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

This is Alex Henderson, Needham, the networking, security and optical analyst. It's a pleasure to have Lumentum here today, and we've got Chris Coldren; and Jim the -- everybody's favorite IR, Jim Fanucchi. And we're going to do a fireside chat discussion of the fundamentals here. [Operator Instructions] So thanks for joining us, Chris. Jim. Nice to see you.

Yes, thank for hosting us, Alex. Thank you.

Pleasure. I hope we've kept you busy all morning.

Yes.

I'm sure that's the case. So why don't we start off with just a recap of what you reported in the most recent quarter for anybody who hadn't kept up on it, so that we can level set everybody.

Yes. I mean, I think probably the most notable news of our print or our earnings call was certainly that we've been able to achieve, for the first time, over 50% gross margin, achieving 52% gross margin in the September quarter and nearly 34% operating margin. And really a lot of things coming together positively in the quarter. The benefit of all of the acquisition synergies that we've been attaining over the past 1.5 years, almost 2 years now since we closed the Oclaro acquisition as well as an improvement in our product mix, where really the legacy products that we decided to get out of somewhat contemporaneous related, but not entirely to the Oclaro acquisition. It's basically gotten down to $1 million or less in the quarter, and they were a real drag on margins. And so really cleaned up the business, and that shut sort of shined through as well as, obviously, it's a seasonally strong quarter for our 3D sensing business and that helped both with the top and bottom lines as well.

Yes. So just to punctuate that point. You actually gave an update of your long-term business model outlook guidance. Can you just remind people of what that guidance was?

Yes. So -- and maybe unwinding a little bit, we had previously provided a target model when we announced the Oclaro acquisition, just to give a flavor to investors of what we thought was possible in a consolidating industry and 2 companies getting together that share a lot of similar structural costs. And finally, this past September quarter, if we look backwards for 12 months, for the full year, we exceeded that target model. So we felt it was appropriate, especially, as I said, it was kind of cleaning up the product portfolio and getting into the later innings of the synergy that we should increase our target model to be consistent with where -- kind of where we are and where we're going to be. And so we increased the gross margin target to 50% or to 50% or above, if you will, and the operating margin targets to 30% and above on an annual basis. So obviously, we exceeded that last quarter, and our guidance implies that we would exceed it again in the December quarter, but those are 2 of the stronger quarters from a product seasonality, if you will, standpoint. But targeting -- and we made the further comment that for the full year, we probably wouldn't get to exceeding that new target model for the full year, probably get close. And -- but then as we look off into the next fiscal year, there's a lot more opportunity to get to exceeding that target model potentially in that time frame.

Yes. I think it's really interesting. We're in a world that's in the middle of recession. We're in a world where one of your largest customers, Huawei is basically been targeted and is biting the bullet here. Yet, the valuation on your company hasn't really changed from the time when you used to -- when this industry was highly competitive fractured industry. And here you are throwing off unbelievably high margins in the trough of the economic cycle and the trough of a business cycle. It's really hard to understand why the valuation hasn't significantly moved up given those parameters. It really is a rather impressive performance to be able to deliver those type of margins in this environment. So I wanted to go into a couple of other pieces of the puzzle to start to break down the individual product areas. So probably the most pressing question is what do you make of the 3D sensing market opportunity? What are you seeing about the forward year in terms of your opportunity to grow in world view and the high-end segment of the marketplace versus the increased competition implied by somebody like II-VI coming in, potentially taking some share from a business that you pretty much -- had the business cornered in, which obviously has to happen at some point. So is this still a category with 10%, 15%, 20% growth to it for you or alternatively does share loss offset that? And what are you thinking about in terms of pricing?

