal year 2018 was 28.0% compared to 19.8% in fiscal year 2017; the Company recorded an additional $8.0 million of income tax expense, primarily relating to withholding taxes on future repatriation of foreign earnings. The Company also increased its investment in internal research and development relating to its new optoelectronic laser platform with the acquisition of Kaiam Laser Limited, and it ramped up its investment in other operations to address market shifts to new technologies driven by advanced engineered materials. Fiscal year 2017 was favorably impacted by other income relating to earn-out and technology transfer income the Company received as part of the sale of the RF business of ANADIGICS. The Company recognized $7.0 million or $0.09 per share diluted of other income related to these transactions in fiscal year 2017.

Consolidated

Revenues. Revenues for the year ended June 30, 2018 increased 19% to $1,158.8 million, compared to $972.0 million for the prior fiscal year. The increase in revenues during the current fiscal year was driven by strong demand from customers across all of the Company’s business segments. In particular, II-VI Laser Solution realized a 26% revenue growth from the prior year, driven by increased demand from industrial based customers for CO2, fiber and direct diode optics and components. This segment also recorded increased shipments of its VCSELs products addressing the growing consumer electronics, datacom and other developing end markets. II-VI Performance Products recorded a 24% revenue increase during the current fiscal year, driven by strengthening demand for SiC substrate products addressing RF electronics and high-power switching and power conversion systems for automotive, communication and military markets.

Gross margin. Gross margin for the year ended June 30, 2018 was $461.3 million, or 39.8%, of total revenues, compared to $388.3 million, or 39.9%, of total revenues for the same period last fiscal year. Gross margin as a percentage of revenues was consistent with the prior fiscal year due to a balance of operating efficiencies and investments to expand capacity. The Company’s II-VI Photonic’s gross margin was negatively impacted by both product mix and the effects of foreign currency.

Internal research and development. Company-funded internal research and development (“IR&D”) expenses for the fiscal year ended June 30, 2018 were $117.2 million, or 10.1% of revenues, compared to $96.8 million, or 10.0% of revenues, last fiscal year. The increase in IR&D expenses is primarily the result of the current year acquisition of Kaiam Laser Limited, acquired in August 2017, which contributed $14.6 million of expense. The Company continues to ramp its investment in new material-based technologies addressing growing market trends in consumer electronics, communications and automotive markets.

Selling, general and administrative. Selling, general and administrative (“SG&A”) expenses for the year ended June 30, 2018 were $208.8 million, or 18.0% of revenues, compared to $176.0 million, or 18.1% of revenues, last fiscal year. SG&A expenses includes $3.7 million and $2.5 million, respectively, for the combined acquisitions of II-VI Integrated Photonics Inc. (“IPI”), acquired in June 2017, and Kaiam Laser Limited, acquired in August 2017. Exclusive of these acquisitions, the increase in SG&A is primarily due to increased operating costs to support the Company’s growing revenue and infrastructure base, as well as its ongoing merger and acquisition strategy. The Company is working to identify and capitalize on synergies created from the Company’s recent acquisitions and is working to improve the SG&A leverage in the upcoming fiscal 2019 and beyond.

Interest and other, net. Interest and other, net for the year ended June 30, 2018 was expense of $13.1 million compared to income of $3.3 million last fiscal year. Included in interest and other, net were interest expense on long-term borrowings, earnings from equity investments, interest income on excess cash reserves, unrealized gains and losses on the Company’s deferred compensation plan, and foreign currency gains and losses. Interest expense increased $11.5 million due to the higher levels of the Company’s outstanding debt. The majority of the interest expense increase was related to the Company’s $345.0 million convertible debt issued in August 2017. The Company recognized $10.8 million of interest and amortization of debt discounts and issuance costs. Other income last fiscal year included approximately $7.0 million of income from earn-out and technology transfer agreements from the Company’s sale of its ANADIGICS’ RF business.

Income taxes. The Company’s year-to-date effective income tax rate at June 30, 2018 was 28.0%, compared to an effective tax rate of 19.8% last fiscal year. The variation between the Company’s effective tax rate and the U.S. statutory rate was primarily due to the Company’s foreign operations, which are subject to income taxes at lower statutory rates. The increase in the current fiscal year’s effective tax rate is the result of approximately $8.0 million of increased income tax expense relating to repatriation on foreign source earnings.

