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

Great. Thanks. Thank you all for joining the Lumentum session. So the next fireside chat that we are hosting is Lumentum. We have with us Alan Lowe, who's the CEO for Lumentum; as well as Chris Coldren, who does business development as well as strategy. And I can see Jim, who does Investor Relations, is also here. Thank you all for dialing in. And Alan, Chris, thank you making for making the virtual conference possible here.

Maybe if I can just start off here with just asking you to kind of address some of the COVID-led concerns relative to when we started off. There were certainly some supply chain constraints that you were trying to address. Kind of just give us, kind of an update on how that has tracked. And overall, where do we stand? And we can get going from there on.

Sure. First of all, Samik, thanks for having us. Appreciate it. It's a lot easier than getting on a plane and going to the East Coast, so appreciate the format. Yes. So we gave an update on our earnings call last week about the supply chain impact. And it basically started and impacted our fiscal Q3 end of March when the Malaysian government put in a movement control order on basically all movement within Malaysia on May 16. So we were shut down for several weeks then. And then progressively have increased the production from our contract manufacturer in Penang, Malaysia, to the point where now we're back to full strength. And I think our output, probably by next week, will be back at pre-pandemic levels. So from that perspective, that part of the business is back and running at full steam. But the first half of the quarter was impacted significantly as a result of not being able to produce product and that capacity is lost. We have been having some supplier issues, and I've been on the phone in fact today already with a couple of suppliers trying to solve some of the challenges we have from suppliers in China, suppliers in Malaysia, suppliers in the Philippines as well as other places around the world who have been impacted, and we're just trying to make sure we get our fair share of supply. I see improvements happening on a regular basis and expect, by the end of the month, most all of those issues will be behind us, and I think June will be pretty clean from a perspective of running back at full steam ahead and really at the kind of volumes we need, as well as we're adding capacity through the process as well.

Got it. That's helpful. Before I move on, let me just remind investors since I kind of joined in the nick of time, you do have the option of sending questions through the Q&A feature, and we'll ask it on your behalf as we go through the fireside chat. Let me go down that route a bit further, Alan. We kind of are hearing from a lot of customers in terms of more permanent changes in the way networks have to function, the additional bandwidth requirements. So we understand the supply chain side, that's obviously temporary. How are you thinking about the longer-term demand implications based on what we are seeing right now?

Well, certainly, our order rate has picked up in the March quarter as well as the first half of this quarter. And I think that's really indication of 2 things. One is, as you say, the bandwidth demands are increasing as a result of things like this that we're doing. We've got 70 people online and video chatting. But I think it's more fundamental than that, that people working from home across the board are using more bandwidth. And so we've seen that both from our network equipment manufacturing demand, but also from hyperscalers and their demand has been increased significantly to the point where I've been getting on the phones directly with them, and they've been pleading their case to get their unfair share of our capacity as well. So I think both in the short term, we're seeing a spike as a result of increased demand, but also lack of supply. And so that tends to have customers order a little bit more than they may necessarily need. And so we're taking that into consideration as we plan our capacity going forward. I do think that there has been a fundamental shift. And even before the pandemic, we were seeing strong demand from -- for build-outs in China, for build-outs in North America and the rest of the world in preparation for 5G. And since China kind of came back to more normal, we've seen an increasingly strong demand for datacom chips in support of 5G rollouts. And so I think that's really now happening. So again, I think that's in the early stages of rollout. And so I think we've got a long, long, time before we can satisfy and catch up with all that demand.

Got it. Since you brought up the topic of China deployment, so let me just hit on that first. We are hearing from a lot of optical companies, including yourself, about the deployment pace increasing in China. Just help us think through the timing here. Because generally, what we're hearing is kind of over accelerated pace of deployment in the second half of the year. What do you -- is that consistent with what you're seeing? And then are there any considerations here in terms of either inventory or anything else that would make you concerned about how much of an accelerated ramp you see yourself in the second half?

Yes. I mean I think that aligns with our expectations, but the network equipment manufacturers in China need the product now in order to build their systems to deploy in the second half. So I think we're seeing pretty strong demand today and consistent demand in forecasts in the second half of the year, calendar year, that is, in anticipation of the deployments really going full speed ahead starting in the summertime.

Okay. If I look a bit more longer term and kind of one of the questions that we get often is, how sustainable is this kind of 5G investment pace that's helping overall telecom demand at this point? How will you think about sustainability here? How long is this investment cycle in your view? And kind of how should investors think about whether it's a very short-term -- kind of short-term lead? Or is there kind of a long tail to it?

