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

Well, folks, thank you for joining us here at the Raymond James Technology Conference held virtually in the cloud instead of New York, thanks to the pandemic. This is Simon Leopold, data infrastructure analyst with Raymond James. I'm pleased to introduce our next fireside chat. We've got the team from Lumentum, CEO, Alan Lowe; Chris Coldren, who does strategy; and Jim Fanucchi, who helps out with the Investor Relations side.

So format today will be a fireside chat, Q&A. Alan and Jim, you're muted at the moment, just heads up on that. But the way I want to sort of start out these sessions is ask you, how do you like to introduce Lumentum to new investors?

Sure. I'll take a cut at it, and Chris can chime in as well. Lumentum started a little over 5 years ago, spun out of a company called JDS Uniphase and, since then, has been able to focus on our customers, our industry, our markets and make decisions based on what was best for our stakeholders. And that has allowed us to really grow each and every one of the 5 years, both our top line revenue as well as our gross and operating margins every single year, and we expect to continue that. We really focus on key markets in Optical Communications, commercial lasers and consumer industrial and really strive to be innovative to the point where we are indispensable to our customers. So the bulk of our business is in the Optical Communication, which breaks out of datacom and telecom. And we've really transformed our business since 2 years ago when we had a transformative acquisition of Oclaro. And that allowed us to gain scale, but also at the same time, look at our product portfolio and eliminate some of the products -- product lines that were less accretive to our margins. And that's transformed our business to now, in our most recent quarter, having over 50% gross margins and over 30% operating margins.

So we think about transitioning into calendar '21 as well as the longer term, what are you most optimistic about? What are your sort of most exciting opportunities?

Well, I think each of the industries in which we participate have a positive outlook from my perspective. If you look at what's driving in our telecom business, the 5G deployment is in the very, very early stages. And you've got 400 gig, 600 gig, 800 gig transmission speeds that have, frankly, been postponed from being deployed in '20 to being deployed in '21. So I think from a telecom perspective, the future is really bright for us. Datacom, we've gotten rid of our transceiver business and have focused primarily -- or 100% on our datacom chip business, and that's grown very rapidly. It's now over $200 million and has semiconductor type gross margins. And so that's going to continue to grow from -- fueled from both the 5G deployments that I said is -- are in the early stages, but also the cloud and hyperscale data centers that are growing rapidly to handle things like what we have going on here today. So our datacom business is quite strong. And then if you look at our industrial and consumer businesses, our 3D sensing business, we've been in it for many, many years. It's quite strong. And we think that the content per device is going to grow as well as the market opportunity outside of mobile phones, where we've been investing in things like touchless kiosks for payment as well as automobile industry for in-cabin as well as LIDAR. So the future is bright for us there. And then our commercial lasers business, which is primarily tied to GDP growth, has, I think, last quarter, really hit an all-time low, at least a recent years' low. And so that, from my perspective, is going to recover as we get through the pandemic.

And so sort of in a similar vein, what do you see as the biggest hurdles or obstacles that you need to overcome in the next year?

Yes. Maybe one of the things that's maybe not well understood is that the U.S.-China trade tension is both an issue in the short term, but also in the longer term, is a tailwind for us because if you look at our markets that we participate in, and mostly in the telecom and datacom space, we have a higher share of wallet of our customers in the western globe compared to the Chinese. And so if you look at Huawei, Huawei was less than a 10% customer of ours, and we guided it to go down to below 5% in 2021. Now as that -- as new networks get deployed and service providers make decisions to move from a Huawei built network to a western network, that's actually a tailwind for us. So while in the short term, we've seen our business with Huawei decline, I think on the longer term, it's a positive for us. I don't know, Chris, do you have anything to add on?

I think you hit it spot on. I mean, certainly, you highlighted, and we highlighted on our prior call that the commercial lasers business probably has some slowness, if you will, to recover to get back to prior levels. But certainly, we feel optimistic that we've made the right investments in the right products, and it will recover, it will just take a few quarters, if you will.

So I want to pivot to the question around competition. Typically, when you're #1 in a segment, you've got nothing to do but lose market share, particularly when you start out with 100%. So if we think about 2 of the markets where you recognize to have a lead, how do you see this playing out in terms of competitive share loss, market share loss? I perceive this as one of the biggest bear arguments around the story. Why don't we start out with the ROADM market and then we'll discuss 3D? So on ROADMs, how do you see your positioning and the potential for share loss?