Segment Reporting

Revenues and operating income for each of the Company’s reportable segments are discussed below. Operating income differs from income from operations in that operating income excludes certain operational expenses included in other expense (income) – net, as reported. Management believes operating income to be a useful measure for investors, as it reflects the results of segment performance over which management has direct control and is used by management in its evaluation of segment performance. See “Note 12. Segment and Geographic Reporting,” to the Consolidated Financial Statements included in this Annual Report on Form 10-K for further information on the Company’s reportable segments and for the reconciliation of operating income to net earnings, which is incorporated herein by reference.

II-VI Laser Solutions ($ in millions)

		Year Ended								%
		June 30,								Increase
		2018				2017
Revenues		$	428.0			$	339.3				26	%
Operating income		$	36.8			$	30.9				19	%

The Company’s II-VI Laser Solutions segment includes the combined operations of II-VI Infrared Optics, II-VI HIGHYAG, II-VI Laser Enterprise, II-VI Laser Systems Group, II-VI OED, II-VI EpiWorks, and Kaiam Laser Limited (now operating under II-VI Compound Semiconductors, Ltd.). The Company acquired II-VI Compound Semiconductors, Ltd. in August 2017.

Revenues for the fiscal year ended June 30, 2018 for II-VI Laser Solutions increased 26% to $428.0 million, compared to revenues of $339.3 million last fiscal year. The increase in revenues during the current fiscal year was the result of increased demand from industrial based customers for the Company’s CO2, fiber and direct diode laser optics and components. In addition, the segment has also seen increased demand for its CVD diamond optics used in the EUV lithography markets, as well as VCSELs used in consumer electronics, datacom and other end markets.

Operating income for the fiscal year ended June 30, 2018 for II-VI Laser Solutions increased 19% to $36.8 million, compared to $30.9 million last fiscal year. The increase in operating income during the current fiscal year was the result of incremental margins realized from increased capacity utilization, increase in mix of higher margin products, offset somewhat by greater investment in growth markets.

II-VI Photonics ($ in millions)

		Year Ended								%
		June 30,								Increase
		2018				2017
Revenues		$	464.4			$	418.5				11	%
Operating income		$	67.7			$	63.0				7	%

The Company’s II-VI Photonics segment includes the combined operations of II-VI Photop and II-VI Optical Communications. The above operating results for the year ended June 30, 2018 include the Company’s recent acquisition of IPI which was acquired in June 2017.

Revenues for the year ended June 30, 2018 for II-VI Photonics increased 11% to $464.4 million, compared to $418.5 million for last fiscal year. Included in the current year’s revenues were $19.3 million of revenues from the above acquisition. Exclusive of IPI, the increase in revenues was primarily attributed to increased demand of optics and optic assemblies for applications for industrial laser products. In addition, the segments realized increase demand for transport and amplification component products, including its 980 nm pumps.

Operating income for the year ended June 30, 2018 for II-VI Photonics increased 7% to $67.7 million, compared to an operating income of $63.0 million last fiscal year. The increase in operating income was primarily due to incremental margin realized on increased revenues but significantly offset by mix shifts and negative foreign exchange effects.

II-VI Performance Products ($ in millions)

		Year Ended								%
		June 30,								Increase
		2018				2017
Revenues		$	266.4			$	214.2				24	%
Operating income		$	30.8			$	21.6				43	%

The Company’s II-VI Performance Products segment includes the business units of II-VI Marlow, II-VI M Cubed, II-VI Advanced Materials, II-VI Optical Systems and II-VI Performance Metals.

Revenues for the year ended June 30, 2018 for II-VI Performance Products increased 24% to $266.4 million, compared to $214.2 million for last fiscal year. The increase in revenues during the current fiscal year was primarily driven by increased demand for SiC products addressing RF electronics and high-power switching and power conversion systems for automotive and communication markets. In addition, the segment has seen increased demand for products and components for the semiconductor capital equipment and military markets.

