Lumentum Holdings Inc. (LITE) Earnings Call Transcript & Summary

All right. We are going ahead. Great. Good morning, everyone. It's Rod Hall. I'm the communications technology, infrastructure technology, we now call it, analyst at Goldman Sachs. Got the pleasure of having Lumentum with us again this year at the tech conference. Alan Lowe, the President and CEO. So welcome, Alan.

Thanks, Rod.

And Chris Coldren, the SVP of Strategy and Corporate Development. So Chris, welcome.

Thank you.

Great to have you guys here again.

I wanted to -- I guess I wanted to kick off with a topical question. I don't know if you had -- Alan you have any opening comments? Or you want me to jump in to questions?

No.

Okay. So the press has now been reporting that the Department of Defense is talking about Huawei again. I thought it'd be useful maybe just to remind people how much revenue you had from them this last quarter? And also how those margins across and we know it's different products that you sell them, but how the margins for those products compare to kind of group averages for the different segments? To the extent you're willing to talk about it.

Yes. Well, maybe I'll tackle the question slightly differently at first, but then come back to what you asked. And we'd commented on this during our earnings call when a similar question came up. And first, the caveat that, obviously, we don't know anything or have any insight into how any rules may or may not change. But based on media reports, if it was as simple as the 25% de minimis shifting down to 10% de minimis rule. We have -- are constantly evaluating our U.S. content in our products, as we need to do to be able to provide products to Huawei at present. And given our manufacturing and supply chain, we don't believe there's a much of a challenge if the change were as simple as that. With all that said, we don't know what the change is and there's lots of other things that could be more impactful. But if it is as simple as that, that's not a big impact to us. So Huawei has represented in our -- going back, I guess, to our March quarter was north of $8 million a quarter. That's dropped considerably since then. And it's kind of leveled off at a certain level, that's now about $60 million or so a quarter. And a different mix of products in that has changed quite significantly as well that has really happened these products where either that are commoditized, and the most extreme examples are datacom modules where we've actually gotten out of them. That revenue was declined or other more commodity-type products, revenues come down dramatically. Whereas our revenue on kind of our newest and most differentiated products has grown, probably not any faster than we would have thought, prior to the May action sort of growing as expected on the customers' product launch plans. Growth on those products is limited in many cases by our manufacturing capacity still. But I think what's good about that is, it is presumably a bit more durable in terms of -- those products don't have another alternate competitor or in the cases where there are, it's another U.S.-based supplier, and we don't see Huawei or, frankly, any supplier other than the current competitors who are still quarter -- years behind, multiple quarters behind, catching up. So I think in our case, the threat of being substituted there is pretty low.

Okay. Great. Thanks, Chris. Appreciate it. What's that you brought up the competition point, so I'll go ahead and maybe ask about that a little bit. Finisar, I'm sure you're -- you've noticed so it's that they think they'll qualify that Sherman facility now by the end of this quarter. What do you think that means for competition? And can you take us out maybe a couple of years? Like how does this competitive environment develop over time in your opinion?

So first of all, there's no more Finisar.

I'm sorry, is it?

So I think it's the same commentary from a year ago when it was Finisar. So we'll see. I think our focus has been driving reliability, quality, cost, and internally, our margins to support continuing to give our 3D sensing customers what they need. So they don't have any reason who want to buy from a new supplier. And I think we've got 600 million devices shipped and no returns and no field failures. And so I think there has to be a compelling reason for them to take a bunch of share away from this, and I -- we're working on everything we possibly can to not give them that compelling reason. And so far, so good. And so I think we're going to continue to drive innovation, drive next-generation technology to keep that distance between us and our closest competitor big. And I think if you look at -- the difficulty we had 3 ramps ago was not getting qualification, it was ramping and getting to millions of units a week. And I think qualification is step 1 in a 10-step path, and so good luck.

And the other thing I understand is technology is evolving. So designs are changing and I wonder, could you guys talk about how much these VCSEL array designs are changing as you look from 1 year to the next? Is it a lot of change? Is it minor tweaks to these arrays?

I'd say it's incremental changes that do make it more difficult to keep up. And so as we look forward to more world-facing, more time-of-flight type applications where the technology is not so radically different, but the process is a little different and the test technology is different, that then puts another hurdle in the way of our competitors to keep up or catch up. And so from that perspective, I'm fairly confident in our share for 2020 as well as beyond because we're integral to our customers' R&D plans and their product road maps.

