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

Good morning. My name is Fahad Najam. I'm the senior equity research analyst at MKM Comm Equipment and Optical Components. Today, it is my pleasure to have with me, Alan Lowe, CEO of Lumentum; Chris Coldren, Chief Strategy Officer of Lumentum; and Wajid Ali, the CFO of Lumentum. This session is for 30 minutes. If you have any questions, please feel free to use the chat session -- the Q&A session in our in your web portal, and I'll be judicially asking questions. I have prepared a ton of questions today. So in any cases, we will probably cover a lot of things today. So gentlemen, welcome, and thank you for joining us today. Let me kick off with kind of my view of the optical component roles, and then I'm hopeful you can elaborate on it, Alan and Chris and Wajid. I think the world is pivoting towards more photonics for electronics, and I think that's really positive for Lumentum. And I think after the NeoPhotonics acquisition, I see only 2 sort of big publicly traded optical component companies left, you and to IIVI. And so the industry has consolidated significantly, and I think the secular shift of an emphasis towards photonics should really enhance your value proposition to society overall.

But with that, let me ask you about the new Photonics deal. In my view, it marks the end of the major phase of consolidation in optical component, and it reflects that the optical component industry is fairly mature. But still the opportunities and the exciting opportunities are still ahead of us, so it's a very interesting dynamic. When you talk about NeoPhotonics, can you walk us through why now, what continue to look at NeoPhotonics. I'll start there.

Sure. First of all, Fahad, thanks for having us at the conference. It's a great opportunity to talk to investors. And so I really appreciate the invitation. On your question about NeoPhotonics and why now? If you go back in time, I've known Tim for many, many years and we've always kind of thought about potentially getting together and never been able to really get it done on terms of what's good for their shareholders and our shareholders until now. And I think that's a result of a couple of things, one of which is -- they've got a lot of great products and a lot of great opportunities ahead of them. And the market for transmission at 400 gig and above court rate is forecasted to grow at a compound annual growth rate of 75%, and that's ports, not revenue. So revenue would be below that as ASPs come down. So between that and the push from some of our customers to have NeoPhotonics in friendly hands and one with a balance sheet they can invest and continue to invest to provide that critically enabling technology to the customers, made it kind of both sides saying now is a good time. Additionally, when you look at their customer base potentially shifting towards more hyperscalers with the ZR, ZR Plus and high-speed optics. I think they realize that having a balance sheet that looks like ours and the ability to invest would give more credibility and more ability for those hyperscalers to say, I'm going to bet my next data center infrastructure on this company, the combined Lumentum-NeoPhotonics. And that's one of the reasons we also extended a $50 million loan to them during this period of signing and closing. So they could invest and show to those customers that they have a backing of Lumentum to be able to make those investments and be there for them as those capacities are needed and they ramp production of new products like the ZR for instance. So I think we got to a point where it's good for our shareholders, good for their shareholders. And I think it really -- the complementary nature of the product lines really makes it more relevant for our customers and the feedback from our customers even before the acquisition announcement as well as after it has been extremely positive.

Alan, you answered my second question was what's the customer feedback been? And I suspected and that my own check suggests that this probably deal was encouraged by your customers to begin with. But let me kind of take a step back and look at the industry. And this is interesting for me as an objective analyst looking at the industry from the outside that the industry is consolidated. I think this marks the end of the last major optical component company out there that's publicly traded. Sure there are a couple of interesting private companies in optical component space, but there are other niches at small. But majority, by and large, I can the optical component industry is consolidated. And I think that's really good for the industry going forward because that means more stability, more rational pricing and for -- at least for your clients, for your customers to have guaranteed R&D sustaining the optical development, which is getting more expensive, right? So the industry is rather mature, it's consolidated. But the opportunities are just emerging, right? I mean whether it's 3D sensing, as you mentioned, 400 gig. So it creates some interesting dynamic that the bulk of the opportunities are still ahead of us, yet the industry structure has matured. So I wanted to get your thoughts on the industry overall as well, if you can.