Operating income for the year ended June 30, 2018 for II-VI Performance Products increased 43% to $30.8 million, compared to $21.6 million for last fiscal year. The increase in operating income during the current fiscal year was primarily driven by incremental margin realized by increased sales volume, as well as favorable product mix toward higher margin products.

Fiscal Year 2017 Compared to Fiscal Year 2016

The following table sets forth select items from our Consolidated Statements of Earnings for the years ended June 30, 2017 and 2016. ($ millions, except per share information):

		Year Ended								Year Ended
		June 30, 2017								June 30, 2016
						% of								% of
						Revenues								Revenues
Total revenues		$	972.0				100.0	%		$	827.2				100.0	%
Cost of goods sold			583.7				60.1				514.4				62.2
Gross margin			388.3				39.9				312.8				37.8
Operating expenses:
Internal research and development			96.8				10.0				60.4				7.3
Selling, general and administrative			176.0				18.1				160.6				19.4
Interest and other, net			(3.3	)			(0.3	)			1.9				0.2
Earnings before income tax			118.8				12.2				90.0				10.9
Income taxes			23.5				2.4				24.5				3.0
Net earnings		$	95.3				9.8	%		$	65.5				7.9	%
Diluted earnings per shares		$	1.48							$	1.04

Consolidated

Revenues. Revenues for the year ended June 30, 2017 increased 18% to $972.0 million, compared to $827.2 million for the fiscal year ended June 30, 2016. The Company had seen continued increased demand from the optical communications customer base as a result of the continuation of the China broadband initiative, datacenter and U.S. metro upgrade cycles (including cable television). In addition, the Company’s II-VI Laser Solutions segment saw increased demand for its products addressing CO2, laser optics, one-micron laser and diamond optic products.

Gross margin. Gross margin as a percentage of revenues for the year ended June 30, 2017 was $388.3 million or 39.9%, compared to $312.8 million or 37.8% for the fiscal year ended June 30, 2016. The improvement in gross margin was primarily driven by incremental margins realized on the Company’s higher revenue levels, which increased approximately $145.0 million from the prior year, as well as favorable product mix primarily in the II-VI Photonics segment.

Internal research and development. Company-funded internal research and development expenses for the year ended June 30, 2017 were $96.8 million, or 10.0% of revenues, compared to $60.4 million, or 7.3% of revenues, for the fiscal year ended June 30, 2016. The increase in internal research and development expense for fiscal year 2017 was the result of the Company’s continued investments in the development of the technology required to produce new optoelectronic devices in large volume for future applications, as well as new product introductions across the Company’s segments.

Selling, general and administrative. SG&A expenses for the fiscal year ended June 30, 2017 were $176.0 million, or 18.1% of revenues, compared to $160.6 million, or 19.4% of revenues, for the fiscal year ended June 30, 2016. The increase in SG&A in absolute dollars was the result of a higher revenue base requiring more SG&A support. The Company experienced favorable leverage as a result of capitalizing on synergies created from the Company’s acquisitions over the past several years.

Interest and other, net. Interest and other, net for the year ended June 30, 2017 was income of $3.3 million compared to expense of $1.9 million for the year ended June 30, 2016. Included in interest and other, net were interest expense on borrowings, interest income on excess cash reserves, foreign currency gains and losses and contingent earnout and technology transfer income from the sale of the ANADIGICS RF business that occurred in June 2016. In particular, for the fiscal year ended June 30, 2017, other income consisted primarily of foreign currency gains of $1.3 million, income from the residual agreements on the sale of the RF business noted above of $7.0 million, and interest income of $0.9 million on the Company’s excess cash reserves, offset by interest expense of $6.8 million on outstanding borrowings. The fiscal year ended June 30, 2016 expense of $1.9 million included $3.1 million of interest expense on the Company’s outstanding borrowings, offset by $1.2 million of interest income on the Company’s excess cash reserves. The increase in interest expense in fiscal year 2017 was the result of higher levels of outstanding borrowings.

