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

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time for us and for NeoPhotonics quite frankly, to get together with someone of more scale for a couple of reasons. Our product portfolio is very complementary. They've got an excellent set of components that go into the high-speed optical networking, transmission space. They're working on ZR and ZR+, we're working on more of the longer haul stuff. They bring silicon photonics as well as other IC capability with TIAs and drivers that are very, very complementary to us. And so we looked at the technology. We looked at the market inflection point as 400, 600 and 800 gig really start taking off and are expected to grow at a compound annual growth rate of 70% on port count, not revenue, but because prices will come down, but on the port count over the next five years. So, we thought it was an exciting time for us. On the NeoPhotonics side, they're on the precipice of really growing strongly and they're having to convince customers that they are the partner of choice for them. And you look at the hyperscalers where they're working to get designed in and start to ramp on things like ZR. And as a stand-alone company, NeoPhotonics didn't necessarily have the balance sheet that would instill confidence that they will be able to continue to invest. But together with Lumentum, that's certainly giving the message that the balance sheet is there, the investment is going to be there, and we're going to invest in the capital and capacity needed to support the kind of ramps that the hyperscalers need. And that was another reason why we offered up in the deal a $50 million loan that they could draw down between the signing and the closing to support these kinds of brands. So it's a very, very exciting time for us.

Yes. And I think people have talked about ZR for a long time as a huge opportunity in your industry, like -- in terms of timing, going into the year, people thought it may be midyear, we're kind of getting later in the year now. What's the time frame on the ZR deployment? Is it actually happening now? Or is this more of halfway through 2022?

Well, I'll give you my thought, and maybe Chris, you can chime in. I think it's a lot of work to get designed in and get both the components they are getting designed into these ZR modules but also the ZR modules to get designed in. But I really think it's a 2022 ramp and probably a more meaningful second half ramp than first half, but I think we'll start seeing some volumes beginning early part of next year.

And can you talk about strategy in the ZR market? Obviously, as a module manufacturer. When you move to ZR, there's a big DSP that comes into play. Is strategically -- does it change the way you look at the market when you go out and have to source a bigger portion of your bond from an IC developer? How does that change the ecosystem with you and your competitors there?

Yes. I mean, our strategy has been to partner with the DSP providers and NeoPhotonics did the same. And so instead of spending the $50 million or $60 million or $70 million to develop a 3-nanometer DSP, our strategy has been to partner with those semiconductor companies. And so far, it's working fine. I mean, we had a partnership on 100 and 200 gig that worked fine. We have partnerships on the 400 gig, and we're looking at what to do next on 800 gig. And bringing in some of the complementary semiconductors around the DSP make a lot of sense, and that's one of the things that really attracted us to NeoPhotonics. But I think our strategy today is partner with the leading DSP suppliers and make sure that together, we have the module costs that our customers need and be able to support the margin profile that we need as well.

Helpful. Switching gears, another part of the telecom business. The transport side, you've seen a bunch of ups and downs throughout the year. You've had some bumps with customers that's largely out of your control to some extent. And then you also have a North American customer who's been going through a variety of different ramps of the year has gone on. So you've called out ROADMs and line cards being impacted by shortages on the last earnings call. I guess question one is the larger question, how are shortages currently and have things really improved? And question two, is with the changing landscape, can [ Coriant ] and Ciena stay at these high single, low double-digit percentage customers? Or is the landscape really changing where you're going to see a more diversified telecom business longer term?

Well, I'm not going to get into the specific customers other than to say that the demand for our ROADMs and ROADM line cards and amplifiers and pump lasers is very, very strong. As we said in the September or the November earnings call for the September quarter, we were unable to satisfy over $30 million of demand in the September quarter. And while we're growing our telecom business in the December quarter and growing the transport part of our business by getting more semiconductors in and being able to supply more, that gap is actually growing because the demand itself is growing faster than our ability to get those chips. And so we expect that in the December quarter, there's probably $40-plus million of unsatisfied demand. But semiconductors we are getting, they're costing a little bit more, and that's putting some pressure on margins. But we're doing everything we possibly can to get our customers what they need when they need it.