Yes. I'll give you my comments. I think Chris can chime in as well. I think the markets that we participate in today all have extremely great tailwinds. And so if you look at what's happening on 400 and above deployments, that have really been delayed through this pandemic and now are starting to happen in a meaningful way. So our ROADMs, our pump lasers, our business that are the transport layer really building the freeways in the optical communications space are -- is really, really strong. And if we only get the components, we really have phenomenal growth in the optical communications segment of our business. And so when you look at that, it's always a leading indicator for transmission. So I think we've got years and years of great tailwinds and growth in our optical communications growth area. If you look at 3D sensing, 3D sensing, we're very customer concentrated. But I think we've been investing a lot in broadening our customer base. And that's not going to happen overnight because our one customer is extremely large for us. But we are making those investments so that the longer-term automobile, industrial, automation, LiDAR for different applications, security, AR/VR, there's a lot of things that are just on the beginning of incorporating 3D sensing. And when you look at our commercial lasers business, EVs and battery processing need lasers. And we've come out with a lot of new lasers that should make that business grow quite rapidly. So across the 5 segments we're in today or business lines we're in today, a lot of great stories that are going on to your point, Fahad. But also when you look at new markets, the emergence of new markets that can use photonics to really advance how they do things and drive down power consumption and look at new ways of really addressing global warming, for instance, a lot has to do with optics. And so we're looking a lot at new business opportunities in new markets to use our core innovation engine around photonics to really grow our available market. Chris, do you have anything to add there?

Yes. I think I was just going to add to Fahad's question that the -- you can look at it as industry consolidating sort of from a financial driver standpoint, but I look at it a little differently, which is the customer opportunities are getting so large and the laws of physics are not kind, right? It's very difficult technology advancement that are required to continue to push forward. So driving scale and bringing more and more capabilities into our company is really essential to meeting customer needs. And I think that's to your point of why customers embrace a transaction with NeoPhotonics and want to increasingly work like with folks like us is that recognition that as much as they buy products from us today, the real product we sell to our customers is our roadmap that looks out several years. Because our customers design and build there, whether it's a network or a networking equipment or whatever hardware they may be building around our product roadmaps. And it's -- they're really dependent on our innovation engine. And so getting the most scale, the most talent and the most intellectual property and technology together to be able to create these disruptive solutions they need to continue to push, whether that's across any of our markets is really important.

That's really good. I'm going to pause here. I want to come back and ask you to revisit strategy in more depth in a bit. But let me focus a little bit on the near term on the transaction of the NeoPhotonics transaction. But you've outlined a $50 million cost synergy target. Can you walk us through -- I know you mentioned 60% of it is going to come from COGS. But I've got in a number of client questions asking us, hey, what are the drivers for the synergies, why only $50 million? Somebody just said it to me the other day, you could practically lay off the entire G&A and sales and marketing overlays of NeoPhotonics, and you've got over $40 million of savings right there. So it sounds like a very conservative outlook. So let me ask you the question. Can you walk us through the synergies and how you're thinking about that?

Alan, do you want to start?

No. Go ahead, Wajid.

Okay. All right. Yes. So Fahad, I think it's a very fair question. We also -- when we took a look at the opportunity for SG&A, synergy opportunities, we were penciling in figures that were a little bit higher than what we had communicated out as well as on the cost of goods sold side. We've got factories in Japan and in China that are very close to each other with NeoPhotonics. So certainly, from an opportunity standpoint, we see the upside to the synergy targets that we that we've laid out there. But we're going to go through integration planning. And so as we go through integration planning, we want to make sure that we've done a double click on every one of the items before we go out and make a commitment that it's bigger than $50 million. So we decided to go ahead and make a $50 million commitment as part of our synergy target. But as you saw with the Oclaro acquisition, we came out with a $60 million target at the beginning, and we ended up doing much better than that. And actually, at some level, transforming the entire company from a business model standpoint as we executed on those synergies. And so our desire and thought process is to do very much the same. NeoPhotonics is a business that we also want to invest in. And so from an R&D standpoint, we wanted to make sure we left ourselves enough room. So if we did decide through the integration planning process that we wanted to do a little bit more on R&D, it wouldn't be hindered by a synergy target that we've put out there. So that was really the thinking around why we chose to put $50 million out there for a synergy target rather than something larger than that.

That's very helpful. So we've got the cost synergies. But let me ask you about the revenue synergies. And also in particular, someone asked the other day about potential revenue synergies. I don't think you sell anything to NeoPhotonics, but I may be wrong. But can you walk us through the revenue synergies and how you're thinking about revenue synergies here?

