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

Great. Thank you, everybody, for joining us today. I'm Meta Marshall. I head up the networking coverage here at Morgan Stanley. I'm joined here today by Lumentum. With us today, we have the whole host -- whole panel. We have Alan Lowe, CEO; Wajid Ali, CFO; Chris Coldren, SVP and Head of Corporate Development; and Jim Fanucchi, who heads up IR. And so if you have any questions, feel free to e-mail them to me, but hopefully, we'll keep this a fairly efficient dialogue. So Alan, thanks so much for joining us today.

And maybe I just wanted to start off with probably what's kind of the question you get the most or what I would assume the question you get the most on, is just what you're seeing as far as supply chain and just what kind of overhang that's creating today and when do you see that kind of resolving itself.

Yes. First of all, thanks, Meta, for having us here today. It's great. I had some great meetings already, and always look forward to this session. As far as supply chain is concerned, as we closed our September quarter, actually, when we announced our September quarter, we indicated that there was about $30 million of revenue that was not satisfied due to semiconductor shortages. We also see that actually improving this quarter through working harder in our supply chain to find where these chips are as well as what we started about a year ago to try to qualify second sources that is not a trivial thing to do. But as we even got more supply and increase in our telecom transport, which is really the area that got hit the most or is getting hit the most, our gap to being able to satisfy the growing demand is actually growing in the December quarter. So it's really a couple of things. One, the supply chain team is working very efficiently and very well to get the supply, but the demand is actually growing faster than our ability to get the added chips. I personally think this is going to go on through the first half of the calendar year at a minimum. And we're doing everything we possibly can to mitigate the impact on our customers by qualifying new sources that maybe aren't as constrained but also working with our suppliers to figure out how do we give them long-term assurances that we're here not just for a blip but really here for the long term for them.

Got it. I mean just in terms of being able to mitigate or find second sources, I guess, just what is the qualification time line? And does it kind of vary by product? Or just how should we think of ability to second source some of these equipment?

Yes. It's really difficult, and it takes about a year, especially when you have to write new firmware to take advantage of these different chips. And so then our customers get involved. We do a lot of testing. So from the time -- and we did start this, as I said, a year ago. The time that gets kicked off and you have the dialogue with your customers until they're accepting product, it's probably a little bit more than a year. But luckily, we did start that effort about a year ago, and we'll start seeing the benefits of that really in the first calendar quarter with shipments.

Got it. Okay. That's perfect. And then maybe just given kind of applicability or newness, maybe let's just spend some time on NeoPhotonics. And so clearly, certainly a leader kind of within the high-speed space. Just kind of if you could refresh us on just why this was the right acquisition at the right time and just how it positions you best as we head into some of these higher-speed upgrade cycles.

Yes. Great question. And one of -- the acquisition, we're really excited about because we believe that, to your point, the 400, 600, 800 gig deployments are starting in a meaningful way as we speak. And we think that the compound annual growth rate of those ports, as estimated by independent third parties, is going to be around 70% CAGR for the next several years. And so I think the timing was right. And their technology leadership in the ultra narrow linewidth lasers is critically important to our customers. And so our customers are very excited about the combination because we bring the strength of a balance sheet and the ability to invest along with their great technology. And together, we're a more end-to-end supplier, a more important supplier to them and one that I think really most, if not all, of our customers are happy with given that it could have fallen into enemy hands, if you will. And we're kind of the friendly hand that has shown that we can do acquisitions and really make sure that the customer is first and foremost in everything we do.

Got it. And maybe this kind of overlaps into the answer that you just gave, but you clearly had a very successful Oclaro acquisition that maybe some of the similar concerns of wanting to see an asset kind of fall into friendly hands and put it into something that had real financial backing. Just are you repeating some of that same playbook? What is it? Or just how will what you learned from Oclaro help in the NeoPhotonics process?

Yes. I think we have a lot of learnings from that in how to attain synergies and how to take care of customers through the integration plan and through the integration itself. I think it's a little bit different now in that we are looking for technologists and R&D engineers. And so our synergies are not going to come from that as much as they're going to come from the fact that our footprint -- our global footprint matches up very, very well with NeoPhotonics, whereas in the Oclaro acquisition, we brought in some new sites in new countries. And I think from our perspective, the synergies should come fairly simple, just by moving the people into a consolidated footprint. And I think through our ability to take advantage of the breadth of capability at NeoPhotonics and combine it with the Lumentum team, I think we're going to accelerate innovation to the point where I think we'll continue to have a leadership position in the products that -- in the markets that we participate in. So I think that's an exciting aspect of the new acquisition as well.