Okay. And then as time goes along, are you going to adjust the way that you look at the universe as well, obviously, your input costs are going up. How do you view your pricing power in this ecosystem? Do you have the ability to go to your customers and say, "Hey, look at our products are costing more, we're going to charge more as well? Or is that something that you wouldn't pursue?

We're in this for the long term, Tom. And our customers have really excellent memories. They are our partners. And as we design new products with them, we commit to pricing, regardless of what happens externally, at least from my perspective, and we honor that pricing with our customers. As we go through new bids and new opportunities, I view it as maybe pricing going down less than typical, given the increased cost. But we're working very diligently to drive down our internal manufacturing costs to offset some of these increased component costs. So I think our customers appreciate our approach to this situation, and they're getting hit, not by -- not just by us or they're not going to hit by us, but they're getting to hit because they buy semiconductors as well. So I'm a little bit sympathetic to them, and I think they appreciate that and we'll hopefully remember this as we get through it.

Fair enough. One more, just digging a little deeper there. If you look at where you were from a supply perspective at earnings and you look where you are now, would you say that the environment has gotten a bit better, the same? Or do you think it maybe has gotten a bit worse? Any comments on that would be helpful.

I don't think it's changed much. I think my frequency of speaking with semiconductor company CEOs has increased, and that tends to be the squeaking wheel that gets the attention. So I think Chief Executive Officer has now turned into Chief Expediting officers. And that's okay because I think that's what our customers need. So I don't think there's anything meaningfully different, and we continue to get surprised from time to time, but working with our suppliers and distributors, we're able to get some of what we need, but not necessarily when we need it.

Fair enough. All right. Switching to another big topic you kind of started off with as a big opportunity for you guys. EML lasers you talk about how big that opportunity is for you guys as a company? And can you just remind us why that technology is so important in the evolving ecosystem that you guys play in?

I'll let Chris go ahead and tackle that one because I've been talking a lot.

You get a sip of coffee there. So for us, well, I take one step back and obviously, the transceivers going into data centers is, say, a very large opportunity measured in the billions and even over the longer run, almost approaching double-digit billions. And the laser component that go into it, just rough order of magnitude, maybe 10% of that market. I think what's important to highlight as we have over the past few years is there's a lot of players at that transceiver level and many fewer players at the laser level. And so as opposed to sort of knocking heads with a dozen other folks at the transceiver level, we've really focused on providing the laser technology at that next level down. And just sort of highlighting the industry structure difference. We're now at revenues that are comparable to early or when we're selling modules, selling chips, because we're able to participate in a much more meaningful way in that it's a healthier industry ecosystem at the laser chip level. And what's really exciting for us is while we had great business at 100-gig transceiver speeds that is as world transitions to 200 gig and 400 gig, it's exponentially more difficult to make the lasers work and function the way they need to do, and that's an area where we have very good technology and market leadership positions. And so we've been growing that business quite rapidly and underscoring how strong demand is. We have multiple quarters of backlog already booked about 8 -- 12 months ago, 18 months ago, we talked about doubling our wafer fab capacity. That's just about coming to productivity at this point, also adding another slug of capacity that will come online about a year-ish, maybe a little less than that time frame from today. So a lot of investments in capacity to serve that growing market as both our market share increases as we go from 100 to 200 to 400 gig as well as, obviously, the dollar content associated with those transceivers increases as you go up in speed.

That's helpful. And you've undergone this massive transition, right? So module player, not a discrete component tree, that's obviously helped the gross margins along the way. You talked about the constraints. Can you talk about your confidence, obviously, there's always risk in ramping new capacity. You need to get this into the market quickly. How confident that you're able to fulfill that backlog you talked about over the time frame that you kind of laid out? Obviously, it's very difficult to do. It's nice to stay in practice. But do you talk to your confidence level of catching up on that demand that's already in the system and getting that capacity online?