Yes, I'll take a cut and then maybe, Chris, you can chime in. We don't really have product overlap. The products are very complementary. And back to my point I made earlier about the $50 million loan, I think there'll be positive revenue synergies when customers feel that the combined company will be able to support their requirements because these hyperscalers, they don't do anything small. And they're reluctant to bet on a firm that may not have the wherewithal to be able to invest and support their demand needs. And so as ZR takes off really in a meaningful way next year, having that balance sheet and capability and access to that loan to be able to invest, I think will accelerate the adoption of NeoPhotonics products in new customers who don't know them very well. And so I think we're going to get some positive revenue synergies from that. We didn't put that into the model. We -- but I do think there are some positive revenue synergies on that. On the cost synergy, I'll just add to what Wajid said. Across the world, our facilities are pretty darn close to their facilities. And so in Japan, 2 train stops away. We use Fabrinet, they use Fabrinet. Ottawa offices, their headquarter offices at a [ stone stroke ] from us. And so just consolidating people, there's going to be some synergies that we'll get in the first year on the G&A side of the business.

So Alan, you mentioned ZR opportunity, and I think that's really interesting because 400-gig ZR could be bigger. And you mentioned about not putting into your model, and I still haven't yet published my pro forma model. And I've done some back of the envelope math, and the key driver in my forecast is the ZR revenue opportunity. And I think, honestly, no one in the sell side has a good model or handle on the ZR revenue opportunity for NeoPhotonics. And I can easily say here that on a baseline view, assuming no meaningful ZR revenue, I think I easily see a path over $7 in earnings per share, like when that deal closes calendar '23 onwards. Depending on your assumption for ZR revenue, this could be well over $8 in earnings per share or almost $9 in earnings per share. And that tells you the compelling opportunity and why the stock is a compelling buyer in my opinion. But I still don't understand the ZR opportunity. So help us understand what do you think about the TAM? How big is it? How big is the opportunity?

Well, I'll let Chris comment on that. But to your point, a compelling buy today, and that's why our Board authorized a $700 million stock buyback that we've been executing over the last couple of quarters. So I'll let Chris talk about the ZR opportunity and -- go ahead.

Yes. I mean, certainly, from a revenue opportunity outlook in several years, and it's -- you have to -- if you think of it as ZR, but there's something after ZR and there's something after that and there's something after that. And so certainly, even with the envelope we're talking about here. It's a couple of $100 million opportunity when the market is in full deployment mode, right, which I think, as you well know, has been a little delayed in the overall market due to a range of factors, but we believe we'll start ramping much more aggressively in calendar '22. And I think the key point is that Alan alluded to hyperscalers wanting to have somebody that's got financial strength. They also are looking for your, as I said, the roadmap and then the combined company, all of a sudden becomes very, very compelling when you think about the breadth of coverage to build that ZR module, if you will, and to be able to invest in what comes after that in 800 gig, et cetera, and the customers view buying product for somebody like us is essentially investing in our innovation engine for the generation after that. So I think to your point, the -- probably in your model, in many Street models, there's a relatively small amount of ZR revenue. But as we look ahead in a multi-hundred million dollar opportunity for the combined company, there's lots of opportunities to well exceed that. And it's on a couple of levels, right? It can be selling ZR modules but it can also be selling the components that go into ZR modules to other folks, depending on how industry structure evolves over time or the supply chain evolves over time. And so our focus in this transaction And in general, our overall strategy is always to focus on having that lowest level building block technology and having the scale to continue to innovate and deliver low-cost so that, hey, we will have a very compelling ZR offering and also the ability to enable others to have very compelling ZR offerings, either way we win our shareholders win.