Income taxes. The Company’s year-to-date effective income tax rate at June 30, 2017 was 19.8%, compared to an effective tax rate of 27.3% for the fiscal year ended June 30, 2016. The variation between the Company’s effective tax rate and the U.S. statutory rate of 35% was primarily due to the Company’s foreign operations, which are subject to income taxes at lower statutory rates. The lower year-to-date effective tax rate was primarily driven by the reversal of certain valuation allowances triggered by the acquisition of IPI, which generated deferred tax liabilities that offset the previously reserved deferred tax asset.

II-VI Laser Solutions ($ in millions)

										%
		Year Ended								Increase
		June 30,								(Decrease)
		2017				2016
Revenues		$	339.3			$	303.0				12	%
Operating income		$	30.9			$	36.2				(15	%)

Revenues for the year ended June 30, 2017 for II-VI Laser Solutions increased 12% to $339.3 million, compared to $303.0 million for fiscal year ended June 30, 2016. Revenues included $24.0 million for fiscal 2017 and $13.9 million for fiscal year 2016, respectively, attributed to the acquisitions. Exclusive of acquisitions, the increase in revenues for the fiscal year ended June 30, 2017 was the result of higher demand for high- and low-power laser optics, one-micron laser applications, and semiconductor photolithography tools and precision optics in laser applications up to 1 kilowatt for marking and engraving.

Operating income for the year ended June 30, 2017 for II-VI Laser Solutions decreased 15% to $30.9 million, compared to $36.2 million for fiscal year June 30, 2016. Operating income was impacted by the segment’s ongoing internal research and development investments for its new optoelectronic laser platform. During fiscal year 2017, this expense increased approximately $30.2 million over fiscal year 2016.

II-VI Photonics ($ in millions)

		Year Ended								%
		June 30,								Increase
		2017				2016
Revenues		$	418.5			$	325.9				28	%
Operating income		$	63.0			$	37.8				67	%

Revenues for the year ended June 30, 2017 for II-VI Photonics increased 28% to $418.5 million, compared to $325.9 million for the fiscal year ended June 30, 2016. The Company realized increased revenues from the broadband China initiative as China continued expansion of its geographical broadband networks. In addition, increased market share gains in the datacenter communications market and undersea fiber optic networks and new product introductions fueled the higher revenues during the fiscal year ended June 30, 2017.

Operating income for the year ended June 30, 2017 for II-VI Photonics increased 67% to $63.0 million, compared to an operating income of $37.8 million for the fiscal year ended June 30, 2016. The increase in operating income was primarily due to incremental margin realized on the higher revenue volume as well as higher margin product mix, including terrestrial and submarine 980nm pumps and amplifiers, and new product introductions which have higher margin profiles.

II-VI Performance Products ($ in millions)

		Year Ended								%
		June 30,								Increase
		2017				2016
Revenues		$	214.2			$	198.3				8	%
Operating income		$	21.6			$	17.8				21	%

Revenues for the year ended June 30, 2017 for II-VI Performance Products increased 8% to $214.2 million, compared to $198.3 million for fiscal year June 30, 2016. The increase in revenues for the year ended June 30, 2017 was driven by continued growth in the 4G base station market which was expanding geographically. Revenue growth was also driven by increasing demand for 150mm power device products as the market entered the manufacturing phase in the transition from 100mm to 150mm SiC substrates. In addition, the segment’s semiconductor product offerings experienced increased demands as EUV lithography ramped as part of its anticipated adoption.

Operating income for the year ended June 30, 2017 for II-VI Performance Products increased 21% to $21.6 million, compared to $17.8 million for fiscal year June 30, 2016. Incremental margins on higher segment revenues led by SiC substrate revenues contributed to the increased operating income.

LIQUIDITY AND CAPITAL RESOURCES

Historically, our primary sources of cash have been provided through operations and long-term borrowings. Other sources of cash include proceeds received from the exercise of stock options and sales of equity investments and businesses. Our historical uses of cash have been for capital expenditures, investments in research and development, business acquisitions, payments of principal and interest on outstanding debt obligations, payments in satisfaction of employees’ minimum tax obligations and purchases of treasury stock. Supplemental information pertaining to our sources and uses of cash is presented as follows:

Sources (uses) of Cash (millions):