Okay. And then -- so while we're on technology, let's just -- let's talk a little bit sort of forward-looking about the technology road map? You've talked about world-facing 3D scanning coming at some point. Could you just talk us through kind of how you see if investors are thinking in the next year, 2 years? What do we see rolling out in terms of new uses beyond just face recognition?

Yes. So certainly, world-facing is continuing to drive further into the consumer electronics customer base as folks look to couple that with literally just photographic applications as cameras go from dual to triple to quad cameras, probably one of those additional going from dual to triple or triple to quad is a 3D sensor to enable additional sensor data, if you will, for computational photography, whether that's to affect the kind of photographic effects that are being used in photography or low light imaging or very bright light imaging. But I think what's -- in that -- in a sense, sometimes when we talk to customers, it's almost unsexy because it just becomes part of their going from Gen10 to Gen11 of their camera architecture. But we think that, that will proliferate relatively quickly and relatively deeply into customers' supply chains. I think also, what's driving that over the longer run, aside from computational photography is certainly augmented in virtual reality. And as those applications emerge, that will drive not just smartphones but other devices, if you will, to adopt the technology. And then I think, obviously, the real long game here is that when we think of here where the Internet of Things may feel a bit overused, but at the same time, I think what I think of the Internet of Things is a microcontroller, some way to connect to the Internet or a network and then in that capability to see or interact or sense what's going on in the environment. I think that's a very long-term, a large opportunity for this, whether that's, I always point to trivially, the thermostat in the room, counting the number of the people in the room and seeing if they're wanting to manufacturing to just about anything you can imagine outside of maybe a server sitting in a dark data center would require the ability to see. And so I think that also gives us a much longer-term, broader base to supply into than the smartphone supply chain.

Do you -- just while we're on the topic of this, any more visibility on when automotive might start to happen? Is it still too far out on the radar screen to really talk about? Or...

I don't think it's too far out to talk about, but it's far out. I'd say that we are investing, and we are working with Tier 1s as well as the actual automobile manufacturers today, but I certainly don't put it in your time horizon, in your model, because it's probably 3 or 4 years out before it really moves the needle. But it is an investment that we have to make today in order to make that a meaningful market for us, 3, 4, 5, 6 years out.

And I think that's a critical point that the automotive industry is somewhat different than a lot of our other product lines where we have to make investments today, and so effectively get design wins in a certain sense in the near term. And then the customers spend several years designing, qualifying, testing automobiles. And so it is very important investment that we make today that plants that seed for something that's a few years down the road.

We'll talk a little shorter term or medium term about margins. Margin progression has been great. We -- one of the reasons we have a buy on the stock is because we thought that margins would pace ahead of consensus expectations, and that's definitely happened that even more than we would have expected. So I wonder if you could talk a little bit about where margins might top out. Can you get this up above 50% gross margins? And then maybe drill into the OpComm's margin success this last quarter, as well what drove that? We have some ideas, but I'd love to hear a little bit more color from you on that.

Yes, I think a couple of things. One of which is we've successfully integrated the acquisition from, whatever, 15 months ago and drove synergies from what we said was $60 million to now what we think we can get is $110 million. And so we're well on our way to really get the value we had internally known we might be able to get, but it didn't commit externally. So from that perspective, margins are going to continue to go in the right direction. And what we did say was that year-over-year, quarterly margins should be better than they were in calendar '19 throughout this calendar year. And we're going to continue to drive that. I think the other thing we're doing is we're getting rid of bad products. We're getting out of the datacom module business and lithium niobate modulator business. And we'll see that drop off significantly in the June quarter. And that in itself will drive margins up relative to where they were before. So I'm not ready to say we're going to have a new model that's north of 30% operating margin, but I will say that we're going to continue to try.

Right. Okay. We -- on our calculation, it looked like the datacom revenues were higher than in the mix, so that helped drive margins. And then also, it looks to us like mathematically, telecom margins had to expand quite a bit in the quarter. And I wanted to ask about telecom margins, in particular. Is there any dynamic within telecom that drove that expansion?

Well, I think it's new and differentiated products. I mean our high-end ROADMs are above average corporate gross margins, and we're going to continue to drive innovation, so that we have that differentiation. So as you move from a datacom module business to a datacom chip business, the profile changes dramatically, but also in -- we're now shipping 200-gig DCOs. So that's a different margin profile expectation. ACO demand is stronger than we had ever expected. And so from that perspective, the components and modules and on the telecom transmission as well as on the telecom transport side are all going in the right direction, as we get rid of some of the drag products that I talked about earlier.

