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

Thanks, everybody, for joining. I'm going to -- I'm Meta Marshall. I laid up the networking coverage here at Morgan Stanley. We're pleased to here -- to have Lumentum here today. We have Alan Lowe, President and CEO; Chris Coldren, SVP of Strategy & Corporate Development; and Jim Fanucchi, who works on the IR team. I'm going to start with a brief disclosure. So for important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your MS Sales representative. So let's jump in with questions.You guys have had a really phenomenal transformation over the past couple of years, moving from high 40s gross margins to -- and 20s operating margins from low 30s and single-digit operating margins pre-Oclaro acquisition. How much of this accretion do you think was just due to acquiring the portfolio to higher margin products? Or what was kind of optimization you were able to do as a result of the Oclaro acquisition?

Yes. I think it was a combination of several things that led up to the margin expansion that we've seen over the last couple of years. As you said, we've divested some of the slower growth product lines and lower-margin product lines, while at the same time, continue to invest in R&D to really differentiate ourselves from our competitors in the high end telecom products, for example, as well as the 3D sensing products. I think the other dynamic is the synergy attainment that we got from the Oclaro acquisition. We far surpassed what we had committed to in the Street, and that helped a tremendous amount. But we've really transformed the business to focusing on the high-growth areas of the market and on the chip business. And the chip business, as you can imagine, is very -- it contributes very much to the growth in our gross and operating margins because we don't buy other products and put it together. We basically sell the semiconductor chip that has very high gross margins. And so I think we're pretty happy where we are. I think we still have room to grow, both in gross and operating margins, and that's why we came out with our new operating model that you talked about earlier. So I think as we get through this pandemic, I see the future being very bright for Lumentum and growth opportunities for us, both in the top line as well as the operating margins and gross margins.

Got it. You touched on 3D sensing. It's clearly an area where investors like to dive in. This has been an ongoing area of growth for you. How have you been able to really keep the leadership position in the market? And how do you see it expanding beyond kind of your core customer over the next couple of years?

Sure. Maybe I can take the first part and then toss it to Chris. I think our focus over the last 4 ramps of 3D sensing. And our 3D sensing history goes back over 10 years with Microsoft and Intel and other customers. And so we have a tremendous amount of learning that we've gone through that our competitors don't. We've shipped nearly 1 billion units, and you don't get that kind of learning by -- in 1 year of production. So our focus is really making sure that we are the design house for future designs for not only our lead customer, but for Android customers across the world as well as automobile and other IoT types of devices. And so far, our customers rely on us as that design expertise resource for them. We also focus on consistency in product, quality of product, reliability of product and ability to do what our customers ask us to do from a delivery and flexibility standpoint. So we're trying to give our customers every reason not to give share to other people, but I think it's natural as we've had such high share for any customer to want to have a second source. We're just trying to minimize that over time. And I think through our execution, we're trying to continue to push really new product, new technology, new development so that we can continue that distancing that we've had in the past from our closest competitor. Chris, you want to take the second part?