Well, I think we've shown over the last several years that the innovation engine in our company has really distanced ourself by not just 1 year, but multiple years and are very high end ROADMs, and we're not sitting still. So I think from that perspective, it's very difficult to intermix ROADM technologies. And so I think when network providers or network equipment manufacturers decide on basing their next-generation networks, which they have, on Lumentum ROADMs, they're -- it's very difficult for them to change. And so that's number one. And then number two, we're continuing to invest in higher port count, very low port count, very disruptive edge ROADMs. And so I think from that perspective, we have such a big scale. Our ability to invest in next-generation ROADMs is going to continue, and we're going to continue to be differentiated.

And so maybe let's pivot to the 3D sensing. So you've got a very strong position. I think many of us envision other marketplaces developing, whether it's Android or even Automotive. So you had a lead, how do you maintain that positioning and how do you perceive the competitive landscape evolving in 3D sensing?

Yes. I mean we've been in the 3D sensing business for, I don't know, 12 years now since the Microsoft Xbox Kinect. And I think the learning that we have gotten over the 12 years is that the cycles of learning is critically important, and scale is critically important. And so I'd say that we've chosen our manufacturing strategy around what's best for our customer and the market opportunity. And if you look back in time, we had internally manufactured 3D sensing diodes for several generations of gaming as well as computer stuff, and then we moved to an outsourced strategy. So I think from that perspective, we choose the best method that meets the needs for the customers and the market. But I'd say that we're continuing to innovate. And we are -- we believe our customers use us as their R&D house for next-generation and next next-generation of technology. So from that perspective, we're going to continue to drive the technology and push it to make it very difficult for our competitors to catch up.

Now are there other product categories where you believe you have a 1 or more years lead over competition?

Chris, do you want to take that?

Yes. I mean, it's certainly -- I think a couple of things. First, we already covered the 3D sensing, which segues into areas like LIDAR and security and access control. And I think we'll continue to push the envelope, and that's really the value of being a leader is these are expanding markets where every generation customers want something new, better. And therefore, it's a lot better to have a strategy being the leader than always being the second source, if you will. But outside of what we've talked about, I certainly think the datacom chip market is something that is very exciting for us that not only have we exited the transceiver business, which kind of liberated our relationships, if you will, with folks that would be buying chips. They don't fear that we're going to be their competitor down the road. But on top of that, as speeds go from 100 gig to 200 gig to 400 gig, eventually to 800 gig, our technology is very differentiated. We're the first out with very high-performance 400-gig products and gaining market share within our customers and enabling our customers to gain market share. So I think datacom chips is another area where we're well ahead of the competition.

Great. That's good insight. I wanted to maybe touch on another one of the bear arguments. And the first one I want to touch on may not seem too bearish. I've got a particular company that just reported a 52% gross margin and a 34% operating margin. What business do you think they're in? Nobody would have said optical components 6 months or 2 years ago, and yet those were your results. So some of the pushback we hear is, well, these are peak margins, how could this be sustainable? Isn't this a business that should be a mid-30s gross margin and in good times a teens operating margin? I would just sort of ask you to reflect on how did we get here, what's sustainable, and where are we going?

Yes. I think, as I said earlier, in each of the 5 years that we've been an independent public company, we've grown top line as well as gross margin and operating margin. I think we're going to focus on continuing to do that. And our ability to remove some of the drag on margin like our lithium niobate modulators and like our transceiver business to focus on where the core fundamental technology comes from, which is -- in most everything we do, it comes from the basic chip technology. And so we've moved a lot of our business to the chip technology, where the margins are significantly higher. And as those markets grow, and Chris talked about datacom chips, that's going to continue to grow. 3D sensing is going to continue to grow. Industrial Diode lasers is going to continue to grow. That part of our business is going to have above corporate gross margin averages. And so that's going to drive further improvement in gross margin. Now I think the other thing to be conscious of is that there is some seasonality in our 3D sensing business. And so the September and December quarter are historically high 3D sensing, and that drives our gross and operating margins higher. But I think as we get more business in automobile or Android or touchless security, I think that smooths that seasonality out. And I think we'll be able to maintain and grow our operating and gross margins. And in fact, we came out with our new model of being able to do north of 50% gross margin and north of 30% operating margin starting in a consistent manner in fiscal '22. So I think that's what we're focused on, and we're going to continue to drive indispensability, which provides value to our customers, and they're willing to pay that -- for that value.