Well, I'm hopeful we don't catch up with it, and we hope that it continues to grow, and that's our expectation. And that's why we actually approved and started procuring the second slug of capacity increase. So yes, you're right, adding wafer fab capacity is not a simple task, and that's why you need to plan for multiyears when you make these investments and it's millions and millions of dollars to do. I'm very confident in the team that we have in Japan where our datacom wafer fab is. They're very diligent and doing a great job bringing that equipment in and then doing the qualification work and then qualifying it with our customers. And so I think it's not a matter of if it will happen. It's a matter of, is it going to be in the March quarter or more in the June quarter. It's happening and the second tranche will happen, as Chris said, really more in the second half of the calendar year.

Right. And I know you don't want to speak directly to customers, but the reason I ask is just a lot of the conversation in the market right now has been this big CapEx increase by Facebook. There's this transition to 200G FR4 next year. So the way that Lumentum benefits from that, can you talk about that? Is that mostly discrete lasers? And then could you maybe, from a hyperscale perspective, talk about what's the opportunity look like for you in those transitions as these hyperscalers move from a traditional appointment to 200 or 400G deployments.

Yes. I mean it's all about what Chris talked about. The capability and our team producing these EML lasers that there's less than a handful of people in the world that can make it and giving them the capability to make those transitions to the 200G FR4 type of product. And so we're working closely with the hyperscalers to understand their road map not just for next year but for the years after because it does take multi-years to develop next generation of EMLs and as well as DMLs. And so we're pretty confident that we have a great a pipeline of new products that are aligned well with the hyperscalers. And so as they move from 100 gig, where there are DML lasers, suppliers and transceiver companies where we don't have a huge footprint because it's not an EML, but as a transition, there's a lot fewer competitors, and that's why we're so confident in our ability to add that capacity and then utilize it as the demand ramps up.

Helpful. And then the last function is here on the datacom side. I think you put the front haul exposure there as well, which is a bit unique in that bucket. So you've seen this ramp of 5G, right? So you've had China, China has kind of come down. And there's this expectation like, hey, the U.S. and Europe are going to start deploying here. You've heard some of your peers talk about that ramp up forthcoming in the next several months. Can you talk about what your exposure is there still? And do you have an opportunity to grow that business versus the peak of where it was with China? Or are we kind of seeing like the heyday of the front-haul market and you kind of are expecting something steadier in the course of the long term.

I was going to say, we continue to participate in the front haul opportunity, obviously, through selling, as you alluded to, we classified under our datacom more from a technology standpoint, even though it's a telecom application, but supplying high-speed lasers that are used in the front haul interconnect I don't think we've seen by any stretch the heyday, if you will, of that. I think what we saw was a time period where, particularly in China, they set national goals to -- and ramped from very little to a lot very quickly. And when you combine that with supply constraints and actions U.S. government took that create an environment where maybe there's a little over purchasing and then they ended up needing to slow down because they weren't able to deploy the base stations as rapidly as they were deploying. And so we're in a position now where we're seeing the inventory in the channel in China, in particular, starting to move, but not as quickly as it needs to burn off the inventory in the last quarter, but we will start to see that revenue tick upwards throughout calendar '22 because 5G is still very much in its early days. And something I wanted to kind of close the loop on Tom, is that you started talking about ZR and 400 gig and when is that going to inflect and we move the data center. I think you have to also -- this is all connected, i.e., the word network and what's one of the reasons why 400-gig ZR and 400, 600 and 800 gig is going to ramp dramatically in the telecom space is that the data centers are upgrading to 200 gig, 400 gig. They need that additional speed going in and out of the data center as well as within the data center. And where is it all going? Well, 5G handsets is a major driver in the future of this. So we're really focused on making sure we've got bets placed across the entire sort of universe of applications for our technology in networking where there's going to be growth. And at the same time, probably missed a little bit in our numbers is over the past couple of years, we've done a lot of work to clean out both the datacom module business, some 100 gig, 200 gig telecom technology that would be cannibalized by what's ramping up in telecom these days. So really, it's great because it -- all these high growth rates you hear about at 400, 600 and 800 gig usually, they're offset by some of the cannibalization of the lower speed, but we've already cannibalized a decent portion of the business that would be negatively impacted by that market transition. So we're going to be a little more uniquely exposed to that high-speed growth over the next few years.

