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

All right. Good afternoon, everyone. Thank you again for joining the UBS Tech Conference. My name is David Vogt, I'm the enterprise hardware networking analyst here, and we're excited to have with us today, Lumentum Holdings. With us from the company is Wajid Ali, the Chief Financial Officer. So Wajid, thank you for joining. Before we get started, I'm going to read a quick UBS disclosure. Any comments that we make on any stock or any security is subject to regulatory disclosure. You can find those disclosures at www.ubs.com/disclosures or e-mail me later, and I can send them to you. So with that out of the way, Wajid, thank you for joining us.

Thank you very much, David. Great to be here.

Great. So we're very excited to have someone here with your perspective on sort of the dynamics within the telecom market and then the datacom market. And so what we've been hearing from a lot of companies over the last couple of weeks is questions about the turn in telco, when does spending improve? I know visibility is low. But I thought maybe before we get into the nitty gritty, maybe it would just maybe help, I think, level set investors where we are today and the business has undergone significant change in the last couple of years from very sensing-centric, telecom-centric to now less sensing and now you have this new Cloud Light acquisition, which enhances the datacom piece. So maybe to level set, maybe can you kind of let's start a couple of years ago and kind of where we are today and kind of maybe we can go from there.

Yes. So that's a great way to start. I think a couple of years back, if you go back 2 to 3 years, the business did have a larger portion of its revenues coming in from the imaging and sensing part of our business. With one large-scale customer that, quite frankly, we had outsized market share with. And because it was a chip business, with that outsized market share, there were also much healthier margins in that part of the business. And it almost overshadowed some of the business that we had in telecom because it was growing so fast and so rapidly, and it was so beneficial to the overall company's financial performance that it soon became the topic of discussion, even though much of our R&D spending was always focused in on the telecom space, serving our major network customers for many, many years and innovating around their systems and solutions for their customers. And so with that, we recognized that, that part of the business would have volatility in it just because it was consumer in nature. We wanted to continue to keep that stream of revenue going as long as we could. But we communicated quite -- I think, quite openly that we eventually thought that there would be market share normalization. And I think most people that have followed our stock would say that, that probably took a little bit longer than management thought -- management thought that it would. I think we were probably a little bit more conservative on how quickly we thought that, that would come down. And so kind of keeping that at the forefront. What we were doing is we were really doubling down through our acquisitions on the telecom and networking space. And through that, as we were growing that part of the business, whether it was the acquisition we did in 2018 with Oclaro, where we got great indium phosphide technology and really kind of the start of our datacom optical lasers business that's grown by leaps and bounds ever since we've taken over to the NeoPhotonics acquisition that we did a little over a year ago and that we're working through synergies on to the most recent Cloud Light acquisition we've done. Really, our focus on the acquisition side has been to strengthen our position with our telecom customers and with our datacom customers. And I think that's been very good from -- for the company because now we're in a position where we can supply just about any product that any datacom customer, whether inside the data center or outside the data center, whatever they need, we have the ability and capability to provide as well as continuing to be strong in the telecom space, whether that's with the [ caustic ] transport products or with our transmission products. And so that's really how the company's strategy has evolved. I know sometimes it might be a little bit blurry just because of some of the telecom inventory corrections that you talked about earlier, and we can certainly talk about that later. But really, that's been the pillar of our strategy is to grow strong with our telecom and datacom customers.

So when we sit here today, so you recently closed the Cloud Light acquisition, so that was part of that investment strategy in datacom and telecom. Sensing has been effectively more or less normalized, deemphasized. When we look at the business today, we can touch on telecom in a second, from an inventory perspective, do we have all the pieces in place that you see it today to kind of meet this overarching strategy of focusing on your network provider customers?

Yes. I mean if you just take a look at the products that we've got. We've got great EML technology. We've got great VCSEL technology. We've got great narrow-linewidth lasers technology that -- we're building our own DSP capability to support our narrow-linewidth technology as it relates to our 400G ZR and ZR+ products. And then our CW lasers that we've got that will now be able to benefit from the Cloud Light transceivers that we've just brought on as part of our product portfolio. We've got a full suite of capabilities not only to support our customers that we've got today, but to be able to effectively compete with customers that we're not very strong with today, but that are -- we're certainly having ongoing discussions with, especially with the most recent Cloud Light acquisition. And I think one of the things that I'm sure some of the investors that have been with us for a while recognize is all this is great from an external standpoint, from a product portfolio standpoint. But really, what it's going to lead to is vertical integration opportunities for us, whether it's with Cloud Light transceiver products or whether it's on the NeoPhotonics side, that we can use to improve our overall operating margin profile as well.

I want to come back to the vertical integration point on Cloud Light. But on telco because that is the biggest question that we get. I'm sure you got it all day today. Obviously, the cycle has been somewhat cyclically depressed, I think, a little bit longer than people anticipated. How would you characterize sort of the inventory position out in the marketplace, whether in the channel, at customers? And kind of what are the signposts or the leading indicators that you're looking at? I know we were just talking before, like I know everyone's trying to figure out the turn but like what's your sense today when that could happen? What you -- let me rephrase that. What's your base case today embedded in your expectations from a planning-period perspective?