Got it. And maybe just turning to Wajid for a second. Just how do you think about kind of the synergy targets that you gave in terms of what you could achieve with NeoPhotonics? And just how do you look at kind of achieving that over the next 24 months?

Yes. No. So Meta, I think Alan mentioned it earlier. We've got a very similar customer base, and we've got a very similar both manufacturing footprint and facilities footprint as well. And that's going to help us a lot when it comes down to some of the synergies that we've committed to. Because they have -- because NeoPhotonics has a very similar customer base, we're going to see a lot of synergies in our SG&A functions and because -- and not so much in R&D. And I think last year, of the $90 million NeoPhotonics would spend on operating expenses, probably about $35 million to $40 million of it was in SG&A. And so there's a lot of opportunity in SG&A because of the similar customer base as well as the manufacturing footprint being similar as well. On the cost of goods sold side, we share some of the same contract manufacturers. They have their pricing model, we have our pricing level. Our expectation is, is that our pricing model is better. And so we'll be able to extract material savings from there from a BOM standpoint. And then from an infrastructure standpoint -- and that's really the reason we've given ourselves 24 months to be able to achieve the synergies on the cost of goods sold side. From an infrastructure standpoint, we do some consolidation. In Asia, they have got a Japan facility. We've got a Japan facility. We've got a facility in China, and I think they've got a facility in China. And one of the opportunities that really exist there is for us to have some type of infrastructure consolidation from a manufacturing standpoint. And then in addition to that, there's some basic business processes that we've really been able to excel on from a Kaizen standpoint and quality metrics and process efficiencies that we honed in very well when we did the acquisition and integration of Oclaro. And we've seen that pay off in spades through the gross margin improvements that all of us have seen over the last 6 to 8 quarters. And a lot of that is the Kaizen work that we've done within our telecom business. And so what we're hoping to do is to copy and paste that from a business process standpoint and be able to achieve better quality metrics and have better cost efficiencies as well through productivity improvements. So kind of when you take a look at all that, we think that our ability to achieve $50 million in pro forma synergies is pretty straightforward.

Got it. That's super helpful. Are there any, just because there is so much kind of customer overlap, either revenue synergies or revenue dis-synergies that we should be thinking of with either allocations? Or are the product sets different enough that that's not a consideration we need to take into account for now?

Well, I think -- so we haven't actually outlined any type of favorable revenue synergies as targets we've conveyed, but I think Alan mentioned earlier that customers are really excited that we're going to be together. And the big reason for that is because we've got a much stronger balance sheet. And so there are multiple customers that are super excited about NeoPhotonics' products as well as their product road map. And if they were on the border line because of the financial situation that NeoPhotonics had, even though they just turned profitable in the last quarter, they're a lot more comfortable with Lumentum being the parent and being able to help service those customers for a longer period of time. Because you can appreciate the investments that end customers are making are pretty significant, and so to have a quality and reliable supplier that can be a partner with them is incredibly important. So the product innovation from NeoPhotonics' side and our breadth and our balance sheet is a great combination. So I think that, that will help from a revenue standpoint. And I don't know if you want to call it revenue synergies, but it will certainly help from a revenue growth standpoint as well as at least on R&D that Alan mentioned earlier that we're looking to do.

Great. That's perfect. Clearly, we've seen a lot of acquisition activity over the past couple of years, whether it be Oclaro or II-VI and Finisar and kind of other acquisitions that they've done. And so just where do you feel like the space is in terms of consolidation at this point? Or are there other meaningful moves that you think are out there or positive...

Yes. I'll give you my thoughts. And then, Chris, maybe you could chime in as well. I think as you can imagine, we have a pipeline of things that we look at from anything in our existing markets as well as in new markets where photonics, we think, is going to be a critically enabling technology for new markets. And so I do think there's going to be more acquisitions, whether it's in telecom or datacom or 3D sensing or lasers or could be in something else that may be an emerging area for photonics in general. So I do think there's more room to go. And I think that given that our balance sheet is continuing to be strong even after the acquisition of NeoPhotonics, we certainly have the firepower to do more should we decide to do that. Chris?

I think the only thing I'd add is -- I mean good point, Meta, that a lot of the companies you think of that were created or at least became known 20 years ago in the telecom boom period, we've seen the industry unwind into a healthier structure with a fewer set of players that frankly, are doing a better job at serving customers because they're better able to invest in technology and manufacturing capability. I don't think that ends in that, as Alan highlighted. We're pushing into new markets, and it's not even just new -- I mean optics is pushing closer to the chip level, for example, in chip-level interconnect, which makes us very relevant to semiconductor space and compute architecture, et cetera, let alone industrial and life sciences and other markets. And M&A is a great way to accelerate innovation as well as scale. There's lots of small- and medium-sized companies that have interesting technologies but haven't quite scaled up, if you will, and are not maybe at a level of being able to do business with the kind of customers that photonics are becoming increasingly relevant to and expects somebody like Lumentum -- Lumentum ends up being a smaller supplier in some ways to some of these large, large companies. And so our ability to integrate both small and medium technology companies as well as opportunities to expand the use of photonics in other end markets, M&A probably plays a critical role in that.

