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

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There was the opportunity to pursue a large TAM, which was one of the reasons that you had outlined in terms of your interest for Coherent. How do you intend to go about that same strategic rival now? What are the different parts that you can see to get to that same outcome without Coherent? And before I let you answer, let me just take a pause and remind investors you can send in the question as well. You just have to ask -- use the Ask a Question button on the website, and we'll ask it on your behalf. So Alan, sorry for that. Please go ahead.

Yes. Thanks for inviting us, Samik, and thanks for the question. We've been following Coherent for many years and really like the business that they were in, and it was a great opportunity for us to, as you say, expand our addressable market. We have certainly other avenues to do that, both organically as well as inorganically. And as we said in our earnings call, at that time, we felt that our stock was the best opportunity for us, both to use the cash we've been generating as well as the cash we've got as a result of the breakup fee. That said, we're very optimistic about the outlook for our organic growth and the demand drivers for photonics across many industries in many different markets. So we're on the precipice of automobiles really driving photonic demand as well as AR/VR, industrial, vision applications and others that are really TAM expanders for us. And then the mainstream products and technologies and markets that we're in today have very good growth drivers driven by demand for the Internet and demand for growth in hyperscalers and 5G markets. So a lot of very positives that will expand our market, both organically as well as inorganically. And we have -- Chris is in charge of our corporate development, and we constantly have reviews of possible and potential targets, but nothing to announce today.

So on the same lines, Alan, I think one of the aspects of the business that has stood out in the past also has been the concentration to certain customers in the individual segments. Obviously, 3D sensing, there's one primary customer. Even in telecom, previously, there was a concentration to one customer. Now that's moderated. But generally, as you think about diversification of the customer base, is that one of the strategic priorities for the management team? How should we think about the business kind of 3, 4 years from now looking different compared to today?

Yes. Certainly, having large customers is a blessing as well as a challenge, right, in managing that. So as you said, we have diversified in our comms business pretty substantially and look for other opportunities, both in 3D sensing to expand not only to other handset manufacturers from our primary one, but also into other markets and opportunities, and I mentioned those automotive work. We're having design wins today in automotive as well as in other kind of Internet of Things applications, security, types of security and biometrics. And so I think that, again, we're at the early stages of that. That years from now -- a few years from now, we'll be less reliant on those large customers. But those, we're still going to be very, very strong partners of them.

Let me move to one of the segments and discuss telecom. [Operator Instructions] I know there's some. I'm seeing questions come in relative to 3D sensing, but let me hit that off in a bit. So let's start with telecom here first. From a demand perspective or demand confidence perspective sentiment related to demand from North American customers appears to be positive here just in light of their comments recently about 5G CapEx, how much of -- you did note some challenges in your telecom segment. So how much of that is purely China-driven as a kind of commentary relative to what is happening in North America?

Well, we were positive on telecom demand. In fact, we said telecom would be growing, and Chris has all the numbers of that at his touch. He can comment more specifically. But our customers are telling us, end-user demand is very strong in lots of tenders and RFQs and things that then lead to deployments later on. So we're not signaling that telecom as weak by any means. And particularly, in North America it's quite solid. What we were signaling was that we think that the second half of our fiscal year or at the end of the calendar year and into next year, we'll see even further strength because, today, we're seeing ROADM and transport equipment being deployed, which is a leading indicator of networks being deployed that will then need transmission products to light up those fibers that are being built in the networks that are being built today. So that's why we said, "Hey, we think that the first half will have growth, but the second half of our fiscal year will have stronger growth." I don't know, Chris, do you have any more particulars....

Yes. I mean -- and certainly, I think, Samik, maybe what you're referencing is the 5G fronthaul challenges that we talked about, which, apologies to everybody listening that gets confused by this, that's why we kind of call it telecom and datacom as a group of product lines, because the 5G fronthaul is served by chips that look at a heck of a lot like our chips for data centers. So we kind of lump it in datacom, even though it is a telecom application. I think what Alan is highlighting is we grew double-digit percentages in the first half of our fiscal '21 in telecom relative to the first half of fiscal '20 once you normalize out lithium niobate and these products we exited, so very strong telecom demand. And the next couple of quarters, as Alan highlighted, the -- we're kind of transitioning from transmission being strong and transport being weaker, which started pre-pandemic, to kind of to the -- to slightly reversing those roles as these new deployments get underway, and then in the second half of the fiscal year kind of having both sets of transmission and transport going. So it's kind of why we sort of highlighted strength and then maybe a slower but yet growing in the first part of our fiscal year in telecom, that is, and then a reacceleration of growth. Also including a little bit of hedging around our supply chain risks, et cetera, that I think investors are well aware of in the industry around semiconductor components and ongoing COVID challenges in this geography or that geography from time to time. Hence, why we tried to provide a little more clarity by providing the next couple of quarter outlook at the company level, at least based on where we sit today.