It depends what your definition of long term is. I'm going to pass it over to Chris to comment.

Yes. Well, I think there's 2 undercurrents going on here. I mean, first, is with the spike in demand and some near term -- near to mid-term, maybe, let's say, we're seeing a lot of demand for existing products or products that we know are sort of later in their life cycles that are in the systems that are deployable and you could add more capacity to those systems today. So demand for that is very strong. As you talk about both, whether it's in China or rest of the world, what we're talking about in the second half of this calendar year and ramping up through '21 and beyond are the next-generation systems. And these are not systems that get deployed in a couple of quarters and then they're done. These are multi-year projects. So we think the long-term demand is fairly durable. Obviously, is there some crossover point where there's an air pocket in this industry? I don't think we've got any way to handicap that and no indication that there is something like that going to happen. But at least in the near term, there's a lot of logical drivers of our business based on the here-and-now products that extend and add capacity. And then passing the baton to the next-generation systems and products that'll be ramping up later this calendar year and into the next calendar year.

Okay. Maybe if, yes, the other way, if we can look at it is, can you break that down in terms of what are you seeing between transport and transmission separately and what does that trend tell you in terms of where we are in the investment cycle?

Yes. I mean I think it mirrors the commentary I just gave, which is a lot of the transmission strength that we're seeing today is on products that have been launched and are in high-volume production already, not that we have transport weakness per se in those products, but the coming wave of transport strength is really on the bleeding edge of the products that either we just have launched, like end-by-end ROADMs that are going into China, or future systems in North American and European customers using such high port count or end-by-end type ROADMs. So I think, again, it highlights that there's sort of a longer tail that's maybe been amplified and extended on the current networks that are just being expanded in bandwidth and in duration. But then the next wave of next-generation systems coming in where the transport will lead the transmission a little bit, just intrinsically in the way that networks are built.

Got it. Moving to kind of Huawei as a customer and some of the concerns that we kind of see continue to be an overhang here, where there is always a discussion of the kind of what the administration does in terms of tightening the restrictions on shipping to Huawei. I mean, obviously, we cannot really predict what happens. But maybe where -- what are the current kind of constraints you have? And how are you kind of thinking what's kind of the most likely approach here? And then if there is kind of further tightening, what's the flexibility that you, as a company, have to take that product and maybe deploy it to other customers, et cetera?

Sure. I think we -- since May 16 of last year, I remember it vividly when the first restrictions came on Huawei. And I think I was in Boston at this conference. But we -- our business with Huawei has gone down from 25%, 30%, some of which is because we've pruned some products out that were low-margin like our datacom transceivers and our modulators. But others is where they've tried to get supply from non-U.S.-based companies. And so that's all fine. So what we're focused on that we can control is continuing our innovation engine and technology and product differentiation to make sure that we're providing something that they can only get from us, or only get from us and maybe one other U.S.-based supplier. And so far, I think that's what we're going to continue to focus on. And really what's fueling now, what looks to be growth in the future for our business with Huawei from high port count, end-by-end ROADMs to some high-end transmission products, narrow line with lasers and next-generation of modulators. But also our datacom chips, where a year ago, we weren't selling datacom chips to Huawei. Now we're selling datacom chips because we have the best EMLs and DML chips in the industry. And so our focus is going to continue to be to focus on what we can control, which is our R&D investment in innovation and product development. And what the U.S. and China government does is really more outside of our control, but we have analyzed if there's a tightening of the de minimis rule. And today, at 25%, since most of our product is assembled and for that part -- for the most part, designed and built outside of the U.S., the 25% rule doesn't impact really any product. At 10%, we don't have very much product impacted either. So that's kind of what we've looked at. If it gets more draconian than that, then I think it's going to be an air pocket that will take some time to recover. But networks are going to continue to get deployed and if they get deployed by other Chinese network equipment manufacturer, we'll be there for them. Or eventually, if it has to be fulfilled by North America European supplier, I think we'll be there for them as well.

You mentioned the growth you're seeing in the datacom chip business as you've kind of transitioned your portfolio away from the transceiver module business to that. How should we think about the kind of addressable market in the datacom chip business? And I think particularly, I think you've started to move beyond kind of one major customer. So how should we think about the growth trajectory and kind of how many -- what's the kind of customer traction you're seeing with that business as well?

