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

Welcome, everybody. This is Meta Marshall. I head up the networking research here at Morgan Stanley. We're pleased to have Lumentum here today. We have Alan Lowe, CEO; Chris Coldren, Head of IR and Strategy. I'm going to read a brief disclosure. 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 Morgan Stanley sales representative. And just a reminder for the audience, if you want to submit questions, I have a live feed coming through here. And so any questions we can get to kind of as we go throughout the session. Alan, Chris, thanks so much for being here. I wanted to maybe start with just kind of refreshing the pieces of the story that you think that investors miss I think people are pretty aware of the 3D sensing story. But what are the trends outside of 3D sensing that you think are really missed today?

I think more than 3D sensing, our telecom and datacom businesses is growing dramatically as a result of bandwidth growth that just continues to grow on an annual basis, more than 30%. And so I'd say that while we have a thriving, growing 3D sensing business, the fundamental underlying parts of our other parts of our business, meaning in the telecom transmission, telecom transport, as well as our datacom chip business, which is while it be smaller, it's a big contributor and growing quite rapidly as 5G deployments are coming online as well as the hyperscalers are building out new data centers. And so I'd say, across the board and including our laser business that was hit pretty dramatically by the COVID pandemic is now starting to see signs of life coming back, and we'll get back to the kind of levels we were prepandemic, say, in the next few quarters. So it's a good time for Lumentum in the fundamentals of our markets that we participate in are all very strong.

Got it. Part of that kind of story outside of 3D sensing is the success of the Oclaro integration. You've raised operating margins over 1,000 basis points, your gross margins by even a larger extent over the last 4 years. Pointing to just a much healthier kind of optical supply chain. How do you get comfort with kind of the sustainability of the profitability targets that you've laid out, particularly given some of the cyclicality that exists in the sector?

Yes. I'd say that the cyclicality that you say is very different today than it was 10 years ago. And I'd say that the competitive landscape is very different. The industry is consolidated. But at the same time, product differentiation has really driven our ability to partner with customers for long-term partnerships that commit us to supplying and them to buying at predetermined prices. And so that allows us to invest in our engineering teams to drive the cost down, to drive the margins to the kind of levels that you talked about. In the earnings call before last, we talked about our midterm type of margin profile of 50% gross margin and 30% operating margins. Saying that we get there next year. And then in last earnings call, we said we'd actually get there this year because of the strong first half and then the continued strength in our ability to drive those margins. So I think from a margin standpoint, we're in good shape.

Got it. You kind of noted there's been a pullback in some of the North American telco kind of towards the end of the -- end of last year, that kind of carries through a little bit to the first half. However, what we saw in 2019 was that a lot of that was transmission focused with less kind of optical content in general. As we look towards the second half, when optical demand should improve, how does that look for Lumentum of its transmission versus transport focused?

Well, I think it's across the board, and it's really driven by a couple of main things. And as you say, typically, transport is a leading indicator of transmission because you have to put in those highways and then you light them up with the transmission. So we've done a lot of work over the last few years, designing in our next-generation MxN-type ROADMs. And while it was first adopted in China, it's now being fully adopted in the Western customers and ready for deployment. So their new network architectures are really designed around that technology. So those will be starting to roll out. Once people get enough shots in the arms to be able to get into the field and deploy these new network architectures. And the growing bandwidth demand will just drive transmission. And what I'm talking about in transmission is really the 400, 600 and 800 gig both components and modules. And that's what we're really focused on, on transmission. Having the best absolute indium phosphide capability for those types of transmission rates.

Got it. When it comes to telecom, clearly, a lot of the conversation with investors ends up around China as a customer, as a growth driver. How do you think the ongoing trade tensions affect that relationship in the long term? Does it necessitate that China builds out its own supply chain, even if Huawei restrictions are lifted? And how does that opportunity develop over the next couple of years?

Sure. I mean, I think we had the first step of the trade tension in May of 2019. And since then, I'd say that our Chinese customers have gone elsewhere where they can. And so our focus is making sure that our products and technology is indispensable to those customers, and we're going to continue to invest in the technology to differentiate and so that there's really no other place they can go other than Lumentum. Meaning we will have the best technology and products to enable network deployments so that we are the choice that they make. And we've seen that over the last 1.5 years since that first trade dispute in May of '19, where some of the common products have gone elsewhere to other countries outside of the U.S. And so we're selling the high-end products that are very differentiated today, and our focus in the future is to continue to invest in differentiation so that we are indispensable to those customers. I don't know, Chris, do you have a comment on that?

