Rising Star Buy: II-VI

My Rising Stars multivitamin portfolio is filling out nicely and performing well thus far. Today I'm adding my smallest company yet -- II-VI (Nasdaq: IIVI).

The business
II-VI (pronounced "two-six") is really in the business of expertise -- expertise in dealing with incredibly complex materials and high-precision components. That right there should perk up your investing ears, because it suggests a core competence that competitors can't easily duplicate.

The company's products serve variety of industries, from medicine to the military. Many of them are laser-related, used for cutting, drilling, welding, and even detecting shoulder-launched missiles aimed at low-flying aircraft. II-VI also produces the compound semiconductor materials required for these components to operate, including selenium, tellurium, and silicon carbide. (In fact, the company took its name from columns II and VI of the Periodic Table of Elements, which combine for compounds such as cadmium telluride and zinc selenide.)

Here's a breakdown of II-VI's operating segments:

*Segments with negative values, such as corporate eliminations, are excluded from the total and percentage calculations. Data provided by Capital IQ.

More than 5,000 companies snap up these goods, including Rofin-Sinar for industrial, medical, and military products; Northrop Grumman, Raytheon, and Lockheed-Martin (NYSE: LMT) for defense products; and even John Deere (NYSE: DE) and Caterpillar (NYSE: CAT), for lasers on their assembly lines. There are also major customers II-VI can't discuss because of nondisclosure agreements. This incredibly broad customer base is also geographically diversified, with roughly 50% of sales coming from outside the U.S.

Why I'm buying
II-VI makes for a compelling investment for three major reasons:

1. High barriers to entry. It's hard to overstate how difficult it is to produce these materials and control their quality, sometimes to "atomic tolerances." Few other companies can do so, and according to management, "there are a limited number of suppliers of many of the components we manufacture and there are very few industry-standard products."

2. Sound, proven, long-term business model. Management uses this expertise to its full advantage by working with many of its customers in the design phase. This tends to entrench II-VI products firmly into the customer process, creating high switching costs and strong recurring revenue streams. II-VI can also use manufacturing sites worldwide to stay in close proximity to its buyers, providing speed advantages that allow customers to employ "just-in-time" inventory processes.

To achieve the kind of growth I'm banking on, the company needs to succeed in new product development -- which requires an emphasis on research and development. Fortunately, II-VI has an advantage here as well. Because military and defense systems use a lot of its technology, it receives external funding for R&D, accounting for anywhere from 37% to 55% of total R&D expenditures over the past three fiscal years. Sweet!

3. Secular growth in target markets. Demand for infrared and near-infrared lasers, and the complex materials required to power them, should continue to grow as everything from missile guidance systems to industrial assembly lines become more complex and efficient. This small, $1.5 billion company is extremely well-positioned to profit from this trend and grow accordingly.

What are the risks?
Being a small, $1.5 billion company has its disadvantages as well. Some competitors are bigger and have deeper pockets, such as Cree (Nasdaq: CREE), Northrop Grumman, Goodrich, and Dow Corning – a half-owned subsidiary of both Dow Chemical (NYSE: DOW) and Corning (NYSE: GLW).

II-VI also makes its fair share of acquisitions, including last January's $95 million buyout of Photop Technologies, a China-based manufacturer. Steady acquirers often have digestive issues after devouring other companies, so I approach this with some skepticism.

Finally, despite a broad customer base, about 30% of II-VI's revenues come from the defense industry. These customers are sometimes highly reliant on government spending, so any slowdown in this sector could harm sales.

Five c-notes for II-VI
II-VI hit my trusty Modified Foolish 8 screen in February. That in itself means that the company has demonstrated strong returns on equity over the past few years, has a good level of insider ownership, and sells at a reasonable multiple compared to its growth potential. Add in its strong competitive advantages, and it's enough for me to open a half position -- $500 worth -- in my real-money portfolio while I continue to follow and research it.

Keep up with me as I keep up with II-VI by following me on Twitter.