Yes. I mean, I think what really drives this business is it's a new end market, new capability, if you will, or kind of market inflections across customer base or across the market. And so obviously, this year is the sort of the first introduction of world facing. And we call it world-facing because that's -- it's where the product ends up landing literally physically in the customers' products. But if you think about it, it's really computational photography that we're playing into. And we think, over time, that's going to be a major driver of Android adoption that today, folks in the Android world do have complex cameras with dual camera, triple camera, color sensors, in some cases, even laser-based distance sensing. So it's much more of an evolutionary standpoint from a customer standpoint to introduce the 3D sensing laser into their computational photography algorithms, if you will. So broadening across the entire Android base, we think will happen more -- with more certainty and more pace than, say, the front-facing applications that -- and in fact, I think in a funny sense, as the world-facing takes off, it will drive certain technologies that are capable of then migrating to the front and will enable front-facing to be a little more practical, i.e., with no notch. The software algorithms will be more mature. And that -- what you do on the back from a camera standpoint, you're naturally going to want to do on the front side. But beyond that, I think what's also a major driver over -- as we look 3 to 5 years out in time, automotive is a tremendous opportunity. I mean, there's going to be some initial opportunities that are a little more modest in terms of in-cabin were used for driver monitoring systems for vehicles that have some level of autonomy or control, then you need to understand is the driver looking in the right place. And should the car takeover or let the driver do what they're supposed to be doing or are they falling asleep. But -- and we talked about on our call having an auto qualified product, and that will go into this emerging opportunity and Europe has issued requirements that starting in calendar '22, driver monitoring systems be installed in new models. So pretty exciting, but more exciting is the outside cabin, LIDAR, collision avoid and safety systems because there, you're starting to talk about tens of dollars of content at the lowest level, laser chip level where we're supplying. And our strategy is to supply very broadly into any LIDAR solution that folks are investigating or trying out because there's not many people that can make the lasers we can make. There's a fair number of folks making LIDAR modules of different flavors. So our strategy is to make sure that our technologies see the light of day regardless of what LIDAR technology ultimately wins, but with tens of dollars of content, 100 million vehicles made per year, it can become a pretty substantial market. Now unlike the mobile or smartphone space, if you go back and look at things like airbags and automobiles, it's a 10-year kind of journey to get to full market penetration. But like airbags, you need to be engaged today and planting those seeds because it's a very sticky business. Once you're in, you're in, but you can't show up a few years late and then expect to do very well. You got to be in on the early days. And then more broadly, after automobiles, we're also seeing a lot of other applications around security and access control, industrial applications and the world's experience with COVID it's actually -- it's an unfortunate situation, but it is driving people to want to have more contactless, touchless control. And for example, in a facility, getting rid of badge readers and having facial recognition for employee access to a facility. And there's a lot of security cameras out there in the world that can benefit from that. And then finally, I think over a longer term, a very broad category, which is literally overused, but IoT devices. I mean you can imagine smart homes and smart infrastructure that needs to sense presence of objects, people interact. And obviously, there's hundreds of millions or billions of devices, appliances, consumer devices made that can benefit from that. I think the cost points have to come down quite a bit for that to penetrate. But ultimately, this is a brand-new category, and I think there's a lot of legs for 3D sensing over the long run.

That's helpful. I mean, just in terms of -- maybe if you just wanted to touch on kind of this cycle versus previous cycles, just in terms of kind of timing of major phone releases and how that impacts kind of the seasonality that you've traditionally seen on that 3D sensing business?

I can take a cut at that. I think we have proven to our lead customer that we will deliver what they need when they need it. And I think so in the past, whereas there might have been some ordering in anticipation of not knowing what the future output would be from a sell-through standpoint, we also have buffer stock in place that over the last 3 years has been drawn down many times as a result of our competitor not coming through and getting the share that they had expected from them. So I think from that perspective, we are focused on really making sure that when they need it, they'll get it, and there's no reason for them to overorder because we've been delivering exactly what they need when they need it. And I'd say that given the later introduction of the device or of the handsets, our expectations is that it will go further into the new calendar year than it has in the past. But that's just speculation on our part, anything can change. So -- but we're pretty positive with how we've been delivering on a completely new set of chips. And I think we're meeting our customers' expectation, if not exceeding it.

Got it. Maybe moving on to ROADMS. This has been another area where you guys have kind of been technically dominant, gaining outsized share. Just how do you think about the growth in this market kind of with or without China, which we can dive into later, how you see that developing over the next couple of years.

Yes. I'd say that we do have a leadership position on ROADMs and the high port count and the NxN ROADMs that we call the very high end ROADM, and we've been shipping those units to field deployments, mostly in China, but also to lab and field trials in the rest of the world. I'd say that COVID delayed the rollout of those new devices and those new higher speed networks, but the demand for those higher bandwidths is not reducing. In fact, I would say it's accelerating. And so I think what we're seeing is continued legs in the older technology in the 100 and 200 gig products and the mainstream ROADMs of a year or 2 ago, but pent-up demand for 400, 600, 800 gig and that very high end ROADMs that when people are able to travel to new countries and make these new deployments and new network build-outs, I think we're going to see an uptick in demand of those new devices. And it's one of those things that it's very, very different than the change from 40 gig to 100 gig. There were 10 people making 100 gig and 5 people making ROADMS, now it's 1 or 2 people making 400, 600 and 800 gig components and 1 person making the very high end ROADMS. And so I think we're in a better position. I think we got to get through the ability for the network equipment manufacturers to travel and deploy and install these networks. And then I think we're going to be off to the races again. Chris, do you have anything to add there, Chris?

No, I think you hit it spot on. Other than adding, obviously, the positive news that you hear about on the public health front with multiple very good sounding vaccines and the time line, hopefully, knock on wood, no issues. But I think that also puts a time line that says we are slowly ramping some of the new stuff now, but it should accelerate through '21, whereas a couple of months ago, there's always a risk of what if these don't turn out so hot, we could be another 1 or 2 years. So I think a very positive development for us in that regard.