Got it. That's super helpful. And maybe just a last question on that before I jump to 3D sensing is just understanding you don't own the asset, but is there anything you can be doing to help NeoPhotonics with any supply chain issues that they might be having just kind of in this interim period? Or are there pretty higher built walls for now?

Yes. I think we're in the higher built wall space. I would say that the one thing that we didn't mention earlier is the fact that we -- as part of the deal, we provided a loan that NeoPhotonics can draw down on up to $50 million. And we think that between the signing and the closing of the deal, there could be hyperscalers that say, "Hey, I'm now ready to bet on NeoPhotonics, whereas perhaps I wasn't before because of the backing of Lumentum and the financial availability of funds to be able to increase their CapEx and increase their capacity to satisfy a hyperscaler," for example. So I think from that perspective, we can help them with that. And we did that and it's in the agreement. But as far as working together to collaborate, that's, I think, post-close effort that we're going to take on.

Got it. So it wouldn't be a Lumentum call without spending time on 3D sensing, and I have some audience questions that have kind of come in around this category as well. But maybe just starting with you guys outperformed kind of your own expectations of the cycle through a combination of what's seemingly share shifts -- favorable share shifts and just kind of a greater kind of demand in terms of Apple. And so just what helps make those share shifts permanent? Are you concerned about kind of other competitors coming into the space? That was kind of a question that came in from the audience, is just will this always be kind of a 2-player market or will there be more players that enter into the market with your leading customer.

So yes, I certainly think we did well in 3D sensing recently and frankly, over the past 5 years. And our focus continually is to always be that partner of choice for the customer. And with that focus, then what tends to happen is winning, right? And that's -- we've highlighted that every time there's something new or different or a new product design, we tend to do very well given that role we play as an innovation leader and partner with our top customers. And we think in the consumer space, scale and volume matters. So your point of is it a 2- to 3-player space over the long run, probably more that than, 5 or more player just because there's no way for anybody to be successful with fragmenting the market that way and not having sufficient scale. And what we've seen is our manufacturing scale and R&D scale allows us to keep pace with large customers that want to move very quickly as well as they want you to develop a lot of products for potential new products on their side and not all of those see the light of day. And so you -- to be able to absorb that uncertainty in your R&D investments, you need to have a certain scale as well.

Got it. I mean in terms of a market that's largely kind of 1 customer today, is that something where you see 2 to 3 providers within that lead customer? Or as the market develops, that will -- it will become a 2- to 3-competitor type space?

I think the answer is the same in a sense that since they're consuming such high levels of product today, they create the market and creates the -- essentially, the competitive landscape. And so I think they certainly have a desire as anybody would have. We talked earlier about supply chain concerns and risks and the impact of having sole-source situations. I think they're a very smart and experienced customer when it comes to ensuring that they manage risk in their supply chain. But our strategy is okay, that's fine. But at the same time, let's give the customer no reason to want to do business outside of that kind of concern and offer superior value in our product offer, superior quality. And obviously, as we hit on more innovative solutions that continues to move the goalpost, then we're running the fastest and out in the lead. So we'll naturally be best positioned for those new goalposts. Now as you look to other markets or other customers, I think it would be very difficult to be competitive with those customers in those markets without having the experience and scale that comes from leading in with the existing customer and applications.

Got it. That's helpful. I mean just in terms of -- obviously, there's a lot you can do with 3D sensing, autos, other -- the Android ecosystem and any number of things. I'm sure there's a metaverse play, which is very exciting for you guys. And so just how do you see those time lines developing? And clearly, you guys are in best positioned to take advantage of that. But just kind of how do you see that process or time line playing out?

