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

Good afternoon, everyone. I'm Samik Chatterjee. I cover hardware equipment at JPMorgan. And the next session is with Lumentum. Alan had to cancel last minute, so we'll do the presentation of the fireside chat here with Wajid, Chief Financial Officer, and the set of questions will remain the same, though. So Wajid, you have now the responsibility of answering them. So thank you, everyone, for coming. We'll stand -- start with the standard questions I had prepared for Alan to give us a broader view of the macro here, and we've been asking every company this, so bear with us.

If I had to ask you to sort of share your thoughts on a potential recession here, and what probability you would put on depending on the customer demand that you're seeing, how would you sort of respond to what's the likelihood of a recession here?

Yes. Can you hear me okay? Okay. So first of all, thanks very much for having us here at the JPMorgan Conference, Samik. I really appreciate it. So much of the growth that we've been seeing in our business has been driven by CapEx investments that companies have been making in both the network infrastructure with growing bandwidth demands as well as increased investments from data center providers, and again, very CapEx-oriented type of investments. And so sometimes when there's discussions about things that are driven from a consumer perspective that may drive a recession or give indications of a recession, it might not come to the forefront to our business as quickly simply because many of our customers and our customers' customers are making investments that are more long term in nature. And because they're taking a 3-, 5- or 7-year horizon as they're making these multimillion dollar investments, we might not see the same type of volatility in our business to give us those type of indicators that would point to a recession. So it's tough for me to say what the probability of a recession is. I think that all of us are still getting data points then we're still forming opinions based on those data points. We've only gotten a few from the market so far that have had some negative indicators. So we're in wait-and-see mode. But again, I think given the CapEx nature of our business and the long-term profile of the investments our customers are making, we may see less volatility given some type of negative economic indicators, at least on the telecom and datacom side of our business.

Yes. Fair, fair. Yes. On the supply situation, we were -- the industry was already running pretty constrained and now you have the lockdowns in China. So how much worse is that making sort of the supply situation? Is it just something marginal in terms of impact? Or do you think it's a more material impact?

Yes. No, good question. So when we came into our fiscal Q3, which our March ending quarter, and we guided for that, the COVID lockdowns that happened in China were not known to us at that point in time. And so after we had provided that guidance, we then saw a 13-day lockdown in our Shenzhen facility, and that obviously caused a bit of a hiccup for us. It wasn't pronounced in nature just because we have one back-end facility there, and we have some suppliers that are providing some components from Shanghai, and we were able to work our way through with their operations team and our operations team. And so that didn't really impact us as much in the Q3. As we got into Q4, we were able to recover from any shortfalls that we saw there, and we were able to incorporate that into our thinking on our June quarter, and so we haven't seen anything really incremental to that from a supply situation, at least as it's related to China and COVID.

And the last one in that sort of series. When does supply normalize? Because I think all investors are hearing the same thing, which is all hardware companies have record backlogs, but in terms of really being realistic about when you can digest backlog, you would first need supply to normalize. When do you expect that?

Yes, it's interesting. We've had a full day of meetings, and we've been asked that question a few times. And if you had asked us that question 9 months ago, we had a view on what our supply shortfalls were and demand continued to increase versus that profile in every successive quarter whether it was the September quarter or whether it was the December quarter. And even into our March and June quarter, we've continued to see supply shortages versus our demand. But it's because our demand has been increasing so strongly, specifically on the transport and transmission side of our business, and as our supply has improved, the gap has actually gotten wider. And so our thinking at this point is that it's going to take us another 9 to 12 months before we start to see some type of material closure in that gap. Just as a reminder for everyone here, we had called out a $65 million gap in our March quarter, and as we guided to our June quarter, we pointed to a $100 million gap between our supply and demand. And so for that to get down to something that's more manageable and workable, we think will take some time.

Got it. I'll move into the company specific questions. [Operator Instructions] So getting to more company-specific stuff here, you've recently outlined an outlook for double-digit growth for the company for multiple years, and that is in the scenario that 3D sensing remains flat, roughly flat, and that is about 25% of your company revenue, which obviously then indicates that the remaining 75% of the company is growing pretty strong. So what's providing that level of confidence? I mean, obviously, backlog is one. But outside of sort of the backlog, what do you think are the sort of demand drivers that can sustain that level of growth? Obviously, you're not thinking 10, you're thinking materially above that?