Got it. I mean, speaking of China, sorry about that. With ongoing Huawei restrictions, there's been challenges to this business. Do you think an administration change, Huawei goes back to being a larger customer? Or is the search for alternative supply chains underway?

I don't know the politics of the U.S. and don't know what's going to happen in the future. I think our focus has really been on ensuring that we provide the best products and technology so that when networks get deployed, and whether they go through Huawei or go through other Chinese customers of ours or frankly, go through the western customers of ours, where we have a higher share of wallet. And if those get deployed in Europe, for instance, whereas Huawei may have been the incumbent, I think that's a positive for us. And so from that perspective, it almost doesn't matter what happens with the trade escalation or de-escalation. In the long term, I think, clearly, there's some headwinds with -- when you have a customer that was a year ago, a 15% customer. And we're very clear on our guidance that in calendar '21, we expect it to be less than a 5% customer. But once we get through that and networks start getting deployed in a meaningful way and people make decisions to change from one network equipment manufacturer to another, that then turns into a very strong positive for us.

Got it. So I mean, in terms of you guys have spoken to kind of being designed into how China architectures are going to be going forward. And so is it a matter of kind of building relationships with all of the OEMs out of China? Or just how do you kind of see working around being a part of the design, but maybe not having some of the flexibility right now to ship?

Well, I mean, one of the things that came along with the Oclaro acquisition was a strong relationship with ZTE, for instance. So we've moved that from a transmission focus to a transmission and transport. So we're now working with them on our ROADMs and are deploying lots and lots of ROADMs through ZTE and for that matter, fiber home. And so I think our focus is really be that enabler to every customer and whoever wins the networks will be using our products. So I think that's kind of our focus today and continue to do our R&D investment. We're growing our R&D investment in this environment and really focused on continuing that differentiation and being indispensable to our customers.

Got it. So you talked about kind of margin accretive opportunities that came along with Oclaro. Datacom chips has clearly been one of those, transceivers had been a business that you kind of exited, not seeing the opportunity there, but datacom chips has been a long -- or has been a much better opportunity for you guys. Is the growth that you're seeing now because we're early in a cycle? Or does -- how do you keep that competitive lead? And how big of an opportunity do you think that datacom chip opportunity can be?

Yes. I'd say one of the things that we probably underestimated was how good of a business it really is and that when we divested the transceiver business, and we're no longer competitors to the rest of the world of transceiver customers, they wanted to buy from us. And so you couple that with clearly having the leading-edge products at 400 gig, for instance, on our EMLs, leading edge VCSELS, leading edge DMLs, that business boomed faster than we had expected. And so from that perspective, we've been adding capacity, and it takes a little while to fab capacity. But as I said in one of our earnings calls, either the last one or the one before, we expect to double our wafer output in datacom over the next 18 months, and that was probably 6 months ago. So a year from now, one could imagine having wafer capacity that was -- is twice of what it was 6 months ago. And I think we -- continuing to have that leading edge product and technology will drive the demand. We have a backlog of demand today that is several quarters long. Putting aside some of the slowdown we've seen, frankly, in the 5G deployments in China. But our demand -- now we're shifting our volume capacity to the hyperscalers on 100, 200 and 400 gig products because we've seen very strong demand in that. But we're so early in the deployment of 5G worldwide that I think that there's a long tail and a long way to go in both the hyperscale data center build-outs as well as the 5G data -- the 5G build-outs. And what that does for the rest of our business is putting data requirements at both ends of the network really is going to drive further expansion of the bandwidth at the core of the network. So I think that's another tailwind that the datacom chip business gives us across the board.

Got it. The industrial lasers part of your business has seen some struggles, most notably because manufacturing is kind of seen some COVID-related contraction this year. Is it simply a matter of industrial production coming back? Or just how do you expand that business above kind of a market rate?

Well, we look at our industrial laser business in 2 separate markets, one of which is the high end cutting and welding of materials, and that's mainly focused on our primary customer today, Amada. And that business is going to go as the industrial production goes. While they're gaining share and such, they're not exposed very much to China. So we haven't seen that pick up that China has been experiencing, they're strong in the rest of the world. So we're expecting that '21 will be an uptick in that part of our business. And we're already seeing a pickup in our micro-machining. So the lasers that go into tools that singulate or ascribe semiconductors or manufacture printed circuit boards or flexible circuits, as consumer electronics grow. And so I think from that perspective, we are at a low point today. And we're continuing to invest in R&D to expand that product portfolio and expand our customer reach in our commercial lasers business. So I think '21 is going to be a great year for lasers as we see the pickup in industrial production.