Yes. So I think what's important to think about 3D sensing this year, I think you hit on some of the key points that really, as this was introduced, 3 -- I guess, 4 years ago, for the first 3 product cycles with our customer, it was really selling largely the same chips, if you will, same products with some minor changes year-over-year. So really, the growth story was about penetrating into -- broader into our customers' product base as they proliferated from initially only on one high-end model to now being on the majority of the models and perhaps eventually over time on every model that they make. But this year, really a -- initiating a step-up in content, and that -- the most obvious is the addition of 3D sensing or what you're calling a LIDAR sensor, if you will, to the backside of smartphones, if you will, have one in my hand here. And that incremental content is -- enables the market to expand quite significantly year-over-year as well as a refresh, if you will, of the front-facing chips, same basic functionality that has been used in years prior, but some new enhanced performance, et cetera, with some increased selling price associated with that. So we expect that the total opportunity within the customer to materially expand year-over-year if you assume units are about the same. I'm -- it's not my place to sort of position of our units. I expect -- frankly, units probably could be better given what's going on in the world and the loss of a Chinese vendor competitiveness in the smartphone space due to their tangling with the U.S. government. But regardless, even on a normalized unit basis, the market opportunity should expand given the expanded content. From a competitive position, certainly, we hear noise in the market and sort of commentary. I think what we're focused on is delivering the best products and best delivery and best quality to our customer. And if we look back to the September quarter, we did $160 million of 3D sensing. And I think our competition probably did 25% of that, something like that. So you do the math. We're still maintaining a pretty healthy share position. And I expect over time, as you said, our customers want second sources and security of supply and all those kinds of things, and we fully expect that. But I think we've been able to make it very difficult for our competitors to keep up with us, and we tend to do very well and win the lion's share of the business. Especially on -- when there's new chips and new products that are harder to make, and we tend to do very well on those products.

So one of the other areas the people are monitoring is the potential to get into the Android market, which has not been tapped. The presumption at this point is that a product cycle coming in the spring probably does not see real adoption because the bias seems to be towards, what I would describe, as keep the price down because nobody can afford to buy anything, kind of the mindset globally. Is that the right way to think about it in 2021?

I think that's possibly -- I would agree with the logic. Our customers don't all share their product launch plans, et cetera. But that's the feeling we get. We've seen a -- certainly concern given the macro economy and who their target customer base maybe being a little more price sensitive than our lead customers -- customer base. But perhaps what's more important is, okay, fine, we'll see. But over a longer time period, we've seen a very strong designing activity going on in the Android space. And really, I think what the shift has happened is away from or less focus on the front-facing biometric side of things for the time being, I think that will eventually come back into focus. But the world facing, which is the killer app is pretty straightforward, photography. There's lots of other killer apps on the time -- longer horizon around augmented and virtual reality and gaming and other entertainment, but just simply photography to enhance imaging and whether that's for low light photography, faster auto focus, introducing bokeh or other computational effects that are difficult to achieve with tiny little cameras on the back side of a handset. And I think a lot of the Android customers were sort of lying in wait, watching to see what our lead customer did, and they launched it first on tablets, but not necessarily with the photography focus, but now it appears that the models with world facing seem to be -- you believe media reports and analyst reports selling very well. And that's driven a lot of effort -- or sorry, have driven a lot of increased effort on the Android engineering side to say, let's get this stuff in, and it's in a different set of customer, a different team within the customers, frankly. The camera teams who are already dealing with dual and triple cameras and color sensors and other sensors, fusing that together in computational algorithms bringing in a 3D sensor while is a leap, it's not that big a leap compared to replacing the thumbprint reader in the front of the phone for biometrics. So we're optimistic that as we go into the second half of calendar '21 into calendar '22 that we're going to see across a wide swath of Android phone manufacturers, this capability proliferate.

So given what you just described, it doesn't sound like you're saying that 3D won't be in Android in the spring. It sounds like maybe there could be some.

Maybe. I just -- again, our customers don't share with us their product plans or launch plans. But I share your concern around the economics and what the focus of those customers will be, at least in the next set of products. But as you go to the products beyond that, I feel a lot more confident.

So maybe in the back half of the year, there -- an off-cycle introduction or something of that sort if the economy starts to pick up.

Well -- and remember, we tend to supply in advance a little bit of their product launches as well.

Okay. Let's shift off of 3D to the rest of the company. One question that I've been getting from people is we've seen a lot of people, for instance, NeoPhotonics, as an example, who had the most exposure to Huawei, basically say I can't ship them anything and completely remove it for their numbers. Yet you guys said that you might have some continuing sales to them. Can you talk a little bit about why you're able to do that and what the magnitude of that looks like? And what kind of products is it that they can still use as opposed to being in a position where they can't really...