Okay. 3D sensing, let's talk about Android a little bit. We've modeled Android out. But could you talk a little bit about where we are with regards to both front and world-facing adoption there? And then is that Android market moving toward lower ASP products than the big customer? Or did those products look to you like they'll tend to be ASP-wise closer to what you've seen so far in 3D sensing?

Yes. So consistent with what I said earlier, the Android market is heavily focused on world-facing applications due to essentially integration into cameras and a little less so on the front-facing biometric security. I think that could change over time, but I think that it's natural, those customers need to be less worried about security in general as well as biometric is a, it's a tougher application because it kind of has to -- it doesn't work well enough. It's not very secure, and it's too stringent. It's a very horrible user experience to unlock the phone. So -- but I think that will change as more software algorithms are incorporated into Android and lowers the barrier. But on the world-facing side, that's definitely proliferating across. I think you saw earlier this week, a major or the #1 smartphone vendor in the world launched, 2 of their 3 flagship products have world-facing 3D sensing capability in it. I think that's emblematic of what's going on in the Android world. I think the only sort of step -- slight step backwards, I think, in the near term has been, obviously, our -- the top customer in China has had some challenges with being able to sell a lot of high-end smartphones, given their inability to access Google apps or some of the Android applications due to the U.S. government actions. So that's muted the growth that we may have expected, say, a year ago to occur over this past 12 months. But nonetheless, they've pushed the envelope on the performance capabilities, which has driven a lot of the other customers. From an ASP standpoint, real hard to say. It's kind of all over the place, meaning there are some customers that want a less expensive product to be able to selling a more cost-sensitive or lower ASP phone that is. But on the other end of the spectrum, there's some Android customers looking at some pretty sophisticated chips. So I think over the long run, I don't think there's going to be necessarily a trend towards generationally lower ASPs, meaning every year, things may go down just on a typical year-to-year price down as volumes go up, but I think actually, folks are looking at least as far as we see, if they start with a less sophisticated laser, they may end up with a more sophisticated laser over time as they realize the capabilities that are enabled by a higher-performing laser.

And just on the -- just to double check, I think that some people have tried to edge-emitting lasers for a while, then kind of gave up on that. Is that still the case? Or people looking at edge-emitting still as an option out in the future?

Well, go ahead.

Well, yes, I mean, we're still working on edge-emitters for more new and differentiated applications like perhaps, through the glass, on the phone to get rid of the notch. And so those require longer wavelengths that are more ideally suited for edge-emitting lasers. So we're still working with customers on that. I wouldn't say that it's a short-term design win, but it's certainly something that is got -- has got a lot of interest, but probably more like 2 or 3 years out before it becomes -- designed into a product.

I think there was a lot of fundamental reasons why customers were looking at edge-emitters for years. But I think we -- edge-emitters were a victim of the success of VCSELs that worked so well that a lot of customers said, "Wow, okay, why would I take a risk in the near term, if I can get the same performance out of a VCSEL." But as Alan highlighted, there's a lot of other attributes of edge-emitters that may drive them forward over the long run.

Okay. Shifting gears to telecom a little bit. You talked about an air pocket in ROADMs and transport in the December quarter, and then that will return to growth in March. Could you just talk about how you see a little bit longer-term growth there? And maybe elaborate on the air pocket as well?

Sure. I mean we've been on allocation on ROADMs for probably the last 1.5 years. And I think that tends to have customers over order. And so I think as we started getting closer to supplying what they were ordering, the inventory adjusted, and we think we saw that in the December quarter. Now we're seeing probably more demand that really represents their end demand. And so we've seen a pickup in the March quarter order rate and not just from China, but across the board. So I think from that perspective, long-term growth for ROADMs is going to continue. And I think we're going to see a continued shift in the average price per unit shipped as more and more of our customers adopt the high port count and they can -- end-by-end contentionless ROADMs that we have a very long leadership on those products compared to our competitors. So I think we're going to see that continue. And whether it's an air pocket here and there, that just happens in our business. And so I think we're focused on getting our customers what they want, especially the ones that have committed their next-generation of system on an end-by-end where if we don't supplying an end-by-end ROADM to them, they're not going to ship a system. So we got to be able to support all those customers.

And the other thing on, I guess, ROADMs is the -- those have traditionally carried pretty good margins. As you -- as that mix continues to shift up, do margins expand there? Or they just continue to be high?

I think they expand. Any time you increase your scale, the fixed costs could spread. And any time you move from a product that has 1 or maybe 2 competitors to a product that has no competitors, I mean, margins go up. So I think we're going to expect that to continue to happen.