Yes. Well, I'd just add that China has been for 10-plus years, trying to build up their own supply chain. So I don't think there's -- maybe there's renewed effort in theory, but the reality is this has been a target area and a focus area for years. But at the same time, this is also an end market that, as Alan alluded to, performance matters. It lowers the total system operating cost when bandwidth is growing 30% per year. In fact, it may be growing faster in China, given China is overall growing faster. Their needs to buy the latest and best technology is as much, if not larger, than Western customers. So we believe over -- obviously, over the long run, there's going to be some amount of increase in domestic ability to get to the medium and maybe even eventually into the high end. But at the same time, we continue to lead in the West and our competitors struggle to keep up with us on the technology front. So we don't see a whole lot changing there per se other than, as Alan alluded to, really our revenue concentrating into those products where we truly have differentiation. But that's actually what's happening with most of our Western customers as well. In that we're focused only on those products. And as you alluded to, the very significant improvement in margins, really related to -- aside from scale and removing fixed costs and redundancy. But also only focusing on products where we have a unique value proposition. And so in a sense, the variable margins as well as the -- variable margins have gone up and fixed costs have come down at that same phenomenon and reflecting the trends that will unfold in China as well.

Got it. On the datacom side, that transformation we just talked about on the telecom side has been incredibly successful. You've gotten out of kind of the lower margin transceiver business into higher-margin laser chips. How do you decide how much to continue to invest in scale here, just given a lot of people coming into the space. You've set out targets to double capacity by the end of 2021. With everybody kind of attacking it from a componentry standpoint, how do you keep the space kind of attractive as it's been over the last year or 2 for you guys?

Well, I think a couple of things. One of which is we are no longer a competitor to our customers and transceivers. And so therefore, we're viewed as more of a partner. That's number one. But number two is making sure we have the leading-edge technology in products. And so our largest competitors are buying laser chips from us. And that really tells us that there is a path for our technology to really permeate the entire transceiver customer base because we have something that's differentiated. And I'd say we're going to continue to invest in leading-edge EMLs, DMLs and VCSEL chips so that we are the partner of choice for all of the transceiver suppliers in the world.

Okay. Got it. Circling back to 3D sensing, and it wouldn't surprise you that every question I have coming through the portal is about 3D sensing. So we'll now get to that. We'll now get to it. But clearly, investors were a little bit surprised about some of the share shifts that we saw after kind of years of dominant share position on your part. You've been vocal around confidence around minimum share contracts you have with your major customer. Well, I know you can't kind of give full detail. Just how do you feel about your share positioning? And I guess, does it matter kind of which module, which version of the phone it is to kind of give that confidence?

Well, I'd say the investors probably shouldn't have been surprised because we've been saying it for 4 years that we weren't going to continue to have the high, high share that we had and the benefits of those type share. So I'd say that we have truly gained the confidence of our leading customer as well as the Android customer base in our ability to ramp product with high-quality and cost that is meeting their needs. I'd say it's natural for any customer to want to have 2 or more suppliers, and we just had the benefit over the last 4 years of having that large share because of our competitors not able to supply at the kind of quality or yield of cost that was needed. So I'd say we're now at a level playing field with respect to share and as new products get introduced as they did last year with the world-facing camera, we will continue to have a very high share because we are viewed as the technology leader. And I think with that as a foundation, we will continue to have a higher share than our competitors, not only because it's contractually obligated by our customer, but it's because we are the provider and enabler to our customer to get those new products out to market.

Got it. And a question we got kind of from the audience, and you mentioned kind of at a conference a couple of weeks ago. As we look to potentially kind of a smaller notch or a redesign that could potentially come in a phone in the next year, just what would that require differently kind of on technology from your standpoint. Would it kind of lead to any different share position in different kind of bomb content meaningfully different?

Chris, do you want to take that?

Yes, sure. So obviously, I can't go into the customer road maps and customer plans. Maybe let's speak more abstractly that certainly customers that the sort of holy grail, if you will, is to shrink or eliminate the notch. And over a long, long run, there'll be a desirability to get cameras under the display and not have a hole or a notch. But that's probably several generations off. And until then, we have a long road map of products that we've been developing over the past 4 years, if you will. That should enable customers to shrink the sizes of modules and/or the notch then related around packaging those modules. And that comes from the multiple years of experience with the current kind of platform of chips that we make. And are we able to get more efficient lasers and pack more in a chip, et cetera. In terms of what does that impact to our share, I think, as Alan alluded to, our past several years have generally been off of share awards that were awarded in a time period where nobody was shipping anything. So you could imagine there was a little bit more equitable, at least from what was awarded. Our competitors weren't able to deliver against what they were awarded. As we introduce new products like we did with world facing, and you can imagine on future generations as well. We're the first folks in have led and helped the engineering teams at our customers, we get more than our fair share for a time period on those kinds of products. So in principle, on kind of a net-net basis, we have the opportunity to grow share into the future given chip changes over time and our ability to get disproportionate share on those new chip designs.