Yes. No, Chris, let me just follow up on that. So from the earnings call, I think your comment was that you're expecting an uplift in telecom revenue starting in December quarter. I mean, I think this is a question we've got from investors. And even as we think through, just given that the lead times are quite extended, most of your customers are expecting a ramp in revenue in their telecom businesses, either in the kind of third quarter or even a bit earlier. Should it be more kind of logical to expect that ramp starting in the September quarter? Or are we missing something here? Or is that what you basically are calling the hedging part of it?

Well, no, I think there's a couple of pieces. First is I think we have been seeing the leading edge of that. That's why we've been growing quite significantly in our telecom business, especially in the new product lines relative to our customers who haven't been growing as strongly as we have because I think our customers have been slowly ramping up, preparing for, as you said, that September, December quarter time frame that I think they're talking about ramping. Secondly, our fourth quarter telecom revenue, June quarter is going to grow. You've got to remember, we're coming off of a 14-week March quarter. So even being flat in telecom is 7% sequential growth, we expect to be flat to up in telecom in the June quarter. And then as we go to September and December, transport is really taking off. It's just transmission is kind of flattish, which is what's moderating the growth and then a little bit, as you said, the hedge over top of some risk just given the overall environment at a conservatism. So I don't think our outlook is inconsistent with our customers. It's just the supply chain has got some lead times and some buffering and inventory levels throughout that all complicate when -- who turns up when. But in general, we've been turning up and expect to continue to grow. ARGES' point is more of the growth comes in the second half of the year when sort of all the factors result in each portion of the telecom and datacom business growing.

Great. Following up to the other aspect, just China and the fronthaul kind of weakness that you mentioned, Chris. What are you hearing latest in terms of timing of tenders? Is -- and how should we think about the likelihood that this spend starts, either in the back half of this year or is it more of early 2022 spend?

You want to go, Alan?

Yes. I mean, I think we're still getting signals that there's going to be hundreds of thousands of base stations deployed in the second half of the calendar year. I have not yet seen the pickup from -- with respect to the inventory being fleshed out of our system, if you will, and that's one of the reasons we took that revenue deferral in the March quarter. So I think that there's -- every indication so far that the second half will have a build-out of the radio base stations in the fronthaul for us, but that will take some time to get rid of that inventory throughout the chain of the transceiver manufacturers and then the OEMs deploying those radio base stations. So I'm positive that the outlook, I think that kind of the timing of that coincides with significant -- our messaging, that growth in the second half of our fiscal year will be across both telecom and datacom, including those fronthaul components.

Let me stick with telecom for one more question. [Operator Instructions], and then I think we'll just start taking some of the audio questions. So particularly, it looks like 3D sensing is where audience has more questions. So just on telecom margins, the margins having grown significantly over the recent years, what's been the key driver there? Is it that the product mix has been more aligned to high-end component? High-end components, is that what's been the primary driver? Just walk us through what's the driver. And how should we think about continuing to improve that telecom margin?

Yes. I think a few things, and Chris mentioned a little bit about the end of life in lithium niobate and other products that were a drag on our margins. We got rid of those. And so now everything is more of a tailwind for margins from a product mix standpoint. That said, we've done a lot of focusing on operational efficiency, yield improvement, quality improvement, zero defect culture that just drives our cost down and the margins up. And I think the other thing is we're providing our customers with products that they can't get anywhere else. And therefore, we sign up to multiyear agreements with our customers, where we know the prices that are going to come down over time, and we can invest our resources, our engineering resources and our supply chain resources to make sure that the costs come down equally as fast to continue to maintain those margins. And our customers are happy. We're happy because we have assurance of demand. And from that perspective, it's a win-win for our customers and for our P&L.

Moving to 3D sensing then, and Chris, on the earnings call, you guided to 3D sensing market to decline 20%, 25% in your fiscal year '22. Obviously, a lot of questions on that. So I mean, just to get the backdrop here, maybe if Chris, if I can ask you to kind of go through what is driving that 20%, 25% decline. I know it will be repeating somewhat of what you've said on the earnings call already, but I know there are some follow-ups on that. So if you can just set that in terms of the background, in terms of what's driving that 20%, 25%.