And Simon, one thing I'd add to what Alan said is, and per your question, this is the first time in decades where the industry structure has been relatively healthy, where the sort of hyper competition that we had of the prior decades with a dozen folks chasing a design slot has tempered. It doesn't mean that there's not healthy competition today, but I think that, that craziness that we've seen in the past, at the same time, optics are becoming even more critical to customer solutions that the only way you can achieve the network bandwidth is as it really just boils down to that sort of analog optical device, if you will. It's not software. It's not -- it's, in some cases, electronics, but it's not -- optics don't follow a Moore's law kind of logic and have the costs come down dramatically or cost per given performance every year. So that's why I think we're in a terrific spot where we're actually at the inflection of where the optical market takes off. And the value of optics are really realized for folks that supply that underlying intellectual property like us.

Maybe -- Chris, maybe you could -- because I think it's important to understand that the telecom market is not in a boom right now. It's actually in a lull. And maybe, Chris, you can comment on that as well.

Yes. I mean I think between what we saw happen in late calendar '19, which was in a sense, it was an Osborne effect, meaning that as 400, 600 and 800 gig started to become more real and customers were getting ready to start ramping it, we saw a slowdown in our prior generation technology, particularly around our ROADMs because they're the products that go in first, and you wouldn't deploy a heck of a lot of the ROADMs late in the 100-gig, 200-gig product cycle. Then COVID hit and impacted supply and demand. So I think we're well set up now for a new product generation to take off and whether that's 400, 600 and 800 gig on the transmission side or the new high-end ROADMs, and it's the first time, I would say, where a true product cycle, if you will, has been launched underneath a more consolidated, rational industry structure, whereas if you go back in the 2015 and earlier when 100 gig, 200 gig was first introduced, I remember the number of conversations of, "Oh, my God, are you getting ROADMs into Verizon and who's got share," and all of that kind of drama, right, with the number of people that we're competing with at that point in time. So things have changed quite a bit. And I think that adds to both the sustainability of the margins through the product cycle in addition to what the average is.

And what's your thought on your strategy for dealing with the prospect of market share loss? So if you are encountering a competitor trying to take share, do you respond with price cuts or is it your intention to try to shift to the next battle and leap ahead with products?

Go ahead, Alan.

Well, I was going to say, I think to Chris' point, this is no longer a market where there's 5 competitors, right? And so I think there's rational thinking, hopefully, at our competitors' level that doesn't necessarily create a pricing war when there is 1 competitor for a given slot. And then some -- in a lot of cases, there's no competitor. And so our strategy has just become indispensable, and that's -- whether that's in the next-generation of products or in the quality, reliability and dependability that we can provide to our customers, such that they don't want to shift share. And we've been talking about losing share on 3D sensing for 4 years now, and it hasn't come. And so we still have a very large share of the 3D sensing business and expect that, even as the pie grows, to continue to have a very high share of that business.

And I was going to add that, I think, Simon, another dynamic is when you are indispensable to your customers and are early in and give them a capability that they view it as knocking out of the park that enables them to win, they come to you and say, "Hey, I need to supply this for the next 5 years into this network build, can you work with me?" And then literally from almost a contractual arrangement standpoint, assure that you'll have the ability to -- that we will put in certain capacity and they agree to certain share and price well in advance of the full product life cycle. So I think the key point here is we're not prone to quarterly auctioning off -- our customers auction off their slots every quarter the way they used to or every 6 months or even every year in many cases. And so that also leads to a lot more stability. Now vice versa, it -- I think it also leads to a more healthy relationship with our customers because then most of our engagement is really about what's next. And again, that leadership position of coming in and really focusing their engineering teams on building the next latest and greatest product enables them to win as opposed to focusing on qualifying third, fourth and fifth supplier.

So the other bear argument, it's really more of a bear argument affecting your OEM customers. But it's essentially the threat posed by the adoption of technologies like VR pluggables or white box optical platforms or even open ROADM. I imagine as an arms merchant, you might be a little bit insulated, but how do you think about those particular trends that affect your OEM customers?