Yes. I mean certainly, within the handset space, it's been disappointing that we've not seen large-scale adoption outside of our top customer. But I also think you've seen some crazy dynamics where -- one of the leading Android vendors in 3D sensing is Huawei. And given what happened with them and the U.S. government, that kind of created a set of dynamics where, all of a sudden, our lead customer started picking up share from their lost business, if you will, at the high end. And it drove the rest of the Android space to focus on maybe cost a little more than features, if you will. But that's, I think, settling down a bit. And now all of a sudden, you see Honor now as a stand-alone company and brand, and they're working on 3D sensing things and the vivo, OPPO, Xiaomis of the world working on 3D sensing now and a lot of that driven via -- for both photography reasons, computational photography, as well as augmented and virtual reality, which we think is going to be the next -- from a time line standpoint, next big leg to the story that it will be both driving handset functionality but also the wearables. And other new devices that will be coming down out of -- whether it's our top customer or other customers in the consumer electronics space really require 3D sensing capabilities, optical sensing capabilities and multiple ways to enable the functionality, as you said, for AR/VR or the metaverse or other entertainment and functionality platforms looking forward. And then you've got the industrial side of things, which you could include automotive in it, but there's also warehouse -- robots for operating in warehouses, delivery vehicles that are all increasingly turning to optical sensing for autonomous operation to reduce the amount of sort of human content needed to ship and manage online retail, if you will. And we see all of those rolling in at various degrees over the next 2 years. And then the traditional automotive is a little bit longer term given the long design cycles, if you will, in the automotive space. And probably, COVID the last 2 years have not been kind to those time lines, I would imagine, just given traditional auto manufacturers' situations.

Got it. That's super helpful. A couple -- just maybe 2 more topics that I want to hit on before we wrap up today. And the first of those is really the China opportunity. When it came to -- kind of a couple of years ago, obviously, you guys have a lot of exposure. You were very -- any tender activity that was coming out of China was moving your stock meaningfully. And just -- you obviously mentioned the Huawei ban. There's been a lot of back and forth with China opportunities over the past couple of years. But just where -- how do you guys see the China opportunity versus maybe how you did a couple of years ago? And how do you find ways to still participate in what is a very large portion of the market?

Yes. So maybe I'll take that, and Chris can add to it. We did have Huawei as a meaningful customer 2 years ago. And when the first government action took place, they basically moved all of the business that they could away from us where there was a non-U.S. supplier. That said, they're still relying on us for many different products like pump lasers and ROADMs that are basically only Lumentum and one other U.S. supplier for the most part. That said, we've become even more important to some other Chinese-based customers of ours that have taken up some share. But I'd say that the whole Huawei thing, as they've lost share through this transition and we have a smaller portion of their wallet, as those businesses -- for example, in Europe, as those networks get built out with Western suppliers that are customers of ours, our share of wallet is much larger. And so therefore, as a shift goes from either a Huawei to a ZTE or FiberHome, we gained share. As it goes from Huawei to the Western or European suppliers that are customers of ours, we gained share. So I think from that perspective, the share loss has already happened with respect to what's going on at Huawei, and now we're starting to see a pickup as the shift from Huawei to other customers has really taken place.

Yes. I think the only thing I would add is we've talked about exiting products over the past 2 to 3 years. That has been a little bit of a revenue headwind. It's been a tremendous profit tailwind. And a lot of those products were targeting Huawei. And so in a sense, that revenue reduction that we've seen with Huawei, we've taken out a lot of the costs associated with that. So it's not been a headwind to profitability, if you will. And then as Alan alluded to, as either outside of China that ramps up, then we get the incremental margin. But as well, China is still a big market, and we have close relationships with all the network equipment manufacturers in China. And even with Huawei, we -- where they can't get products from the non-U.S. suppliers, they have to turn to us and we'll continue to focus on winning in every geography and maximizing the opportunity in the telecom space.

Got it. And if anybody has a quick answer just on -- or not quick answer. We have a couple of minutes. But just in terms of -- there has been a lot of new builds that people have been waiting for and looking for, kind of certain transport -- kind of increases in transport. Clearly, that's kind of more of a supply chain constrained area right now. But just what you guys are seeing in terms of new build versus transmission growth and just how you're seeing that develop currently.

Yes. I mean we -- over the last couple of quarters, we've seen near-record pump laser shipments. And pump lasers are really critically important to amplification. So to your point, the first thing to go into new build networks are amplifiers and ROADMs, and we've seen that the pump laser part of our business, really, really picking up. And that's typically a great leading indicator for more transport equipment as well as transmission gear that comes on after you build out the transport layer of the network as you light up new wavelengths of light. And so that gets back to your earlier question around why we're so excited about NeoPhotonics. Because that's perfect timing for us to really take advantage of the growth in 400, 600, 800 gig transmission rates and what we think is really a great opportunity for the combined company.

Perfect. Well, with that, we can wrap up. I never said my disclosure. So if you didn't check out our disclosures, you can check them out at morganstanley.com/disclosures. But Lumentum, Alan, Wajid, Chris, Jim, thank you so much for being here today. And if anybody has any questions, either follow up with myself or Jim, and we can get back to you. Perfect. Thank you so much.

Thanks for having us.