And so maybe turning to, I think, as a lot of people think to the next gen, the data center silicon photonics has become much more of a topic on investors' minds in an investment area of networking and optical systems vendors. So where do you see this as an opportunity for you guys to participate and potentially a threat?

I'll take that one, Meta. So I think it's broad. I mean silicon photonics plays into data center, plays into telecom more broadly, if you will. We're not a materials company, we're a device component subsystem company. We're focused on delivering whatever will enable our customers to win in the market and solve their problems and today that's by making indium phosphide-based solutions or in the case of some shorter reach, gallium arsenide-based solutions, they clearly deliver the best performance at the lower speeds, and it's the only thing enabling 800 gig in, say, telecom today. And we continue to see indium phosphide really offering superior performance for the foreseeable future in the telecom side, that's why we got out of lithium niobate. It was an alternative approach. We haven't really launched silicon photonics products, if you will, ourselves. But with that said, we're not religious if silicon or another material comes along that enables us to make higher performance devices, we will use it. And within the data center, I think what you might be referencing is there is over a longer time frame, some of the switch and compute folks that make silicon are trying to move the optics maybe perhaps closer to their switcher compute chipsets. And if that's done in silicon, is that an opportunity or a challenge for us. And frankly, it's probably an opportunity in that all of those silicon photonic devices need laser light and given the nature of silicon photonics need a lot of high-power laser light. And so for us, that's another key capability we have is high-power lasers. And so we should be able to -- what's really getting cannibalized there is electronics that were used to drive electrical traces on a printed circuit board now being replaced by optics in a sense. So it's really an opportunity, not a cannibalization of our existing business per se.

Got it. I want to circle back to 3D sensing real quick just before we kind of wrap up. And you guys have chosen to kind of outsource some of that production capability. And just as that business ramps over time, is that ever something that you would think of kind of bringing in-house or bringing kind of a baseline level of production in-house?

Yes. I mean, I think our perspective is the most efficient supply chain with the best cost and infrastructure to be able to have flexibility that our customers demand. In the case of 3D sensing to data, as you say, the foundry partner model is absolutely the right one to use. In the future, might it be different? Maybe. I mean, I think as we look at things that Chris talked about on 3D sensing for longer wavelengths that might be a different material set, so there might be a hybrid model. But it may be -- it kind of depends on what the market demand looks like for a given technology or product and how best to satisfy that through either internal manufacturing, which we have or a hybrid model or complete outsource. And so we're going to continue to evaluate the different supply chains and whether that's internally or externally, we're going to pick the best one, not because we have a bias towards one or the other.

Got it. And then maybe just last question. You guys have paid down a lot of the kind of Oclaro leverage at this point, you have some pretty meaningful balance sheet flexibility. Just how do you think about kind of ongoing M&A, particularly with a far more kind of consolidated industry than it was, call it, 3, 4 years ago?

Well, I mean, Chris is in charge of that. So I'll give you my perspective and then let Chris chime in. I think it's nice to be generating the kind of cash that we are. And you're right, we paid off our term debt a year ago. And so we're in a pretty good position with regard to our balance sheet. I think there are additional acquisitions to be had in the industry, whether we're a part of that or beneficiary as a result of others doing it. We'll see. It's an active thing we talk about all the time. And when the time is right, we'll take action. But you're right, it does give us some flexibility, and it allows us to move quickly, given our cash balance today.

Yes. I think the only thing I would add is we're very careful. M&A is something that you do where even a modest-sized deal it consumes a lot of company resources for a long time. And so we really want to make sure we find the right target between the technology they have, the market exposure and synergies. And once you find that, you have to have a willing seller and asks you at the right price, and that tends to be kind of a stars aligning type situation, so it takes time. But certainly, it's not an overnight process, but we're confident over the coming years that we will create a lot of shareholder value with our M&A strategy.

Got it. Well, with that, I know you guys are right up against time. Appreciate you guys speaking with us today. Alan, Chris, Jim. Thanks for participating and talk to you guys soon.

Great. Thank you. Have a good day.

Thank you very much.