Well, I would say, I think, first, your point of us being a little more insulated by being at the technology level, selling the bullets, not necessarily fighting the war. But I think also, it's probably a bit overblown, all of this, right, that our top network equipment -- these deploying a nationwide or even a regional network at speeds of 400, 600 and 800 gig is not easy. This is not a commoditized technology and our network equipment manufacturers are very well positioned to continue to be the suppliers into that. I think what's probably going on a little bit more is if you look to network operators, sometimes get a little frustrated. You can imagine we have situations where we're the supplier of a particular technology, say, a ROADM that goes into a large service provider's network, but we may be supplying into 2 or 3 network equipment manufacturers. And their equipment doesn't interoperate. And you can imagine that gets very frustrating to imagine if you went and every piece of equipment you bought doesn't plug into the same socket in the wall, you had to have something customed for everything you bought. So I think there's some level of ensuring interoperability, but I don't think that necessarily changes the landscape dramatically at our customer level.

Are there any other bear arguments that maybe I didn't touch on that you guys wanted to address?

I don't think so. I mean I think Alan hit the point of our relationship with Huawei and business in China upfront that I think the key point here is that we ultimately win more with our western customers. And as they succeed around the world, we will do better. Reciprocally within China, we will continue. We're not giving up or going away. There's lots of opportunity in China, and whether that's through the largest customer there, through other customers, through other channels to that market, at the end of the day, if you're building a network that's -- in every country in the world, in particular, in China, their network bandwidth is growing very dramatically. They're growing faster and twice the GDP that's rest of the world. They need the most bleeding edge technology more than anybody else, and our technology will find a way to enable those networks.

So maybe let's pivot to China for a moment. So I think on the last earnings call, you suggested that some of the activity in China related to 5G might be slowing, and it's interesting because others in your position, peers have suggested very similar trends, yet some of the OEMs, Ericsson, in particular, have said that China keeps plugging away, that it will grow in calendar '21. And so we -- in the investment county, has gotten a little bit of a mixed message about what's going on in the China 5G builds. Maybe you could revisit that and tell us your perspective on what's going on short-term and longer-term on China 5G and your role?

Yes. So maybe start in reverse. Our role is we supply laser chips to transceiver vendors who then supply the transceivers for 5G fronthaul connect base stations, if you will. And what our customers have told us is that with, obviously, the largest 5G supplier in China being impacted by their ability to get chips from the western world, U.S. suppliers or frankly, chips from anywhere using U.S. technology, that's impeded their ability to continue to deploy existing designs of base stations. As such, customers in China or 5G equipment providers in China are back redesigning their equipment to lessen their or eliminate their dependence on U.S. chip supply. As they do that, that's causing a sort of pause in deployments because the end network operators want to deploy the same thing, not something that's got to go away over time and be replaced. And given our role, we supply into those customers, the transceiver vendors, this is, they've come back and said, "Hey, slow down a little. We still need the product. It's a couple of quarters before things will resume." And in fact, as they resume, they'll probably resume even faster than when we stopped, given this is China and they set sort of national goals to achieve certain deployment milestones, and they will still achieve those kind of on an annual or every so many year basis. So we're still very excited about the market opportunity. It just is more of a reaction to system-level vendors having to reconfigure their product for lack of U.S. supply.

And then -- and sort of the next question, of course, is around Huawei. I was a little bit confused, and I doubt I'm alone on this, regarding your commentary on your last earnings call, suggesting that your shipments to Huawei would be below certain thresholds. Now granted, 0 is also below 5% of sales. But I'm left with the impression you're still shipping or still able to sell certain products to Huawei because you didn't say the unambiguous, we're selling nothing to Huawei. Could you help us understand maybe some of the nuance there?

Sure. And then Chris, you can correct me. I think that the regulations are such that, first of all, we're adhering to all the regulations. So there's no misunderstanding there. But that said, we have R&D facilities and manufacturing facilities and locations outside of the U.S. that don't use U.S. technology. So take, for example, our datacom chip business. It's designed, developed, manufactured in Japan. And our fab is very, very Japanese-tool based. And so those types of things are not restricted by the current regulations of the U.S.