Yes. Maybe I'll start and talk about our customers, and then Chris can talk about the market size. I think if you look back 1.5 years when we closed the deal with Oclaro, they had been kind of the leader in selling to transceiver companies, the datacom chips. Two main customers that made up the vast majority of that business. And -- but then we also had a transceiver business. So we've divested that to CIG. That's now become a large datacom chip customer of ours. But as a result of divesting and getting out of the transceiver business, now we are viewed as a partner of the rest of the transceiver industry as a whole as opposed to a competitor. And I think we've seen a lot of traction from that point over the last year or so to now we have a very diverse customer base. Last quarter alone, we grew 20% quarter-on-quarter. We expect to continue to grow through the calendar year. And we're adding Datacom VCSELs to our portfolio using a very cost-efficient supply chain that we use today for our VCSELs for 3D sensing. So I think the future is very bright for our datacom business, and the margins are quite nice, and you'd imagine them being more like semiconductor kind of margins. So as that grows, it should also help our overall company gross margin. Chris?

Yes. And I think the way to think about it is obviously what we supply is only a portion of what goes into a transceiver. So the market at the component or chip level is substantially less than the size of the -- or lower than the size of the transceiver market. But yes, there is a -- I think, on a typical 40- to 10-gig, 40- to 100-gig type transceiver, a lot of the components we supply can be 10% to 15% of the value, if you will, of a transceiver. But I think what's most important to think about is how that evolves over time, that as we go from 10-gig speeds to 25 gigs that are enabling 40 to 100, and then subsequently to 200 and 400-gig transceivers, that a lot of the cost of the transceiver, outside of a few pieces of optical componentry or electronic chips, isn't changing that much from a cost standpoint. The value equation in that transceiver as you go from 40 to 100 to 200 to 400, is increasingly shifting towards differentiated optical components and a differentiated electronic components, if you will. So for example, as we transition to 400-gig transceivers, guys that are supplying PAM4 electronic chips do very well and guys like us that are supplying very high-performance EMLs that are capable of modulating at those speeds are also doing very well. And so I think what we'll see is an increasing shift in the value of essentially the profit pool, maybe not less the revenue pool, towards guys that are supplying the key differentiated components as speeds go up.

That's helpful. Let me move to the most interesting topic, 3D sensing, and ask you, how confident are you relative to keeping market share, your market circulation with the primary customer as we look at the upcoming product cycle? And how should we think about the economics about the world-pacing modules, free-sensing modules relative to what you already have in terms of the front-facing modules?

Yes. So we're on the third year of very similar chips that we launched 3 years ago, and I would have expected to have not kept the kind of share we had for 3 years. So it's good that we've got a competitor that's says they're qualified and starting to ramp. So I have no problems with that. As we've been working over the last 3 years in refining our process controls, our uniformity of devices, our quality performance, and focusing on next generation and next generation of product designs. And so I'm fairly confident that as new products and new chips get rolled out, we will have a very, very large market share, if not the sole source at the launch, much like what we believe we have today on the world-facing products that could have been announced as a tablet. So I think our expectation is that we have new world-facing chips coming out this year, in the new products. And some of those products will -- or some of those devices will have world-facing as well. And we look at the kind of the revenue per unit being increasing as a result of the new chips having a slightly larger footprint or bigger real estate on the wafer. And basically, pricing typically goes with size of chip and then we have another 50% increase because we have 1 world-facing chip on some of those devices that will be hopefully announced later this year.

Okay. Got it. Let me move to asking you about the opportunity outside this primary customer. How are you thinking about kind of the Android base here where you were ramping revenue steadily with the Android OEMs? And particularly, if I kind of keep this current environment in mind, are you seeing anything in terms of the OEMs trying to de-spec phones just to keep pricing low? And is that going to impact how much of a revenue opportunity or ramp increase is something you can see with the Android OEMs?

Yes. I think you're spot-on with respect to the adoption of 3D sensing in a broad range of Android phones. Today, it's a pretty narrow niche of high-end phones. And until there is really a compelling application, and I'm hopeful that later this year, there will be, to really take advantage of the capabilities on a world-facing 3D sensing. And I think there are already some, computational photography and high-end AR/VR types of applications, I think there will be a slow adoption, but I do think there will be adoption further. I think we had kind of a setback when our largest China-based phone customer had challenges getting components and getting operating systems for that matter. And we're not selling a lot of high-end phones. And so I think once that gets sorted out, I think longer term, the Android market is a huge market for us. And the adoption rate has just been slower than anticipated. We're still working with all of them. And so we're confident that eventually, as it becomes more ubiquitous across the product lines, that we'll see a growth in Android. I do think that something that maybe is lost on some of our 3D sensing efforts is that if you take, for instance, kiosks in China -- pay kiosks China, we're supplying 3D sensing today for facial recognition in those kiosks. And while it's small compared to the mobile handset quantity, it is an indicator that it's going to find its way into more and more devices and more and more applications as we move forward, especially with the pandemic of people not wanting to touch things. And I think having a way to pay with your face is a good way to change that. I don't know, Chris, do you have anything on that?