That's a very interesting point. You mentioned the road map because I agree with you 100%. I think we are all looking at 400-gig ZR, but there's quite a -- if you look at what Amazon is doing inside the data center, Andy Bechtolsheim had this good presentation at ECOC where he was talking about 800 gig and 1.6 terabit. 800 gig started literally at Google this year. And then by calendar '23, Amazon is like we could move to 800 gig. So the upgrade to 800 gig is probably going to happen a lot faster. And so you obviously need to have a roadmap addressing 400-gig ZR, 800-gig ZR. 800-gig LR, which is coherent light, which is probably going to be a huge TAM expansion opportunity for suppliers like NeoPhotonics, right, for the narrow lasers, narrow tunable lasers. So exactly, I think the opportunity is big. I've seen industry analyst projections around $500 million TAM for 400-gig ZR. But maybe is much larger if you assume 800-gig and coherent light in that math. So it certainly seems that the TAM is far greater than I think even the industry analysts project, but if you include 800-gig ZR and coherent light in that mix. So yes, I think I think the opportunity is big. And if I'm not mistaken, NeoPhotonics is literally designing to every major ZR supplier out there today, right? Their tunable lasers are pretty much deployed by Acacia, Cisco, Inphi, Marvell and Fujitsu, and I don't know about Sienna yet. But they have such a huge presence there. So definitely, I think is a great acquisition for you guys and a phenomenal asset. So we talked about NeoPhotonics and it's at but let me revisit the strategy. Now that we have done with optical component consolidation, what's next? You don't have a coherent DSP. If you see your largest customer and competitor announce Cisco with their acquisition of Acacia, Marvell acquires Inphi. So how are you thinking about your strategy going forward, when you were buying, you wanted to acquire Coherent, you talked about diversification. So how should investors be thinking about your strategy going forward? How are you thinking you doubled down on optical communications and go up the vertical stack? Or are you looking to diversify and get into other end markets? Can you walk us through how you're thinking about your strategy?

Yes, I'd say all of the above. I think the opportunity to get together with NeoPhotonics was now. And it does strengthen our relevance and do all the things that we talked about earlier. But it's not an acquisition that drains our ability to do more different things. We're going to be focused on the integration planning with NeoPhotonics over the next few months, and then we'll think about what's next. But I'd say that we're looking at everything from further vertical integration downward to make us more cost-competitive as well as diversification. So there's a lot of things still out there that are tangential or have optics at their core and markets, either existing markets or different markets. And I think we're subscale in lasers, although that business is growing very, very rapidly. And I'd say that we're probably going to have record revenues in the next few quarters in our commercial lasers business. that's an area of diversification that as that grows organically and potentially inorganically. I think that's a good opportunity for us as well. So -- and then as I said before, we're also looking at organic ways to get into different or adjacent markets using our photonic integration engine or photonic innovation engine. And I think that's going to take a little bit of time as we do it organically. But that may also lead us to acquisitions to get us into those markets and accelerate the entrants in the growth of our TAM.

I think Alan, one point I would add to your answer is that leases are getting prevalent in every aspect of society. It's -- Rockley Photonics just went public, and they're doing silicon photonics for health and wellness end market and potentially getting into medical diagnostic market, which [indiscernible] is not new to lasers, they've always been there. But the opportunities are just far wide in laser. So it's a very exciting time to be a laser company in my view. So shifting focus now. I want to come to 3D sensing, talking about the team of diversification. 3D sensing. Last fiscal 1Q '22, you had record revenue from your largest customer, far beyond what most of us on the South side had modeled. Can you walk us through on what drove that strength? There is some concern in the industry now that there might be some inventory buildup at Apple because of mismatch between their inventories across other components. So can you walk us through on how you're thinking? You mentioned fiscal 2Q '22 is going to follow typical seasonality from the calendar '20 year -- fiscal '20 year. So walk us through the dynamics there, if you can?

Sure, I'll give you at a high level, and then Chris can talk a little bit more about the numbers. I'd say that if you recall a couple of quarters ago, we said, hey, chips are getting smaller so the available market, assuming no growth in units, is going to be down 20-ish or more percent. The chips did get smaller, ASPs were probably not as down as we had forecasted at the time. And so the combination of new chips in the front side and us gaining a lot of share as we launch new products, and I think that's inevitable. Anytime our lead customer introduces new chips, new products, they count on us, and they count on us first. And I think that's the dynamic that happened there. We're trying to give them every possible reason not to move any share. But as any customer, they want assurance of supply. And I think that the pandemic has given people a reason for wanting to do that. I'd say that the component shortages that they've talked about on their earnings call and their missed opportunity to supply that demand is one reason we wanted to make sure that every signaled, that December quarter is going to be lower than the September quarter. But that also may make the March quarter better than typical. And so Chris, maybe you can take it from there and talk a little bit about that.