Yes. So basically, we're thinking about our business in a couple of different product lines. So one is the telecom and datacom part of our business, and that's where we're expecting the most growth to come from, and I'll talk about industrial lasers in a minute as well. We're expecting to see growth in the industrial lasers segment of our business as well. It really kind of comes down to bandwidth demands. And what we're seeing is, we're seeing a relentless bandwidth demand from our customers and indications that we're getting from their customers as well. And what that's really driving is increased CapEx investment from those network providers and also from the hyperscalers on the datacom side, we're seeing upwards of 50% growth in terms of the type of CapEx investments that they're making in order to meet the demands for their customers. And so when you see that type of robust demand at an end market level, especially from a CapEx perspective, that gives us a lot of confidence in terms of our ability to increase our product sales into them as well. The other thing that's happening is that we're seeing a lot of transformation from a technology standpoint. And so where there was demand for 100G products, there's now a demand for 400G and 800G products. And where there was demand on the datacom side for 100G products, there's now demand for 200G and 400G products. And so as that technology transformation is occurring and as there's more demand for those higher-end products because we've got a product portfolio that meets demands from our customers, we have a lot of confidence in the type of revenue growth we should be able to see from the telecom side of the business. And then on the datacom side, we've had multiple quarters where we've been -- we've had shortfalls in supply and that's really been our own doing. We haven't invested fast enough. We're unable to get some of the CapEx equipment within our fabrication facilities up fast enough to meet that demand. We've had one slug of capital that has allowed us to guide up for our June quarter in datacom, specifically within the EML category of our products, and then we're expecting a second slug of capital to come in at the end of December, again, to support expected demand growth for EMLs as well. And so kind of the backdrop is really CapEx investments from some customers with pretty deep pockets and us having a product portfolio that across the board can meet their demands, not only from a product specification standpoint, but also from a quality and reliability standpoint as well.

Okay. Wajid, I guess the question on that front would be, I mean these are all sort of demand drivers you're seeing, but I did go back and look at your historical sort of track record and Lumentum has done double-digit revenue growth in the past, but those have typically been years where 3D sensing actually grew a lot, right?

Right.

So what's changed in terms of when you take a telecom and datacom, obviously, capacity investment is more a decision based on what you're seeing for demand? What changed from what we had a few years ago to now where you have this high confidence into a double-digit growth trajectory?

Yes. So I mean we've been laying the groundwork for a number of years across our transport and transmission products and our datacom products because we knew that there would be some secular growth that would happen in each one of these end markets. And we just didn't know the exact timing of it, but we were doing a lot of joint cooperation and joint development with our customers, specifically on ROADM products as an example. And the feedback that we were getting throughout the period was that, hey, higher performance products would be needed and there would be demand for them. And so the R&D investments we were making happened years ago that would then pay off, whether it was 2021 or 2022, that was meant to happen. Now in between, we've seen great growth on the 3D sensing side, as you mentioned, but those were from investments that we had made in 2016 and 2017 and that led to those growth levels on 3D sensing. But all the time, not only from an R&D standpoint, but also from a manufacturing footprint standpoint, you've been following us long enough to know the type of investments we've made in the back end in our Thailand facility that we call internally our Nava facility, and a lot of that was predicated on the secular growth we were expecting on telecom and datacom products. So I think it's been coming for a while and now it's hit us, and now we'll be able to really enjoy the return on the investments that we've made in capital and in R&D. And really just a phenomenal product portfolio and customers that have a lot of goodwill with us and want to work with us on making their networks and data centers successful.

Okay. Got it. Moving to sort of a question more in terms of profitability, but I think I'm using 2015 here as a starting point. So it predates you, but revenues have doubled compared to 2015. Operating income is 10x what you had in 2015. So clearly, there's been a big transformation of the company or the operating model. How do you think about the drivers of that improvement continuing now that the market still remains very competitive. It's still -- the optical components market is pretty fragmented despite the consolidation that's happened. So how do you think about sort of the improvement continuing, competitive landscape that's still pretty fragmented and everyone's very focused on sort of gaining that extra bit of market share.