Yes, absolutely. And I think maybe first, it's also useful to kind of look back a little bit in history to understand that over the past 4 years of providing products into this market, revenue has grown, obviously, over the past 4 years. But we've delivered significant price downs every year, kind of consistent with this market space, double-digit type price erosions when you're doing apples-to-apples, meaning the same product sold year after year. The reason we've been able to grow is units have gone up as customers have broadened the penetration of 3D sensing in their products. We've also seen the introduction of things like world facing that add additional dollar content. What we're highlighting this year is that we don't have the same offsetting factors, if you will, to price decline. So even on existing like-for-like, apples-for-apples chip, no pun intended there, we're going to see some double-digit price erosion on those. And then on top of that, that we were able to engineer a new and challenging chip to make that enables perhaps new capabilities or new features, if you will, in our customers' products that are very compelling to them, but they happen to be smaller, and they know a smaller chip doesn't mean that our costs remain the same. Our costs are going to come down in line. And therefore, they put a lot of pressure to say, "Hey, we're partners. Why should -- if the chip goes down dramatically in size, shouldn't price at least come dow in some manner?" And it did. And as a result, that's kind of our point of the -- assuming the same units, assuming the same mix kind of normalizing on the portfolio, that 20% to 25%, which is a little more than historical, but not ForEx historical, right? It's because of the combination of the normal price erosion, the smaller chips and a maturing, if you will, at least for this product cycle, amount of penetration in the product portfolio. That said, margins will remain healthy. It's -- the beauty of our manufacturing model is costs will naturally fall in line with the reduction in chip size, assuming yields remain steady, and they're very good yields at this point. And as we look forward, we expect more opportunities to grow dollar content as well as penetrate further into the portfolio with 3D sensing. So we just kind of view this year as got a little bit more of a lull given the nature of their product cycles and not a particular trend, if you will.

I know that was kind of repeating what you had already said on the earnings calls and probably multiple times after that, I mean, as you may. So follow-ups. Is the entire 20%, 25% just driven by price decline? Or does it include any -- does it embed any changes in terms of your market share from fiscal '21 to '22?

Yes. I mean, certainly, when you define a market, our comment was it's the market has nothing to do with share, if you will. And certainly, we'll see. The race has not been run at this point, right, to see where share lands. But I think we feel pretty good about -- we've always done very well when there's new chips that are challenging to make, and so that presents us an opportunity to, not only from a customer commitment of minimum shares to us, but as well from a what do we actually achieve, there's opportunity for upside. All that being said, it's still early, right? We're in the first quarter of production on the products for the fall, and so there's a ways to go to see where we ultimately land, but we're feeling pretty good about share overall.

A question that came and reads, your competitor in 3D sensing is not seeing the market down 20%, 25%. Why are they more positive on the market than you, especially when you may gain some share back or at least have stable share?

I don't know. I think that's a better question for them. We've been pretty clear. The drivers -- are they denying that prices come down year-over-year or there's not new chips? Maybe they're not in the new chips, I don't know. Maybe you'd ask them that.

The other follow-up, Chris, can you give more color on the minimum share agreements that you talked about and what the increase or magnitude of increased fundamental share could look like as a function of the minimum share agreements as you kind of take that forward a few more generations? Like how are you thinking about the magnitude of share that can change on account of that?

Maybe I'll take that one, Chris. I think we've been a great partner to our lead customer. And as a result of that, we believe we are their development partner and their launch partner. And as a result of that, we sign up to put the resources in place to make sure that we do exactly what they want us to do for the new designs and the next-generation designs and the next generation of designs. And as a result of that, they make commitments to us around share that we're not going to get into, but if it's very -- at the front end of products, it's considerable. So I think that just gives us confidence that we're in good shape. Yields, as Chris talked about, are very solid. And I'd say that as Chris said, the race hasn't been run, but we're at the starting line, and we've got a lean and head start. So we feel pretty good about it.

Just another quick follow-up. Chris, you mentioned the margins remain largely unaffected by this, which I understand would be largely true for gross margins, and the costs are coming down as well. But when you start thinking about operating margins, is the underlying cost structure where you can take cost out to align that because, I believe, your OpEx remains consistent, you should have a drop in operating margins, if not on the gross margin level. Why are you suggesting gross margins are higher and operating margins remain kind of flat?

Well, certainly, I'd been -- we're not going to reduce operating expenses, which are primarily R&D as a result of kind of a one-year change in the market. We continue to believe in this being a very long-term growth market, so we're investing very heavily in new customers and products and programs. There's not any -- if you kind of think of it as -- there's no significant selling costs or anything like that in this business. So certainly, as revenue comes down, that's a headwind to operating margin overall for the company in general. But gross margins will be consistent year-over-year, and we continue to invest for the future.