I mean, if you're moving to kind of a smaller laser and VCSELs or tend to be priced kind of on size of the array. Is the natural assumption that kind of the ASP of those would come down? Or is that maybe not the case just because you're trying to get to a more efficient laser? Or there's kind of more technology in that VCSEL?

If you let me kind of tackle different way and say, one that we disclosed, if chips are getting bigger, smaller, anything like that. But what you can imagine is, certainly, if the total 3D sensing solution, cost and size comes down, then -- and that's enabled by in part at least, by what we can accomplish at the chip level, then we're bringing more value to our customer and more value to the overall solution.

Okay. Perfect. So you just talked about doing well within the Android ecosystem, maybe Android hasn't ramped quite as quickly as anybody has been expecting. Just what is it that you're starting to see that gives you more confidence that the Android ecosystem can take off? And then how do you kind of maintain the leadership position that you've had with your lead customer to date as that ecosystem expands.

Well, I'd say that we did have the leadership position in Android, and it was really driven primarily by one large Chinese customer who's now having trouble getting the chips to be able to produce those high-end devices. And in fact, divested their mid-range products to an unrelated party. So I'd say that's an opportunity for us. And I'd say across the Android system, we are continuing to work with each of them to enable them. When they decide to put 3D sensing into a device that will be the partner of choice. And I'd say we're going to continue to do that. And I think that our lead customers, innovation and new product releases this past year has driven an accelerated desire for the Android ecosystem to come out with products and technology that try to follow quickly our lead customer. And I'd say that the computational photography aspect of that world-facing camera is absolutely phenomenal. And I think will need to be replicated across the board for the Android market to keep up. And we'll be there for each of them.

Okay. Got it. Another question we get from investors is just around AR/VR headsets, whether lead customer, otherwise. And just kind of what type of content from a 3D sensing standpoint, there is kind of maybe versus a mobile phone given there are so many cameras within it?

Yes. I'd say more generically, one should think about wearables in general because there's certainly AR/VR headsets, but there's other wearable devices. As you could imagine, that benefit from 3D sensing. And maybe not even things that have cameras, but as you have little tiny devices that are on your body, you all -- and you want them waterproof and buttonless that all of a sudden, things of gesture control become more relevant than perhaps in the past. But yes, certainly, AR/VR headsets, we have a range of customers that go on one end have tons and tons of content because you're looking at world facing, you need things tracking your hands, tracking your face and eye movement, et cetera. So there's lots of 3D sensing content. And then there's others that are also looking at, let's say, a little simpler or less -- not a big monstrosity on your head in terms of AR/VR headset that has a little less content, but still not out of the ZIP code of what a mobile phone has. So I think you're going to see a range of devices come out depending on performance and consumer preference the level -- higher than mobile phones, the same as mobile phones and in some cases, even a little less, if it's a very simple functionality, at least from a 3D sensing control standpoint.

Got it. Yes, we had Viavi here yesterday, and they were talking a lot about kind of the biometric health care angle with 3D sensing. So in terms of auto, another major use case for LIDAR, how do you see this ecosystem developing with so many vendors right now? How do you think about allocating resources? And just what are the timing for maybe in-body and exterior opportunities?