Yes. I mean at the end of the day, it really comes down to our product roadmap. And I think that whether you take a look at our ROADM products, our 10G tunable products, the 25G tunable products that we just called out at our last earnings call, our set of coherent products, our EML products, I mean we are leading edge from an innovation standpoint and from a product roadmap standpoint across all of our product lines. And so when you've got that level of innovation and joint cooperation with your customers to build those type of products, you can then enjoy the revenues and the margins that flow from that. Now I'm certainly not calling out the type of performance that we've seen from 2015 that was starting from a real low point, but when you take a look at and you model out some of the growth we're seeing on the top line and how that could flow through to the bottom line, it is certainly quite respectable over a 3-year period. And so we're making investments to think about a 3- to 5-year period, and we're hoping that those bets really pay off and we can see the continued financial performance of the company. But really mimicking nothing different than we did in 2015, which is work with our customers to deliver the best possible products for their customers, we're just really copying that strategy and putting it into our telecom and datacom products. Now there will probably be a little bit more of a secular wind in that part of our product line than we saw in 3D sensing, but the strategy is really the same.

Okay. And as you think about sort of this growth strategy as well as the secular tailwind, like how is NeoPhotonics fitting into the overall growth expectations? Particularly, like how would you think of the secular tailwinds related to NeoPhotonics?

Yes. No, I think we're really looking forward to NeoPhotonics being part of the Lumentum family, and they have a great set of products that will continue to enhance our transmission products, specifically 400G, ZR and ZR+ products as well as the form factor that they've got with their pluggable modules, really allowing us to have more of a fuller product portfolio that we can service our customers with. I think we'll also have the added ability to provide them or provide their customers with a strong infrastructure and whether that be an infrastructure from a balance sheet standpoint or whether that be an infrastructure from an operations standpoint or a quality standpoint, I think we will be able to provide their customers with a better experience with great products that they've developed while they were NeoPhotonics on their own. So we're quite excited about that.

Okay. Good. As a reminder, again, for everyone on the webcast, I think webcast working, so you can submit your question. Moving to ROADMs, and I'm sure you're getting a lot of questions on that front as well, including supply constraints. But one of the things -- if I again sort of go back and think about ROADMs as a technology, there has been sort of from your customers a higher reliance on Lumentum and II-VI for that technology, right?

Right.

And there have been multiple discussions at different points of time that would reduce over time as more competition came in, but we haven't really seen that. What continues to drive the differentiation that you and your sort of primary competitor have relative to the rest of the market, which I'm sure there's a big broad base of customer -- competitors trying to catch up on the ROADM technology?

Yes. We've been very successful with ROADMs, and I think a lot of it goes really back down to what I said earlier. We have worked with our customers. We've worked with our customers' customers to really come out with specifications and performance that really serve the needs of the broader customer base when it came to ROADMs. And we kind of hit it out of the park right at the beginning. If you take a look at each one of our successive ROADM architectures, the next one has gotten better than the latter. And even the latest set of architecture that we've got from a ROADM standpoint is really world-class, and it's based on input and feedback and iterations that have happened between our CTO office, our R&D team in Ottawa and our broad set of customers. And so that's what's really made us leaders in ROADM technology. As you know, ROADMs are a critical part of the overall network infrastructure. And so getting the ROADM architecture right with the right performance specifications is extremely critical, not only for us, but to the entire supply chain of customers that are going to be investing in the overall network. And so -- because of that, I think that there's a lot of interest in making the right investment and getting the product right among multiple parties, and we've just done that really, really well. And even our latest ROADMs that are coming out just are very, very high end, and they were built on joint cooperation with our customers, and so I think that's why we'll continue to do well there.

Okay. So ROADMs, that's optical transport. If I move to sort of transmission products and pluggables that the entire optical ecosystem is now investing in, and you definitely have a position there as well. We're seeing sort of these 2 diverging sort of 2 sort of separate roadmaps where everyone is investing in pluggables. And at the same time, companies like Cisco are talking about the need to sort of potentially collapse ROADMs and build a router and a pluggable together into a different architecture, right? That sort of takes away the need to have a ROADM. So how do you sort of think about that architecture decision? And would that -- I mean how are you -- what's the likelihood that, that does happen? And how does that impact your ROADM business?

Yes. I mean our current architecture has actually done quite well for us, right? And we've got a full product portfolio around DWDM products that we've continued to invest in, and our customers are demanding, specifically those customers that are looking for applications and products that can support long-haul investments, right? Because if you really want to have a good long-haul investment, then you want to have the current architecture supporting those type of investments. But certainly, for shorter haul investments, pluggable technology is really good for that, and that's certainly an architecture that's successful. And that's one of the reasons we made the investment choice with NeoPhotonics given their strength in pluggable technology. And so our view is, irrespective of which way the architecture decision is made, we think that there's a place for both of them, and both of them bring advantages to the overall investments that the broader market is making, and we'll have a full product portfolio that supports that.