Yes. And we're not changing our target model, right? I mean, it's still 50 points of gross margin and 30 points of operating margin. And I think we should be able to attain that, as we did. And we forecasted it not happening in fiscal '21, and it looks like we're well on our way to do that already.

Good. Great. So let's move to the positive side of it. You talked about 3D sensing market accelerating or getting back to growth in fiscal '23. So just help us understand the drivers there. What are you seeing there? I mean, if I now put together your pricing comments, definitely looks like you are seeing enough opportunity on the 3D sensing market in fiscal '23 to offset some of the annual price declines with your primary customer. So just help us walk us through the drivers there for your fiscal '23 comments.

Yes. I mean, I think the point of the fiscal '23 comments is, as we've been alluding to over several quarters, that we have customers outside of even the mobile space, for example, in the automotive and security and access control. And we say automotive, even in the near term, it's like -- we call it automotive, but it's really delivery vehicles and, in some cases, warehouse vehicles at large retailers, if you will, are investing in. So we really view that this fiscal year is a pivotal year from a customer design in and start to ramp up, so that we see the fruits of that in fiscal '23, and fiscal '21 was a lot of the design win activity in markets outside of handsets. That said, we also believe in the handset market in '23. There's a lot of favorable tailwinds between -- essentially everybody outside of our lead customer has had a very tenuous relationship with 3D sensing, if you will. But I think between the photography and then, ultimately, I think fiscal '23, calendar '22 to calendar '23 time frame is really where augmented and virtual reality become much more of a meaningful market and inflect as customers launch wearable devices, but as well incorporate that functionality and applications on the handset, and that will really push a lot of the handset manufacturers to really require that in their products. And so that's what we're seeing from a design-in standpoint at this point. And on top of that, as we've also alluded to on earnings calls, our product roadmap is rich in products that are not just, hey, yet another spin of the same kind of chip, but adding more and more functionality, perhaps even consuming dollar content that was surrounding the chips, if you will, by integrating them on the chips. And we should start to see the benefit of that also out in the '23 time frame.

Let me move to taking a couple of the investor questions that have come in. So I'll read out this one, which is more on the Coherent bid. And the question reads, did -- can you ask Lumentum if they saw the deal that their Coherent competing bidder signed up and if they looked at it? And if you -- if we see a deal announced in the space, can we assume that you've looked at it and passed?

I'm not sure I totally understand it. But I mean, since we were in the driver's seat, we got access to every bid that came in from any competitor and knew the details of them. So we were very aware of what was going on. I'm not sure I understand the second part of the question.

That's fine. I think we can move to the next one, I think, that looks like. Second follow-up question from investors. So I think this one is more about the supply chain constraints. So let me -- kind of first part of that, let me ask that you give us an update on the supply chain constraints. Where are you seeing those constraints? And since you've reported earnings, which I know hasn't been in a long time, but have things got better? Have things got worse? Any updates on that? The second part to that. Does Malaysia shutting down for 2 weeks impacted the supply chain?

Yes. So let me go back in time and say that a year ago in the spring time of '20, we made a strategic decision to add buffer to our inventories of raw material. And we've made that a perpetual decision and strategy, so that we've been isolated somewhat from some of the semiconductor challenges or other component challenges. That said, I've never chased so many parts in my life. And so we do get impacted by lead times that go from 20 weeks to, all of a sudden, 53 weeks, and so we work with our suppliers and our partners to overcome those. And I think for the most part, we have done that. I'd say from a Malaysia standpoint, and I think different countries have different issues all the time, there is a flareup, obviously, and we've seen it before. And we have people on the ground there, monitoring it very closely. We only have a small portion of our telecom transmission products that come out of our partner in Malaysia. And so from that perspective, while there might be an impact, I think it won't be significantly material. I don't know, Chris, do you have any other comments in there?

No. I mean, I think certainly, a similar thing happened a year ago in Malaysia and -- but it's a little -- I wouldn't say draw the same conclusions just because it's been a year. We've learned to do things differently, and that came on the heels of China lockdown, and so it was a little bit of a different situation. But it's very early in what's going on, and we'll update folks as we learn more and as is appropriate.

Alan and Chris, I'll ask you this follow-up just because we're asking every company this question, which is, primarily, we're hearing about the extended lead times, but is there also aspect where your suppliers are raising prices on you or kind of you're paying expedite fees? Has that become a headwind to margins? And in your capacity, are you able to pass some of that through to your customers?