And maybe just as much -- maybe not a Lumentum specific, but as an industry expert, what's your view on Huawei's ability to navigate the current restrictions? Maybe it's a question of how much inventory do you think they have? How much vertical integration do you think they've been able to establish? What's your expectation for next steps for Huawei?

It's hard to predict the future. I do think they have a lot of inventory of chips, so they'll continue to deploy for some period of time. I think the question in my mind is, will the network providers continue to choose Huawei for next-generation greenfields? And -- or will they change to western suppliers, given the uncertainty of their ability to get componentry and chips, in particular, to build out and complete networks. And as Chris said and I said earlier, that's actually a positive for us with respect to if those networks in Europe, for instance, go to a western company, our share of wallet is significantly higher than with Huawei.

So I want to pivot to 3D sensing because conversation wouldn't be done without that, of course. So I think one of the points that we picked up on is that the iPhone 12 has been a big success. I got 4 of my own. And I'm happy with it. And so what we've been hearing is that particularly for the high end that orders being placed today won't be delivered until the beginning of 2021. So what's your thought on this particular cycle in terms of seasonality and the setup as we look at the next year and the next several quarters? Any kind of outlook you can offer on 3D sensing and the seasonal or non-seasonal patterns we should think about?

Yes, Simon, I think what we've -- obviously, everybody has seen that this year is a little different in that our top customers products were launched later in a staggered manner. So that naturally leads to a sort of a delay in a broadened, if you will, expectation for the sort of the shipment profile, if you will. So anything can obviously happen with -- when you have 1 customer driving the business. And so what their inventory and what their demand ultimately is, is always a question mark. But if you park that to the side, if all things go as normal, we would expect a shifted and broadened, which means that as opposed to March being much, much more down from the December quarter, that probably we will see less or more muted, rather, seasonality going into the March quarter. And there will be some seasonality, right, but it's probably less than we've seen in prior years.

And maybe if we step back and think about this market from a broader perspective beyond the one iPhone and the product cycle, what's your expectation for the Android ecosystem and the time line for getting into other applications like autos?

Yes. So the Android ecosystem is -- been slower to develop than I think we all had hoped or expected. With that said, certainly, the challenge is those of us sitting here in the West don't fully realize how far along Huawei was with their 3D sensing, and they had done very well. Obviously, they're struggling with being a smartphone vendor, given their reliance on U.S. chip supply. But having said all that, world facing, I think, is very equation changing for anybody making smartphones in that the world-facing laser capability is integral to the dual, triple cameras that folks are putting in their high-end smartphones, and that will eventually proliferate to the mid-range smartphones over time. And so we've seen a lot of design in activity going on over the past year for world-facing and in particular, an acceleration once it became more clear what our lead customer was doing perhaps earlier this calendar year as they introduced that capability into tablets, if you will. And I think there's -- in a sense, a lower barrier for Android customers in photography because they're already writing complex software to integrate images from 2 different focal length lenses and using some measure of auto focus, in some cases, using lasers today. So if they switch that simple laser that they're using to measure distance to now measure X, Y and Z, if you will, distance in 2 dimensions and the third dimension, it's a much -- it's not radically different than when you walk in and talk to a thumbprint reader guy and say, "Hey, let's put it on the front facing." It's a very different capability. And that's what will really drive, I think, Android adoption. Now having said that, as soon as you see world-facing out in mass, the front side of the -- the front side of the phone still has a camera, and we believe it will, in a sense, the world facing is a Trojan horse for the front side that you got it on the backside, why would you not have it -- why would you not have it on the front side, especially given the backside uses a little bit different technology that doesn't require the notch that is in -- viewed in some Android folks as deleterious to a display experience, if you will. And -- but you still have to have a punch hole through the front for a camera, and we believe that the 3D sensing capability, leveraging world-facing technology, can move to the front side as well. So several waves are rolling out in the Android world that we're a lot more excited about as we get into the second half of calendar '21.

How about autos?