Year Ended June 30,		2018				2017				2016
Net cash provided by operating activities		$	161.0			$	118.6			$	123.0
Net proceeds on long-term borrowings			153.0				104.0				59.5
Proceeds from exercises of stock options			10.5				15.1				9.7
Additions to property, plant & equipment			(153.4	)			(138.5	)			(58.2	)
Purchases of businesses, net of cash acquired			(80.5	)			(40.0	)			(122.2	)
Purchases of equity investments			(52.1	)			-				-
Purchases of treasury stock			(49.9	)			-				(6.3	)
Debt issuance costs			(10.1	)			-				-
Payments in satisfaction of employees' minimum tax obligations			(6.6	)			(4.1	)			(2.0	)
Payment on earnout consideration			-				(2.0	)			-
Proceeds from the sale of business			-				-				45.0
Other financing activities			-				-				0.6
Effect of exchange rate changes on cash and cash equivalents and other			3.2				0.3				(4.3	)

Net cash provided by operating activities:

Net cash provided by operating activities was $161.0 million and $118.6 million for the fiscal years ended June 30, 2018 and 2017, respectively. The increase in cash provided by operations during the current fiscal year was due to a combination of higher non-cash items such as depreciation, amortization, and share-based compensation expense and better working capital management of accounts payable, income tax payable and other operating net assets.

Net cash provided by operating activities was $118.6 million and $123.0 million for the fiscal years ended June 30, 2017 and 2016, respectively. The decrease in cash provided by operating activities during the fiscal year 2017 was due to increased working capital requirements to support higher revenue growth mainly relating to increased inventory build to address product demand as well as higher levels of accounts receivable from the revenue growth.

Net cash used in investing activities:

Net cash used in investing activities was $285.0 million and $177.2 million for the fiscal years ended June 30, 2018 and 2017, respectively. The increase in cash used in investing activities was the result of a higher level of investments in property, plant & equipment to continue to build capacity to meet the growing demand for the Company’s product portfolio. In addition, the Company completed several strategic investments in both wholly- and majority-owned investments during the current fiscal year, totaling approximately $132.6 million.

Net cash used in investing activities was $177.2 million and $135.2 million for the fiscal years ended June 30, 2017 and 2016, respectively. The increase in cash used in investing activities was the result of increased levels of capital expenditures of $138.5 million in fiscal year 2017 compared to $58.2 million in fiscal year 2016 was primarily driven by additional capital expenditures to increase the Company’s capability to produce new optoelectronic devices as it accelerates its new technology investment platform. Additionally, during fiscal year 2017, the Company purchased IPI, located in Hillsborough, New Jersey, for $39.4 million, net of cash acquired and certain assets of DirectPhotonics Industries GmbH, located in Berlin, Germany, for $0.6 million.

Net cash provided by financing activities:

Net cash provided by financing activities was $97.0 million for the year ended June 30, 2018 compared to net cash provided by financing activities of $111.6 million for the year ended June 30, 2017. During the current fiscal year, the Company completed its offering and sale of $345 million aggregate principal amount of convertible notes. In addition, the Company borrowed $100 million on its revolving credit facility to fund its investments in capital expenditures and research and development to address new and growing technology platforms. The net proceeds from the convertible debt offering as well as cash generated from operations was used to repay $272 million on the revolver, $20 million on the term loan and $10.1 million of convertible debt issuance costs. The Company also utilized $49.9 million of convertible debt proceeds to repurchase 1,414,900 of its common stock. The Company realized $10.5 million of proceeds received from the exercise of stock options offset, by $6.6 million of cash payments in satisfaction of employees’ minimum tax obligations on the vesting of the Company’s restricted and performance shares during the current fiscal year.

Net cash provided by financing activities was $111.6 million for the year ended June 30, 2017 compared to net cash provided by financing activities of $61.5 million for the year ended June 30, 2016. During fiscal year 2017, the Company borrowed $129.0 million to finance its current year acquisitions and investments in capital expenditures for its new VCSEL investment platform and other growth platforms. The Company also received $15.1 million of proceeds from stock option exercises. Offsetting the increase in cash were payments made on outstanding borrowings of $25.0 million, $4.1 million of minimum tax withholding obligations on the vesting of employees’ restricted and performance shares, $2.0 million of payments on contingent earnout arrangements and $1.4 million of debt issuance costs associated with the Amended Credit Facility (as defined below) entered into on July 28, 2016.