Okay. Got it. Before I move to 3D sensing, let me just check in the room if anyone has a question. Anyone with the question in the audience, please go ahead and raise your hand. Can we get a mic over? Sorry, are you running a mic?

If you're able to share, could you speak about like your integration of MEMS devices into like your technologies versus like the [indiscernible] like timing solutions or timing devices.

The competitive landscape versus Chinese competitors.

Sorry, no. That's not the question. The question was, could you speak to your integration of like MEMS timing devices, your micro-electromechanical systems devices versus [indiscernible] devices and your products?

Yes. I mean our ROADM products are probably the best place to talk about some of the investments and innovation we've made in MEMS and actually across all of the optical technologies that go into our high-end ROADMs, and so we've made incremental investments there. We think that we've actually supported MEMS technology quite well when it comes to ROADMs, but obviously, we're not a MEMS provider, per se. But where we've been able to invest in MEMS and support having excellent performance on MEMS, specifically on ROADMs, we've done a great job. And actually, that's helped the vertical integration of technology that's given us more of a competitive advantage on ROADMs as well.

Okay. So Wajid, moving to 3D sensing? I know you've tried to take that discussion somewhat out of the picture by guiding to flat, but it won't die down. How sustainable is the market share position? I think what you've sort of outlined is more of a balance between you and the primary compared to there, but what gives you the confidence that there's not going to be another competitor in the picture in the next few years?

Yes. Well, no, that's a good question. So I think for a couple of years now we've said that our market share position could be normalized at any point in time, depending on our competition's ability to ramp up on new products. And we had made similar comments to that last year as well in addition to some of the die size decreases that we were expecting on the chips related to 3D sensing products. And I think we've gone through one cycle, which was last year, last -- our last fiscal year, and we had higher market share than we had expected. And a lot of that was because there were multiple new products that were launched. We were the leader. We are the leader from kind of launching new products, and there was a great comfort level of having Lumentum be the supplier of choice. And that's one of the reasons we did so well from a market share standpoint. In the second cycle, we've pointed to the fact that, hey, by now, we believe that there's more of an opportunity for our competition to increase their share because it is the second year of the cycle. And so assuming that there's improvements in our competitions ramp, we felt it very reasonable to kind of bring that to perspective for everybody that's investing in our company that we could see some more normalization when it comes from a market share perspective on 3D sensing.

Okay. But I guess, Wajid, the follow-up would be, as you look over the next 3 to 5 years, what gives you confidence that it's not a third competitor that emerging?

No, there certainly could be a third competitor that comes in. I will say that it takes a lot of investment to be a viable competitor. And so we've shipped over 1 billion units of 3D sensing products. I think we eclipsed that about 9 months ago or so. And so we are a viable competitor to somebody else when it comes to 3D sensing. So there's others that are also trying to invest, but they just don't have the history or the credence of the type of units that we've shipped without any quality issues. So I certainly think that there's others that are trying to get into that market as well, but based on the success we had -- we've had, we think that a more reasonable position to take for us to continue to be the majority supplier, but to be less than where we have been historically. And then I think the other part of it is that we've been investing in other markets that are related to 3D sensing, specifically in automotive, we've seen multiple proof points and design wins that we've announced with Hesai and with Stanley Electric on LiDAR opportunities as well as in-cabin opportunities. And so as we've -- as we're expecting some of that share to come down in the smartphone side, we're making the investments that are necessary to grow other parts of that business as well. And then there's obviously AR, VR and computer vision that are also out there as well, but some of the proof points that we've called out are the design wins that we've made press releases on.

Okay. Good. Going back to your comments about share in 3D sensing with the primary customer because we've got questions on this. It does sound more of you just taking a prudent approach, given this is the second year of the cycle rather than sort of the other part of that could be that you have enough those design wins and the visibility that your share cannot be over a certain percentage based on the sockets you won on the phone, but it seems to be more of the former. Just wanted to clarify that, that you're taking a prudent approach based on that being the second year...

Yes, I think that that's fair. I think that's very fair. We're taking a prudent approach because it is the second year, and by the second year, our competition should be able to increase their production on 3D sensing products. It just seems very reasonable.