That's helpful. Understanding the dynamics there. Okay. So I said I'd wait a little bit here, and Alan, I know that you mentioned I'd get to it eventually, but I just wanted to dive into the 3D sensing ecosystem. So when you look at your report the numbers kind of imply a very high share in the new models of your largest customer there. So can you talk about -- and I understand it's sensitive, but to your best of your abilities, can you talk about why share would move so drastically in a market like that? And just talk about your expectations for the remainder of this ramp. Can things move around? Do you feel like you have a good position there just talk to what you're seeing in that market right now?

Yes. I mean I think any time a customer or a lead customer in this case, has a change in technology or change in chips. And we've shown over the last five years now that we can be their partner of choice for these ramps, they tend to want to go with a proven track record. And I think that's what you saw in the September quarter results. That said, I do think it's natural for any customer of ours to want to have security of supply and to give some share to a competitor. Our focus is really to give them no reason for doing that and focus on really ensuring the highest possible quality that we have a track record of doing making sure we have the components there when they need them and have the ability to up flex if they continue to demand more and really not have any reason on a cost standpoint. And I think our foundry partner model with 3D sensing has given us a competitive advantage of that flexibility, the quality, the proven track record and a cost because our team was working very closely with the partners to drive cost out and it yields up and have just pristine quality that I think really doesn't gives our lead customer no reason to want to shift more to another supplier. So our focus is to continue that. We're working on a bunch of new chips for 23, 24, 25, some of which may never see the light of day. But we want to be that partner of choice from production back to R&D to development, to concept and we get consulted from time to time on is this possible? What do you think? And I think that's the approach we want to take with that customer as well as every customer.

Yes, you answered it partially there. But when you look into future generations of that customer, there's been talk about major structural changes. You saw a large strength this year, which is in its own right, a major structural change, and you guys were able to execute there. But I think a lot of the conversation is about you've seen the Android community move more to time-of-flight solutions I think that there's a real conversation out there about your largest customer moving in that direction as well. What would that mean to you in terms of a content perspective? And then does that open the doors from a technology perspective to people who aren't as successful as you in terms of the VCSEL arrays in the front of the phone. You talk to that dynamic as you move into future generations?

Sure. I'll give you my thoughts, and Chris you can chime in on Android and such. I don't know the product plans of our lead customer. They don't tell us. We work on chips that we have no idea what -- what's the purpose of them, have an idea. But I'd say, at least my belief is content this past year went down because of chip shrink. It's really hard to shrink it more and have the same functionality. So my belief is that there's going to be more functionality in next-generation devices, whether that's mobile handsets or tablets or other products, and that could actually increase the content per device. And so I think -- our -- again, our feeling is, whether it's time-of-flight or structured light, it doesn't matter to us. The competitive landscape is pretty much the same. I'd say that our lead customer has a superior track record of that front-facing capability of security and dependability and it just works. And I think from our perspective, a change at that point. I don't know what might compel them to do it, but I'd say that we might see actually an increase in content as we look forward into the future years. Chris, do you want to talk about the inquiry?