0.25% Convertible Senior Notes

On August 24, 2017, the Company entered into a purchase agreement with Merrill Lynch, Pierce, Fenner & Smith Incorporated, as representative of the several initial purchasers named therein (collectively, the “Initial Purchasers”), to issue and sell $300 million aggregate principal amount of our 0.25% convertible senior notes due 2022 (the "Notes") in a private placement to qualified institutional buyers within the meaning of Rule 144A under the Securities Act of 1933, as amended. In addition, we granted the Initial Purchasers a 30-day option to purchase up to an additional $45 million aggregate principal amount of the Notes (the “Over-Allotment Option”).

On August 29, 2017, the Initial Purchasers exercised their Over-Allotment Option to purchase the entire $45 million in aggregate principal amount of additional Notes. The Notes mature on September 1, 2022, unless earlier repurchased by the Company or converted by holders in accordance with the terms of the Notes. Interest is payable semi-annually in arrears on March 1 and September 1 of each year, beginning on March 1, 2018.

The sale of the Notes to the Initial Purchasers settled on August 29, 2017, and resulted in approximately $336 million in net proceeds to the Company after deducting the initial purchasers’ discount and the offering expenses. The net proceeds from the offering and sale of the Notes were used, in part, to repurchase approximately $49.9 million of our common stock. The Company used the remaining net proceeds to repay $252 million on its revolving credit facility and to pay debt issuance costs of $10.1 million.

The Notes are governed by an Indenture between the Company, as issuer, and U.S. Bank, National Association, as trustee. The Notes are our senior unsecured obligations and rank senior in right of payment to any of our indebtedness that is expressly subordinated in right of payment to the Notes; equal in right of payment to any of our indebtedness that is not so subordinated; effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness and other liabilities (including trade payables) of our subsidiaries. In the event of our bankruptcy, liquidation, reorganization or other winding up, our assets that secure secured debt will be available to pay obligations on the Notes only after all indebtedness under such secured debt has been repaid in full from such assets. Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at the Company’s election.

As a result of our cash conversion option, the Company separately accounted for the value of the embedded conversion option as a debt discount. The value of the embedded conversion option was determined based on the estimated fair value of the debt without the conversion feature, which was determined using an expected present value technique (income approach) to estimate the fair value of similar nonconvertible debt; the debt discount is being amortized as additional non-cash interest expense over the term of the Notes using the effective interest method with an effective interest rate of 4.5% per annum.

The equity component is not remeasured as long as it continues to meet the conditions for equity classification. The initial conversion rate is 21.25 shares of common stock per $1,000 principal amount of Notes, which is equivalent to an initial conversion price of $47.06 per share of common stock. Throughout the term of the Notes, the conversion rate may be adjusted upon the occurrence of

certain events. The if-converted value of the Notes amounted to $318.5 million as of June 30, 2018 (based on the Company’s closing stock price on the last trading day of the year ended June 30, 2018).

Holders of the Notes will not receive any cash payment representing accrued and unpaid interest upon conversion of a note. Accrued but unpaid interest will be deemed to be paid in full upon conversion rather than cancelled, extinguished or forfeited.

Prior to the close of business on the business day immediately preceding June 1, 2022, the Notes will be convertible only upon satisfaction of at least one of the conditions as follows:

	a)	During any fiscal quarter (and only during such fiscal quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding quarter is greater than or equal to 130% of the conversion price on each applicable trading day;

	b)	During the five business day period after any five consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such trading day; or

	c)	Upon the occurrence of specified corporate events.

On or after June 1, 2022 until the close of business on the business day immediately preceding the maturity date, holders may convert all or any portion of their Notes, in multiples of $1,000 principal amount, at the option of the holder regardless of the foregoing circumstances.

As of June 30, 2018, the Notes are not convertible. The Notes will become convertible upon the satisfaction of at least one of the above conditions. In accounting for the transaction costs related to the Note issuance, the Company allocated the total amount of offering costs incurred to the debt and equity components based on their relative values. Offering costs attributable to the debt component, totaling $8.4 million, are being amortized as non-cash interest expense over the term of the Notes, and offering costs attributable to the equity component, totaling $1.7 million, were recorded within Shareholders' equity.