I'd say that it's not a material amount, but we are paying expedite fees, and we don't pass those on to our customers. I think we're in it for the long term, and this is an issue of making sure we can supply them what they need. So we haven't passed that along. If it gets much worse, maybe, but it hasn't been a huge drag on our costs. And at the same time, we continue to focus on operational improvements and efficiencies to offset some of these increased costs of expedite fees, if you will.

The next investor question is on 3D sensing. It reads, is there any risk 3D sensing gets designed out based on advances in computational photography, software leveraging, tradition camera sensors? So I think the question is, basically, if the 3D sensing get designed out because software essentially leverages some of the traditional camera sensor.

I would say, certainly, there's been -- if you look over the past, that was kind of a dual camera, stereoscopic approach kind of ran its course. And certainly, as compute horsepower increases, it can do a lot more things in software. That said, I think it's very difficult to accomplish the level of accuracy and depth sensing that we're accomplishing in 3D sensing today. And so, at least on our customer roadmaps, we see more -- not a dumbing down of the laser, which you would think would be the first step, if you will, putting more and more back into software and computation, but actually more and more to make the lasers sophisticated, to make the computations easier because you have to also remember that computation takes time and burns battery power to accomplish those steps. So sometimes, it's just easy measuring something as opposed to inferring it.

No. That's good. Any other investor questions, please feel free to send them over and we can ask them in the final few minutes here. I guess now, finally, I do have some time to kind of ask you on datacom here. So firstly, the 400 gig transition, that's obviously kind of top of mind for investors. How is Lumentum positioned? I know you had largely stepped away from a lot of the module business and more focusing on datacom chips. So how should we think about the leverage there in relation to 400-gig opportunity?

Yes. I mean, I think it's a huge opportunity for us and one that we're very, very excited about because our EML offering, which enables transceiver manufacturers to make 200- and 400-gig transceivers is very, very differentiated. And in fact, we're selling that to vertically integrated transceiver module manufacturers. And so from that perspective, and as we said on the earnings call, we booked $90 million of orders for EMLs last quarter alone. Orders have continued to come in as customers see the benefit of designing their transceivers around our EMLs. And so our focus has really been on how do we increase our EML capacity faster, and we took the steps a year ago to start that process and the equipment is online, it's getting qualified. And we think that by the end of the calendar year, we'll have a meaningful increase in our ability to meet the demands of the hyperscalers that are really focused on that transition from DML-based 100-gig transceivers to EML-based 200 and 400, and we're working with them on next-generation products as well. So I think we're very well positioned on the EML and that transition that's happening in the hyperscalers today and over the next couple of years as those move away from 100 gig. The economics are hugely in their favor for making that transition as fast as they possibly can, and we're going to be the beneficiary of that transition.

Yes. I'd even add to that, Alan, that we have DMLs that are now targeting 400-gig, so kind of the -- a cost-reduced, power consumption-reduced 400 gig to really accelerate 400 gig in the coming years and kind of be the basis for things that are beyond 400 gig as we look at 800 gig and 1.2 terabit for the data center. So that move to get out of transceivers is not only liberated us with our direct customers that we don't compete with any longer but, frankly, with the cloud engineering teams directly because there's not this commercial, semi-adversarial in a certain sense, relationship. They're like innovate, innovate, innovate. And we'll push out your technology to the transceiver supply chains to make sure that we get what you guys are producing because it's -- you're listening to us, lower power consumption, lower cost, increased bandwidth. And so that's put us in a very, very good position for the next several years.

Great. So last question, and I think in the minute we have left here, Alan, you talked about announcing the capacity addition roughly a year ago. And I think everyone remembers on the call here that you talked about doubling capacity roughly. How should we think about the revenue impact of that? Because there's obviously some different economics as you go through down the cost curve. So how does that volume -- doubling of the volume capacity really impact revenue?

Yes. I think there's -- our EML chips are bigger, so you don't get the same amount of chips per wafer, but they are at a higher average on the price. And so -- and prices come down over time. We try to support our customers the best way they can -- we can to make them continue to be competitive. So doubling up capacity doesn't mean a doubling of revenue, although it's certainly more than 50% increase as that capacity comes online, and we see that come to fruition over the next few quarters. That's why we're -- we continue to think that calendar '22 has got a bunch of tailwinds that are going to hit at the end of the calendar year this year, including this capacity coming online, the next generation of telecom coming on and ramping. And so it's a pretty exciting time at Lumentum.

I think we're close to the end-of-the-session time here. So Alan, Chris, Jim, thanks for taking the time to do this session, host this session, and thanks for participating at the conference as well.

Yes. Great. Thanks for having us.

Thanks, Samik.

Thank you, everyone, for dialing in. Thank you.

Thank you. Have a good day.

Bye.