Got it. Moving to commercial lasers and that business has been in a steady revival over the recent quarters. So how are you thinking about sort of that steady improvement continuing in that business? And how is the diversification beyond sort of that one large customer way?

Yes. No, so our lasers business has done very well and the outlook for that business is also quite exciting for us, specifically with our kilowatt laser products as well as our ultrafast laser products. And what I think the management team of that business has done really well is really focused in on new applications and new customers that can support those applications and take our products that will continue to expand our reach into multiple pillars in that business. And that's really what gives us the confidence that we think that, that business could grow greater than 10% a year over the next couple of years. Now obviously, this year, we've seen a more buoyant growth, and a lot of that has been because last year was a little bit of an anomaly as some of our customers were drawing down inventory. But even moving forward, the demand signals that we've gotten, like I said, for both kilowatt lasers and our ultrafast lasers, have been quite strong, and we're quite excited to see the new applications and new customers that those products are going to go into.

Okay. On new applications that you just referenced, can you just outline how you think about those contributing over time? And how they help you diversify? I mean, obviously, given your concentration communication as a vertical, this -- those are sort of good opportunities to diversify the business. How would you sort of see them ramping from here?

Yes, certainly. I mean so the end markets that will aid us are really the EV markets, the semiconductor markets, expanding our ability to provide manufacturing upgrade capability to our customers by using our kilowatt and ultrafast lasers. And so that's beyond kind of the traditional markets that we focused in on as we've grown our lasers business over time. And as those end markets are growing, we're certainly seeing the opportunity for us to continue to grow.

Okay. And a follow-up there is then, how do you think about M&A respective to scaling these businesses quickly?

Yes. No, we certainly think that there's opportunity for M&A, specifically on the laser side of the business. There's -- we've got a very strong business that we could then jointly add on new opportunities for us. I can't really say much more than that, but there's certainly opportunities for us to continue to build that business, both organically and inorganically and really allow some of the excellence that we've got in that business to spread over to whatever else we were to acquire.

Okay. Got it. Last couple of questions. So your operating model that you had sort of outlined for the company had 30% operating margin, and so with even the revenue that you gave up to Apple with the reduction in die size, you fairly -- remain fairly consistent with or close to your long-term operating model. Now as you integrate for NeoPhotonics, how are you thinking about sort of tracking to that long-term model as you go through sort of driving the synergies. Actually, let me get you to answer that and then I'll...

Yes, sure. So I mean the NeoPhotonics business year-over-year has grown quite well, and so we're really excited to see the growth that they've had as a business standalone. And certainly, the investments that we've made in their working capital have helped them get more business, but their gross margins are significantly lower than what our gross margins are. And so we've laid out some targets out to our stakeholders in terms of what we expect to get over the next 24 months as we integrate the business. Now obviously, some of the OpEx synergies will be quicker to attain, but from a COGS synergy standpoint, many of their facilities are in the same locations as our facilities. And so our ability to integrate their manufacturing operations, both at the front end and at the back end is something that the teams are going to be working on so that we can improve the gross margins of that business. The other part of it is really us being at kind of the front of hyperscalers, growing their data center CapEx investments and some of the 400G, ZR and ZR+ revenue upsides that we're expecting to see in that operation should also, much like our own business, enable better manufacturing overhead utilization and improve those margins as well. But yes, there will be a transitory period where our operating model will have to communicate what it will be over a 12-month period and then a 24-month period and then a longer-term period as we integrate NeoPhotonics.

Okay. And just to sneak in the last one here, then sort of capital allocation, and there are multiple sort of confluence of multiple things going on. You are waiting to close an acquisition and integrate it. You also have strong demand visibility while supply sort of constrains your revenue. And you have a market sort of condition where clearly, you're not getting sort of full credit for the backlog that you have. So given all those, how you're thinking about capital allocation priorities?

Yes. I mean a year ago, our Board had authorized a $700 million share buyback plan that was increased to $1 billion in our March ending quarter. We bought back approximately 10% of our outstanding basic shares once you include what we bought back under the plan as well as the convert that we undertook in our fiscal Q3. And so that should really speak to the strength we're expecting to see in our business over the medium to long term. And we made those moves because we thought it was a great use of capital. We continue to believe that M&A and share buyback can coexist as part of our capital allocation model.

Great. Thank you. Thanks for coming to the conference, and thank you, everyone, for attending.

Thank you.