So auto's in a little bit longer time frame. I mean, we talked about on the call that we had recently qualified auto VCSELs through a manufacturing partner, putting together a module that will first find in-cabin applications. So in Europe, there's new standards that start in calendar '22 around driver monitoring systems that will, in many cases, involve VCSELs. And like all things automotive, if everybody remembers airbags rolling out, it's probably a 10-year process that begins at the high end. But nonetheless, once it starts, it's sort of -- it's on rails, if you will, and especially when it's driven by regulatory requirements. But beyond the in-cabin experience for monitoring drivers, we're also supplying and, particularly, working very broadly to be designed in across a very wide range of folks working on long-range as well as sort of shorter distance, LiDAR applications for outside cabin. Our strategy here is to be the laser supplier of choice for all of the folks that are chasing LIDAR opportunities. There's very few of us that have that fundamental laser chip capability, and there's not that many auto manufacturers. There's a fair number of folks in the middle developing LIDAR technologies. So our strategy is to make sure that we plant lots and lots of seeds to make sure that our technology sees the light of day. And we're having a lot of success in that. Now I think you're looking at calendar '23, '24, '25 kind of time frames. But again, like we said, you've got to be in today to be able to be seeing that revenue out several years. And it's a very sticky kind of at least purported to be, based on experience of others in the auto manufacturing world, very sticky opportunity. Once you're in, you're in for a very long time.

Do you think you could put some numbers behind calendar '21 TAM versus maybe calendar '25 TAM? What are we talking about?

Well, I think in calendar '21, it's very small, at least at the laser...

No, total 3D, all 3D, so including your smartphones, your autos.

Yes. If you believe third-party market research, which I think is reasonable, it would say that the TAM is in the $1 billion-plus range in calendar '21, perhaps a bit more than that, again, at the laser chip level. But certainly, it's multiples of that as you go out into the calendar 2025, just given we're in 1 -- effectively 1 smartphone vendor that has sub-20% market share. So I think that's pretty -- it's really going to be the consumer electronics that are probably driving things on that timescale at the laser chip level.

So before we run out of time, and we always have more to talk about than we can get through. I want to touch a little bit on the telecom space. And I think, Alan, you mentioned something that I agree with. This is not necessarily a boom time for telecom. In particular, your ROADM products have been a bit weaker of late. Maybe some of this is around the pandemic, but could you offer us a perspective on how you see this particular line of your business performing during calendar '21?

Yes. I mean I think it's the -- in the short term, the slowdown is really around the ability for our customers to get on planes and deploy new network configurations. And I'm pretty confident that the vaccines are rolling out in a few months' time, that we'll be back to being able to get on planes, get into central offices and deploy these networks. And so from that perspective, I think we're going to see growth throughout calendar '21, especially in the second half with strong ROADM deployments and strong higher speed coherent deployments and in the shape of 400, 600 and 800 gig that have been announced but not -- but haven't had huge, huge volumes yet. And so I think that's also a little bit pent-up as well. The demand for bandwidth continues to grow, and it needs to be satisfied through these higher speeds and higher-performing ROADMs. And so I'm pretty positive on the outlook of 2021.

And another market that's in the telco space that I sort of heard an increasing, I'll say, buzz from industry participants is around submarine applications. And maybe this is dovetailing with your comments about higher speed. But do you see a submarine cycle? And what does that mean to Lumentum's products?

Yes, I think we've seen submarine half cycles. I mean it had boom and bust times over the last several years to the point where, today, in talking to our leading customers that do deploy submarine cables, they have a pipeline of demand that looks pretty consistent and constant, upwardly trending. So I think that, that's going to be -- whether you call that a cycle or just a new way of getting data and communication across the oceans, I think that the submarine market is very strong. And will grow quite rapidly over the next 3 years.

Great. And so we've just about run out of time. I want to close with the following. What do you think is the least appreciated aspect of Lumentum's story and the stock?

That there's room for growth. There's room for growth both in the top line, and we've shown it over the last 5 years. We're going to continue to grow. And there's room for growth in margins. And so we're going to continue to innovate and make sure that we have differentiated products that our customers really, really want because it differentiates them. And I think that's what we've been investing in and what we've been talking about. So I think from that perspective, I talked about the markets that we're in. I think '21 and '22 are big positive years for us. And then finally, I think the Huawei thing is a long-term positive for us. And so we're in a pretty good position, and we're pretty happy with where we are.

Well, with that, let me wrap up. Let me thank you, Alan, Chris, Jim. Thanks for joining us. Folks, thanks for signing in for the Lumentum call for the Raymond James Tech Conference held virtually in the cloud. Thanks a lot, guys.

Thanks, Simon.

Thanks you, Simon. Bye.