Yes. I mean I think that's the key point that we've -- at the end of the day, it's easy to make the argument, at least at first blush, of de-spec your product, put in a cheap thumbprint reader, and it's all good. But I think, as Alan highlighted, there are new applications emerging. And as I sit back and think about not only the biometric security for financial transactions and trying to be in a touchless, cashless economy. I mean think about -- I have young kids here trying to do learning from home, et cetera. I think there's a tremendous opportunity as -- particularly in the Android world where phones are often used as a tablet as well, big, big devices around -- overused, but augmented virtual reality, really thinking about entertainment but also remote work, education, telemedicine, these are all things that I think have fundamental long-term trends that while maybe adding 3D sensing does increase the BOM cost of a phone, I don't think you're going to accomplish this camera-based functionality with the thumbprint reader, and 3D sensing will become just a ubiquitous sort of addition or complement to their traditional camera technologies that are needed on both sides of mobile devices over the long run.

Got it. Let me go back to kind of the core part of the business, including telecom and datacom. And kind of one of the concerns that comes up a lot from investors is kind of the increased demand that you're seeing is leading you to increase capacity. A lot of investors kind of perceive that as largely adding capacity at the top of the cycle. And maybe if you can firstly share your thoughts relative to that? And secondly, how does your leverage of contract manufacturers really allow you to do that with much more lower risk that investors foresee at this time?

Well -- yes, I'll -- let me get started, and then Alan can correct...

I have to find my unmute button. Sorry about that. So we've been in this game before. I think the difference this time is that for a lot of the products where we are constrained with our ability to supply, we're sole-sourced on and if you go back, and we have gone back and looked at what happened in 2008, if you look at ROADMs, I think there were 7 ROADM manufacturers at the time, and no one can get enough ROADMs. And so they -- each customer went and they gave each of the 7 ROADM suppliers 25% of their business. And you can imagine what happened is everybody added capacity at 300% of what was needed. I think in this situation, where we're sole source in the very high end ROADMs for -- an example, we're only going to ship what we put capacity in place for. And so therefore, it's a very different world. And I think you look across the industry and the dynamic that has changed over the last 12 years since the '08 recession or slowdown, I think that there's a very different dynamic. Lots of consolidation, lots of differentiation at the high end, and that's what we're focused on. So there's not 7 guys making tunable lasers anymore. And so I think it's a different world that people aren't adding 50% of the capacity to end up having 300% of what's really needed when it all gets caught up.

Let me kind of ask you this question, which I asked your competitor as well, who presented this morning. Primarily, like in my conversations over the last couple of years with investors, we've seen the general kind of perception that the optical component industry is very competitive, and investors have then always try to avoid the space in the past. We've seen a lot of acquisitions or consolidation over the last kind of 2 years or so. Just wanted to get your thoughts on how the fundamentals of the industry have changed driven by these acquisitions, which you've done some yourself, including Oclaro. And kind of how does it kind of help you in terms of some of the longer-term margin targets that you have for the combined company as well?

Yes. I mean we've -- since the spin-out, we've improved margins dramatically, both from investing in R&D and having differentiated products, like we look in a ROADM marketplace. But also through the acquisition and the synergies we attained, we still have a little bit of synergy to go but we will have taken out $110 million or more millions of dollars of annual run rates spending as a result of the work we did in synergy attainment. And I think as we continue to reap the benefits of the R&D investments we've been making over the last 3 or 4 years in products we are introducing today, we should see continued improvement in gross and operating margins and then take on -- put on top of that, we're discontinuing products that have low margin and basically no operating margin when the transceivers and lithium niobate modulators. And so I think once those tail off, we could see improved performance. So again, it gets back to the fundamental difference in the landscape, which is where we either sole source on many products or where we're not, it's one other competitor and us. And so from that perspective, the dynamics are changing. We're going to supply our customers where we can add the most amount of value. And if that's at the chip level, for instance, in datacom chips, we'll do that. Margins are quite high there. And so I think we're going to continue to drive our operating margins and gross margins as a result of the continued R&D investment and differentiation. And I think that's going to continue to happen in the future. And if that means we're going to do more acquisitions in the future, so be it. I think we're generating a lot of cash right now. Having $1.5 billion in cash is -- feels pretty good going into this kind of environment. But we'll get -- we'll all get through it, and we're going to do something with that cash as...