The Company was in compliance with all the covenants set forth under the indenture.

The following table sets forth total interest expense recognized related to the Notes for the fiscal year ended June 30, 2018 (representing an effective interest rate of 4.5%):

Year ended June 30,		2018
0.25% contractual coupon		$	731
Amortization of debt discount and debt issuance costs including initial purchaser discount			10,058
Interest expense		$	10,789

The unamortized discount amounted to $49.3 million as of June 30, 2018 and is being amortized over 4 years.

Amended Credit Facility

On July 28, 2016, the Company amended and restated its existing credit agreement. The Third Amended and Restated Credit Agreement (the “Amended Credit Facility”) provides for a revolving credit facility of $325 million, as well as a $100 million term loan. The term loan is being repaid in consecutive quarterly principal payments on the first business day of each January, April, July and October, with the first payment having commenced on October 1, 2016, as follows: (i) twenty consecutive quarterly installments of $5 million and (ii) a final installment of all remaining principal due and payable on the maturity date of July 27, 2021. Amounts borrowed under the revolving credit facility are due and payable on the maturity date. The Amended Credit Facility is unsecured, but is guaranteed by each existing and subsequently acquired or organized wholly-owned domestic subsidiary of the Company. The Company has the option to request an increase to the size of the revolving credit facility in an aggregate additional amount not to exceed $100 million. The Amended Credit Facility has a five-year term through July 27, 2021 and has an interest rate of either a Base Rate Option or a Euro-Rate Option, plus an Applicable Margin, as defined in the agreement governing the Amended Credit Facility. If the Base Rate option is selected for a borrowing, the Applicable Margin is 0.00% to 1.25% and if the Euro-Rate Option is selected for a borrowing, the Applicable Margin is 1.00% to 2.25%. The Applicable Margin is based on the ratio of the Company’s consolidated indebtedness to consolidated EBITDA. Additionally, the Credit Facility is subject to certain covenants, including those relating to minimum interest coverage and maximum leverage ratios. As of June 30, 2018, the Company was in compliance with all financial covenants under its Amended Credit Facility.

Yen Loan

The Company’s yen denominated line of credit is a 500 million Yen ($4.5 million) facility. The Yen line of credit matures in August 2020. The interest rate equal to LIBOR, as defined in the loan agreement, plus 0.625% to 1.75%. At June 30, 2018 and 2017, the Company had 300 million yen outstanding under the line of credit. Additionally, the facility is subject to certain covenants, including those relating to minimum interest coverage and maximum leverage ratios. As of June 30, 2018, the Company had $2.7 million outstanding and was in compliance with all covenants under its Yen facility.

Aggregate Availability

The Company had aggregate availability of $246.4 million and $73.5 million under its lines of credit as of June 30, 2018 and 2017, respectively. The amounts available under the Company’s lines of credit are reduced by outstanding letters of credit. As of June 30, 2018 and 2017, total outstanding letters of credit supported by the credit facilities were $0.4 million and $1.3 million, respectively.

Weighted Average Interest Rate

The weighted average interest rate of total borrowings was 1.3% and 2.2% for the years ended June 30, 2018 and 2017, respectively. The weighted average of total borrowings for the fiscal years ended June 30, 2018 and 2017 was $476.6 million and $272.1 million, respectively.

Share Repurchase Programs

In August 2017, in conjunction with the Company’s offering and sale of the Convertible Notes, the Company’s Board of Directors authorized the Company to purchase up to $50 million of its common stock with a portion of the net proceeds received from the offering and sale of the Notes. The shares that were purchased by the Company pursuant to this authorization were retained as treasury stock and are available for general corporate purposes. The Company purchased 1,414,900 shares of its common stock for approximately $49.9 million pursuant to this authorization.