Yes. I mean I think the point to highlight is our guidance for the December quarter in 3D sensing. It's down and we referenced 2 years ago, but that was more on a qualitative basis. On a percentage basis, it's going to be down perhaps a good bit more. And that's out of exactly, as you said, a conservatism both in the outlook we're being provided by our customers. And obviously, we try to be more conservative than that, given it's one customer. And they have risk in their outlook, especially this time of year, right, as they're trying to figure out what their sell through is, et cetera. So to Alan's point, we've seen over time kind of the December quarter numbers come down a little bit; in the March quarter numbers come up by about the same amount, reflecting that what is -- we're not being necessarily overdriven in a vacuum that we are seeing the same kind of things that you're referencing where there may be some pushouts due to constraints. But again, it's obviously, as you know, and it customer in this time of the year. It's a dynamic environment, and so that's why we tried to be pretty conservative. And I think though a different question, it's also why folks appreciate, there's a lot of telecom and datacom growth in our December quarter guidance that perhaps is masking how much the 3D sensing assumption, at least, for how the guidance is happening.

We're under 5 minutes. So I want to do a better job asking shorter questions. Very quickly, behind the screens, there's a lot of questions around future designs. What's the opportunity behind the screen, facial ID, smartphone cameras?

Well, I would say a couple of things. First is, obviously, within our top customers. It's a new technology and harder technology. And as Alan alluded to, we tend to do pretty well when something is new and difficult and it both on the innovation, but the ability to ramp that up. The other part of that opportunity that's driven is that in the Android space, there's been some challenges in getting them to adopt as quickly as we had all hoped. And one of the front side impediments is they like the full edge-to-edge display, et cetera. So being able to go under display, also offers a feature that customers might be more willing to adopt than something that requires a notch.

Okay. Very quickly. I think in the infrastructure bill that President Biden just sign into law, there is a new mandate for automobile manufacturers to have anti-intoxicated drug driving technology in the cars. What do you think about that opportunity for you? I suppose this is going to be a massive new opportunity in the in-cabin 3D sensing. So you can walk us through that?

Yes. I'd say that, that mandate already happened in European cars, and we'll be into I don't know, the next 2 years of future models that need to incorporate that. So we've gotten our feet wet certainly in getting going with design-ins for in-cabin monitoring 3D sensing. I think this does accelerate the adoption in the U.S. And so that makes the market bigger, faster as opposed to the typical adoption in automobiles, which is very slow without government intervention. So I think it's a great opportunity for us.

Switching gears to ROADMs at telecom, obviously, you had component shortages impacting your ROADM shipments. But walk us through component shortages. What are you seeing right now in terms of -- walk us through the dynamics in the telecom end market.

Sure. I think in the September quarter, we said that we missed about $30 million of demand that turned out to be closer to $40 million of demand because of chip shortages, mostly from telecom, mostly from telecom ROADMs because it's got so many ICs on it, in a ROADM or ROADM blade. As we look forward and to Chris' point, our telecom and datacom revenue is growing dramatically in the December quarter, but the demand is growing faster. So that gap in demand at the end of December, we believe, is going to be north of $40 million. And so the reduction in 3D sensing in the December quarter is being offset by the growth in telecom and datacom, which is exciting, but the demand is even growing faster. So I think we're in a great position. Chips are becoming more available if you're willing to pay for them. So that's what we've been doing last quarter that supplies chips this quarter that allows that growth. And we think that the chip shortage is going to be -- we're going to be impacted by that through the first half of next year.

All right. That's really good. I think we've got maybe 30 seconds. Alan, what do you think about industry cadence? Cisco just announced a 1.2 terabit of wavelength solution? I think the industry is on for a 2-year cadence cycle. Any quick thoughts there?

We're going to certainly enable the heck out of that. So it's a great thing that the combined NeoPhotonics-Lumentum company has the core building blocks to enable that kind of thing, whether it be silicon photonics or indium phosphide and ultra-narrow tunable laser is definitely required for those high-speed programs. And so I think the tailwinds are continuing.

All right. With that, we're almost out of time. Thank you for your time, and I wish you all a very good rest of the day and rest of the week. Thank you.

Thanks for having us. Bye.