Okay. As a reminder, investors, if you have any questions, feel free to send it to us. I think there was one on 3D sensing, which we addressed already. Moving on then in terms of kind of top themes here. One of the things that kind of as we have conversations with investors across your different product lines, one thing that stands out is there is a customer concentration discussion for every product or kind of segment that we can talk about. When it comes to telecom, we talk about Huawei as a customer and the risk there. When it comes to industrial lasers, there's kind of a reliance on Amada as a customer. 3D sensing, it goes to Apple. So kind of maybe just help us think about longer term, how you're thinking about customer diversification across these segments? And how much of a priority that is?

Well, it certainly is a priority, and -- but not as a result of lowering our business for those big customers. I think our focus is growing our business, for instance, as I talked about before, on 3D sensing with China and Korean mobile phone manufacturers as well as other applications that can utilize 3D sensing. In telecom, I think there's a consolidating customer base, but also a consolidating supplier base. And so I think I'm not sure there's going to be a lot of network equipment manufacturer startups that are going to get the traction that they with the carriers. But I don't think that's a bad thing. I think a balanced supply base and customer base in the telecom segment is okay. I think on datacom, our customer base has dramatically changed from 1.5 years ago where we had 2 main customers having datacom chips to probably now 10 to 12 that are buying datacom chips. And so I think from that perspective, there's some diversification happening in that area. And then as far as lasers are concerned, while Amada is our key primary fiber laser customer. We certainly have plans to broaden our applications for lasers, including our ultrafast lasers for glass cutting, display cutting and processing of semiconductors. And so I think we're going to see broadening of our laser customer base as well.

Got it. Let me end with a couple of questions. Firstly, one on the manufacturing kind of footprint and your strategy related to manufacturing because your primary -- one of your primary customers is quite vertically integrated. So how do you kind of see the advantages and disadvantages where you are more kind of -- you leverage the contract manufacturers a lot more? And how do you think about longer term where you want to be in terms of mix of kind of in-house manufacturing versus leverage of the contract manufacturers. And then we'll close out with a question on cash flow.

You mean one of our competitors is vertically integrated?

Yes.

Yes. So we're a mix, as you say. We have our own indium phosphide and gallium arsenide fabs. And we rely on 3D sensing, outsourced partners and foundries. That seems to work -- have worked pretty well, given that we haven't had to make a huge investment and we capitalized both on our technology and design with the strengths of our partners and foundries and -- but we've also had to teach them a lot. We've had to introduce new processes that we think are highly proprietary to us. And so I think that balance between in-house and outhouse -- outsourcing, rather, supply chain is a good mix in that area. If you look at our back-end assembly and test operations, we're now about 3 years into our own assembly area in Thailand. That's been a huge success for us from a cost and quality and performance in new products standpoint as we lessened our reliance on China and a contract manufacturer there that we got out of about a year ago. With Oclaro, we acquired both a contract relationship -- contract manufacturing relationship as well as a factory in China. So I think we have a good balance, and it gives us flexibility with respect to where do we put new products, how do we maximize the use of our factories, but at the same time, have flexibility to flex up and down our contract manufacturers. And so from that perspective, I think we've got the best model in the industry.

Got it. Finally, just to close out, given the current environment, which is a bit uncertain when it comes to demand, how are you thinking about kind of challenges to cash flow or in terms of managing working capital in the meantime? And this, you mentioned kind of the $1.5 billion you have on the balance sheet. Appreciate that every company trying to kind of be more focused on liquid in the near term, but side-by-side with M&A, would you kind of think in the long run of having a more kind of consistent buyback or capital return program for investors?

Yes. So let me talk about cash flows. I mean last quarter, we generated $135 million in operating cash flows and about $400 million year-to-date in the first 3 quarters. So I think from a cash flow perspective, I'm pretty happy with where we are. And a lot of that cash out for restructuring is done. So I think we're going to continue to increase our cash flows from operations and add to that cash balance. We have a discussion with our board every time we get together about what do we do with our cash. Should we do buybacks or not buybacks? And I think nothing to announce today, but we're continuing to assess our MA funnel that Chris is responsible for collecting and kind of chiming in on, and as well as what else we should be doing with our cash. Eventually, we have to pay back so that debt. We have 4 and 6 years to go on that. So we're in pretty good shape with our liquidity.

Great. That's kind of the time that we have. But also want to thank you all for attending the conference and making the conference happen. Thank you.

Thanks, Samik.

Thank you.