In August 2014, the Company’s Board of Directors authorized the Company to purchase up to $50 million of its common Stock through a share repurchase program (the “Program”) that calls for shares to be purchased in the open market or in private transactions from time to time. The Program has no expiration and may be suspended or discontinued at any time. Shares purchased by the Company are retained as treasury stock and available for general corporate purposes. As of June 30, 2018, the Company has cumulatively purchased 1,316,587 shares of its common stock pursuant to the Program for approximately $19.0 million

Our cash position, borrowing capacity and debt obligations are as follows (in millions):

		June 30,				June 30,
		2018				2017
Cash and cash equivalents		$	247.0			$	271.9
Available borrowing capacity			246.4				73.5
Total debt obligations			439.0				342.0

The Company believes cash flow from operations, existing cash reserves and available borrowing capacity from its credit facilities will be sufficient to fund its needs for working capital, capital expenditures, repayment of scheduled long-term borrowings and capital lease obligations, investments in internal research and development, share repurchases, internal and external growth objectives at least through fiscal year 2019. The Company expects to complete its acquisition of CoAdna, Inc., a publically traded company on the Taiwan Stock Exchange, on or about September 1, 2018. The purchase price will be approximately $85.0 million, net of any cash acquired and will be financed by a combination of cash on hand and borrowings on the Company’s Amended Credit Facility.

The Company’s cash and cash equivalent balances are generated and held in numerous locations throughout the world, including amounts held outside the United States. As of June 30, 2018, the Company held approximately $218 million of cash and cash equivalents outside of the United States. Cash balances held outside the United States could be repatriated to the United States. The recently enacted Act created significant changes to the taxation of undistributed foreign earnings and has changed our future intentions regarding repatriation of earnings. The Company is currently evaluating the full impact of the Act and may update future cash repatriation intentions.

Off-Balance Sheet Arrangements

The Company’s off-balance sheet arrangements include the operating lease obligations and the purchase obligations disclosed in the contractual obligations table below, as well as letters of credit as discussed in Note 7 to the Company’s Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. The Company enters into these off-balance sheet arrangements to acquire goods and services used in its business.

Tabular Disclosure of Contractual Obligations

		Payments Due By Period
						Less Than 1				1-3				3-5				More Than 5
Contractual Obligations		Total				Year				Years				Years				Years
($000)
Long-term debt obligations		$	496,548			$	20,000			$	46,548			$	430,000			$	-
Interest payments(1)			28,181				7,368				12,244				3,591				4,978
Capital lease obligation			24,940				579				2,168				2,703				19,490
Operating lease obligations(2)			127,900				20,100				33,600				21,500				52,700
Purchase obligations(3)(4)(5)			118,351				114,307				4,044				-				-
Total		$	795,920			$	162,354			$	98,604			$	457,794			$	77,168

(1)	Interest payments represent both variable and fixed rate interest obligations based on the interest rate in place at June 30, 2018, relating to the Amended Credit Facility, the Notes and interest relating to the Company’s capital lease obligation.

(2)	Includes an obligation for the use of two parcels of land related to II-VI Performance Metals. The lease obligations extend through years 2039 and 2061, respectively.

(3)

A purchase obligation is defined as an agreement to purchase goods or services that is enforceable and legally binding on the Company and that specifies all significant terms, including fixed or minimum quantities to be purchased; minimum or variable price provisions, and the approximate timing of the transaction. These amounts are primarily comprised of open purchase order commitments to vendors for the purchase of supplies and materials.

(4)	Includes cash earnout opportunities based on II-VI EpiWorks and IPI for the achievement of certain agreed-upon financial and operational targets.

(5)	Includes the Company’s intention to acquire CoAdna Inc., during the first quarter of fiscal year 2019, in a cash transaction valued at approximately $85.0 million, net of any cash acquired.

Pension obligations are not included in the table above. The Company expects defined benefit plan employer contributions to be $2.7 million in 2019. Estimated funding obligations are determined by asset performance, workforce and retiree demographics, tax and employment laws and other actuarial assumptions which may change the annual funding obligations. The funded status of our defined benefit plans is disclosed in Note 15 to the Company’s Consolidated Financial Statements.

The gross unrecognized income tax benefits at June 30, 2018, which are excluded from the above table, were $10.3 million. The Company is not able to reasonably estimate the amount by which the liability will increase or decrease over time; however, at this time, the Company does not expect a significant payment related to these obligations within the next fiscal year.