Yes. Well, I mean, our -- I would say, at the outset, our first and foremost, an unequivocal priority is to abide by the regulations and rules that are set out there and not even push the edge of the envelope, but to be cleanly following the rules. With that said, we also want to focus on serving our customers as best we can, right, within those constraints. And the nature of the rules, in general, are prohibiting the sale of U.S. technologies, if you will, to Huawei. And in our case, with our sort of global footprint, we have teams around the world that -- and it's not in a last-minute effort of moving technology offshore or to other locations. We have large operations in Japan, Canada, United Kingdom, Italy, that have, for decades, developed products and have their own technologies in those countries. And so if we're able to both develop and manufacture and supply products that are not containing U.S. technologies, then those might be products that could continue on to be sold. Vice versa, we have highlighted that Huawei's been a greater than 10% customer for quite a while, and they now are down in the 10% or below range, and we expect them to decline every quarter and get below 5% in the March time frame as both our ability to supply. And perhaps, to a certain extent, their demand wanes over time, and we get down to -- and we didn't say it's 5%. We said below 5%, that could be 0% because for whatever reason, demand could be 0% or not able to supply. But based on at least the limitation of what we believe we can supply, it would be in that 0% to 5% of sales range.

Now one the subtleties on this is that I think you've had some hesitation to take capacity that had been earmarked for Huawei that was around designs that were specifically developed for that customer and take those lines off and reconfigure them to something that would support another customer with that same capacity. And so the hesitancy to move that capacity has limited some of the availability to some other customers that might be constrained still. Can you talk about that aspect of it? Because I think it's a little subtle, but it is something that I think you justifiably want to make sure that before you move something off that you're not suddenly whipsawed and bring it back up again and...

Yes. Well, and I mean, it -- the other point that folks have to understand here is China is a significant geography from a market opportunity standpoint. And Huawei is a big supplier into that market, and it's not clear that they're totally out of business forever. Secondly, there are other Chinese customers that supply into the Chinese market, and we don't want to put ourselves in a position of sort of alienated and end up being a -- unable to supply or customers in China not wanting to have us supply to them, which is a delicate balancing act. But to your point about manufacturing capacity, it's very product specific. So for example, the highest end ROADMs, Huawei was the lead customer on that product as they kind of wanted the leapfrog the technology for domestic China deployments. Those same technologies, though, NxN or very high port count ROADMs are being adopted by virtually every other network equipment manufacturer just a little later because it's really tied to these next product cycles that people don't think in ROADMs, they tend to think more in 400, 600 and 800 gig speeds. But at the same time, those next-generation customer platforms also have new ROADMs, and we will need that manufacturing capacity for those customers. I think Alan alluded to a little bit on the call that you -- there's a couple of time constants associated with things here, right? There's both pent-up demand in customers. There's also do -- our other customers pick up share from Huawei over time. And in that case, if you're -- if we have a customer who's designed in right side-by-side with Huawei, they might be able to, more quickly, pick up share, whereas if there's other instances where they're having to be designed in from scratch, that's probably measured in multiple quarters or a year kind of time frame, not somewhat instantaneous. So what that -- and then we -- not every customer buys the exact same products as we were supplying to Huawei, so there's a time lag in sort of re-jiggering the supply chain and the production. So I think what that leaves is not that we provided explicit guidance beyond the December quarter. But as Alan talked about on the call, that as we go into the March quarter, kind of this crossover quarter, right, where we're trying to reconfigure for our other customers and ramp up the other customers' next-gen systems as Huawei is ramping down on those similar products. And I think the net-net of that is potentially a negative just given that switching gears does remove some of the efficacy of that capacity. But then as we come out into the remainder of the year, I think we better utilize the capacity over time. And I think something that, little surprised, I haven't heard as much about. But if you hear some of our customers have made some public commentary that's akin to basically saying, look, there's not a lack of demand for product out there. There's a lack of ability to get that product into the geographies where that demand, ultimately, is due to COVID-19 and health issues and inability to travel, et cetera. And I think that's very real, and I think it would become more real and more concerning as time goes on. But I think with a lot of the progress that we've heard about literally in the past week or 2 around vaccines and vaccine efficacy and availability, I think the world has, not to diminish the probably pretty rough couple of months, but beyond those couple of months, I think there's a lot more confidence of the second half of calendar '21 and into calendar '22 of these 400, 600 and 800 gig or next-generation systems that we've been geared up for and gearing up for starting late last calendar year, finally, actually taking off in a much more material way. I feel pretty good about that compared to how I felt even a couple of weeks ago, right, when you look out that far in time.

I'm ready to roll my sleeve up and get a vaccine on it. I hope to shift gears a little bit and talk about the capacity additions that you did in the ROADM high-end, NxN high capacity segment versus the mix of lower end stuff that you continue to produce. Can you talk about how much capacity you just brought on? And how you see that ramping? And when do you expect the next slug of capacity to be needed?