Yes. I mean I think -- well, I think one is not to confuse. I mean time of flight is gaining traction in Android because it's usually world facing and world facing is, in general, time of flight, LiDARs, time of flight based. And now that said, the chips are similar in that they're based on kind of a similar VCSEL laser platform. They introduce new complexity of having to be able to post the lasers on and off very rapidly. So I don't think it changes the playing field for new entrants in any way. And at the same time, you're still talking about hundreds of millions of laser chips that are needed. And I think that's a -- what we've seen is a very capable and competent competitor working for five years. And clearly, it's not easy, right? And so the bar or barrier, if you will, to entry is probably only going up over time, not going down. And in the Android space, it's really been unfortunate, but a side effect of what's happened with the U.S. government action against Huawei. I think Huawei was producing great phones with 3D sensing front and backside and really driving the charge and everybody else in the Android space was trying to copy that when their business was decimated, it created a kind of a change in the dynamic. We're actually seeing probably that volume that would have been in Android now appearing in our lead customer who's clearly been gaining share at the high end and at the low end, there's been a little bit of competition around price, not feature I think that's stabilizing. And we're now seeing, for example, Honor be a stand-alone company and engineers at Huawei that working on 3D sensing have now appeared at Honor. They've also appeared at Vivo Xiaomi. They're pulling hard on new engineering design. So I think the combination of them having that capability, stabilizing of that change in the industry, combined with augmented and virtual reality, which is probably one of the larger killer apps over the long run, even for handsets, let alone wearables and other devices, the Android space is saying, "Hey, we've got to have that capability to enable augmented reality." So I think over the next 12 to 24 months between both the handset space and what you're going to start appearing in glasses or headsets will really start to cement what the augmented virtual reality world is going to look like. And that's really dependent on 3D sensing capabilities because you're imaging the world, you're imaging hands for hand gesture recognition. You're also imaging eyes for eye tracking or face tracking, if you will. So it's very high on the content of 3D sensing and to the point of shrinking the dye and reducing power consumption that we did in the mobile handset, you imagine that's also very relevant as you try to push into smaller wearables, where there's less size, weight and power allowed for batteries in these kinds of functionality. So you think of it as while why did you go design chip that is smaller? Well one, customer wanted it, but two, it opens up the application space to drive a lot more opportunities over the long run.

Helpful. I think we've got time for one or two more. So I'll get you involved here Wajid, sorry to keep you on the side here. We'll transition to more of the CFO-type questions. But I wanted to touch briefly on the margin front. I think one of the premier store lines of this company really over the past year plus has been this transition to this 50s margin model. Chris spoke about it earlier, getting out of some product lines that maybe have been cannibalized, focusing on areas of the business where you could see a sustainable margin advantage you've seen that happen. You saw in the September quarter, largely as a function of the big ramp that you have with your largest customer at 55% gross margin. You talked about that, that might not be the most sustainable way to look at the business. But could you just remind us what's the right way to look at this business longer term? And why can't you make this transition to 50s gross margin business steadily for years to come here?

Yes. Thanks, Tom. So I think we said about a year ago that we wanted to shift our margin model for the company to be a 50% plus and 30% plus gross margin and operating margin type of model. And we thought actually at the time that it would take us over a year to be able to achieve that on a trailing 4-quarter basis. Because as you mentioned, some quarters will be above 50%, some quarters will be slightly below 50% depending on product mix. Now what's happening right now is that we're seeing a lot of tailwinds. And Alan and Chris have talked a lot about those tailwinds, both in datacom but also in our telecom and in our lasers business. And so what the benefit of those tailwinds is, is that it's really helping our manufacturing overhead quite a bit. And at the time of our earnings call, we didn't want to change our margin model because we knew we still had 3 quarters to go in the year. But I think more importantly, as we closed the NeoPhotonics acquisition, we didn't make a change to our margin model either. And we've kind of put a stake in the ground and said, "Hey, look, we're going to continue to target that type of margin model once we get the pro forma synergies out of NeoPhotonics." And right now, NeoPhotonics is running in the high 20s, our goal is to bring those margins more in line with the rest of our telecom business. And so as we have the tailwinds in datacom and in our lasers business, hopefully, those, along with the synergies we see in NeoPhotonics can enable us to maintain the margin model that we committed to over a year ago. And so that's really the way we're looking at it right now.

Very helpful. I'd love to dive into some more, but I think we've run out of time here. I just want to really thank Alan, Wajid and Chris again for joining us. Have a great day, and thanks again for joining us here.

Great. Thank you, Tom.

Thank you.

Thank you.