Yes. I mean, it's -- given the number of parties and -- and at the same time, the wide range of technologies that are -- or approaches, if you will. There's not a clear -- this is the way you do it at the kind of highest level solution. What that causes us to do is focus much more at least in the near-term on selling laser solutions, a laser chip level in general, but sometimes a little bit beyond laser chip level. And the reason for that is the incremental development cost, incremental manufacturing costs to deliver the various kinds of lasers that customers need for their unique LIDAR solutions is low relative to if we were ourselves chasing 10 different system level, module level approaches. But beyond just the ability to invest, this is not that we're necessarily limited in the dollars to invest, but also the fact that if there's a dozen folks crawling over each other to build something at a certain level, that's probably not the greatest industry structure relative to how many people in the LIDAR world operate indium phosphide gallium arsenide wafer fabs and have decades of experience producing these chips and have made hundreds and hundreds of millions of them, et cetera. So we think focusing at the laser chip level is the right thing to do in the near term. And in terms of opportunities, there's in-cabin outside of cabin, but even within that framework, there's also a range of different applications, whether those be what normally people think of as the ADAS assisting kind of car that you or I might buy, we think that's a little longer term, that's several years off before there's any substantive revenue from that, whereas in the areas of delivery vehicles, last mile delivery vehicles, industrial robots and guided vehicles within factories or warehouses. There's a more significant market in the nearer-term that perhaps starts in the next 1 year, 2-year time frame. And what's great about those kinds of markets is they tend to be driven by a large end customer that can kind of turn on the opportunity almost overnight, right? They decide to build a large delivery fleet, if you will, an autonomous delivery fleet that turns on a lot faster than a high-end Mercedes or BMW Audi model that comes out with LIDAR and takes 7 to 10 years for the whole model range to penetrate. So we think in the next few years, you'll see that outside cabin and delivery vehicle. But in Europe, where there is level of driver assistance already today, and even if it's not LIDAR, driver monitoring systems are mandated, if you will, starting in calendar '22 on certain types of vehicles. And over time, they will be mandated on all vehicles. We expect that to be the same in Europe -- sorry, in North America and Asia over time as well. So we expect in-cabin to start becoming revenue more meaningfully in calendar '22, '23 time frame. Now with that said, that's a lower selling price than LIDAR. So it's going to be less impactful relative to when LIDAR is in full stream. But nonetheless, it's happening.

Okay. Perfect. So with that, the other portion of the questions are obviously about kind of coherent. With the success of Oclaro, from a financial and strategic standpoint, you've been active again. Is there any update that you can give now that there's multiple bidders? Or just how are you kind of viewing yourselves throughout that process?

Well, I think we're in the driver seat. As far as having both Boards approved and signed a merger agreement, we are going down the path of executing upon that with coherent until their Board deems that there might be a -- or there is a superior proposal. And to date, that hasn't happened. And I think there's been some -- certainly, some news published about what's going on in that process. But our focus is do the filings continue down the road and see what happens because I think this is not a new phenomenon that there's multiple bidders in this transaction. I mean, they all had their chance beforehand, and we came out the clear winner as a result of at least the coherent Board's view of our antitrust provisions and our ability to have certainty of close, and that's really a result of what we signed up for, but as well the complementary nature of our product launch. And so I think from that perspective, we're in good shape there, and we'll see how it plays out over the next few weeks.

Okay. Great. I mean, in terms of whether coherent is successful or not, clearly, you guys still think that you're in the driver seat. Should we expect an attempt to kind of broaden out investment themes? Are there still consolidation opportunities within the space? Like just kind of how do you view expansion of markets versus maybe continued consolidation?

Well, I think we're focused on both. I mean, from the standpoint of entering new markets, I continually get asked what's the next 3D sensing? And we're looking for that thing and have been. And are investing quietly in those types of new market opportunities that utilize our technology that we can bring to those markets to change those markets and enable those markets to use photonics. So I think from that perspective, certainly, we have a funnel of M&A targets that landed us with looking at coherent strongly and ending up where we are today, there's still plenty of opportunities across the markets we participate or into new markets. And so I wouldn't limit ourselves to looking at acquisitions within the 5 markets that we kind of carved out for Lumentum.

Got it. And then maybe just one last question from the audience. Essentially getting to data center architectures evolving towards either onboard optics or just more silicon photonics, in general, you guys have continued to kind of point out indium -- the benefits of indium phosphide, but just how do you think of opportunities in datacom, silicon photonics, just how that market evolves?

Yes. So I think the easiest way to sum it up is silicon doesn't generate light. And therefore, there are folks that are pursuing trying to integrate more of silicon photonics closer to switch or processor chips, if you will, to avoid and to essentially, what isn't eliminated is the lasers or the indium phosphide but eliminating electronics, eliminating the clock and data recovery and the drivers to drive current circuit board lines from where the chip is to where the transceivers are at the edge of the board. As such, all of those opportunities require very high performance, lasers, high-power lasers, if you will. So we have a strong engagement with customers around laser solutions to enable silicon photonics, in addition to, obviously, our lasers, EMLs, DMLs, et cetera. So I think kind of having unique laser capability positions us well regardless of which pathway the end customers choose to build their data centers over the long run.

Okay. All right. Well, I have a long list of other questions that people have submitted, but we're now out of time. So I appreciate you guys being here today. And if anybody else has any other questions, we'll funnel them through Chris and Jim and try to get you guys answers. So appreciate you guys being here today. Thanks.

Thanks for having us, Meta. Bye-bye.