Yes. So up until now, we've been using what information we're receiving from our end customers. I will say that I think overall visibility, even at our end customers is not great. Because what we've seen very regularly is push out of forecast of when end customers expect demand to start picking up from their perspective as to when their inventory levels come down. I don't think that anybody is shying away from the fact that telecom continues to be a growth market. It's probably still a mid-single-digit growth market. But kind of how that plays out over the next 6 to 9 months still is bumpy. But to answer your question more directly in terms of our base case scenario, so our base case scenario is that probably by the middle of the calendar year 2024, we would start to see a pickup in our revenues associated with the telecom side of our business. By that time, it will have been over 4 quarters for the inventory correction to occur. And so that seems to be a reasonable position that we're taking. But we're constantly monitoring it. In terms of leading indicators, we're taking a look at what orders and new forecasts, and quite frankly, some of the conversations we're having with our customers because we want to be able to support them with our manufacturing capacity effectively. And one of the reasons our gross margins have been so negatively impacted is because of the underutilization expenses we've had at our various facilities. Those underutilization expenses are occurring because we're keeping the capacity open for demand and for the market to come back. And so there's a little bit of a push and pull from a discussion standpoint, but that again, to answer your question, that's probably the base case.

And can you talk about -- so you mentioned underutilization, obviously, the margin profile of the business has changed pretty dramatically because of the different mix. Is there a way to quantify what underutilization is costing you right now from a gross margin perspective?

Yes. I mean it varies quarter by quarter, and it's in the millions of dollars per quarter. And a lot of it depends on whether the underutilization is occurring in our back-end facilities or it's occurring at our fabrication facilities in Caswell. And so that's why the number can vary a little bit. So I think it's probably better to take maybe a single quarter and provide that information moving forward. But it is in the millions of dollars every single quarter. And so $4 million is 100 basis points right there.

Right. Got it. And so coming back to the vertical integration concept. So when you look at the portfolio today, you've become significantly more capital heavy with Oclaro and to a lesser degree, NeoPhotonics. Now you have this Cloud Light acquisition, there's an opportunity to vertically integrate there as well, right? So move production to, I would imagine, your facility in Thailand, use your own lasers. Is that how people should think about the Cloud Light business?

Yes. Yes. So the Cloud Light business has a couple of tailwinds to it that are probably just natural. One is that as the business is -- has a very steep rise over the next couple of quarters, we're going to see some operating leverage fall through just in terms of their own operating performance. So I think that is just given, their own revenue streams. I think the second piece is as that part of the business looks to expand, we've got back-end availability both in our Thailand facility, but also in our Futian facility as well. And so our ability to quickly add that capacity without actually adding overhead expenses is there as well. And so I think that that's the second piece of the puzzle. But then there's the vertical integration piece. Do we start supplying our own CW lasers into Cloud Light. And we -- prior to us owning them, we provided a little bit, but we didn't have majority share of that part. And so the CW laser is built at our NeoPhotonics facility in Japan. And so we certainly have an opportunity to go in and really kind of turn that around from a margin standpoint. The second area is probably around our own VCSEL technology. And so currently, with Cloud Light, the VCSEL technology is outsourced to -- from other suppliers. And we certainly have an opportunity with the growth of their AOC business to be able to provide our own VCSEL technology. And then the third piece is our EMLs, and that's really the Holy Grail, right? In our view, that's really kind of our ability to really take the most benefit out of the transaction and also an opportunity to provide customers with a truly differentiated design backed by Lumentum with Lumentum IP in it from an EML standpoint. And I think from a 100G perspective, there's opportunity there. But I think more importantly, as we have 200G EMLs that we're currently sampling to customers, that becomes much more critical as transceivers move from 800G to 1.6T. And just like everything else, we're looking to lead that transition. And our datacom chips with 200G could really help enable that. And so if you kind of say, "Wajid, what are you most excited about?" It's probably that last piece because everything else we're like, "Okay, we can kind of count on that, but that would be -- that would be the -- yes, that would be a real upside for us." And something for the combined company to be really proud of as well.

Got it. So maybe I should take a step back and I'd be remiss for not asking. I think there was some confusion when you closed the Cloud Light transaction, sort of the near-term impact on the financials. Maybe just to clarify, I think you said it would be EPS sort of accretive.

Accretive. Correct.

And that takes into consideration all the different moving pieces. So the financing aspect, the low teens margins, I would -- for Cloud Light. So when we think about the growth, the volume leverage and the factors that you just laid out, when you look at the path for the margin trajectory at Cloud Light, how should investors think about that over the longer term? Obviously, not this quarter, not next quarter, but what is the dynamic there?

Yes. So I mean, we've only had the transaction under our belt for 3 weeks. And most of the time that management has been spending -- the general managers of the business have been spending with customers, which is great. But on the back end, between the finance and the operations team, we've been taking a look at how quickly some of these things can come in along with our product teams and how quickly that could improve our margins. And so what we've communicated as part of the transaction is that we could get the business to high teens margin level -- operating margin level within the next 24 months. I think with everything that I laid out earlier is that it doesn't seem like a high bar. And so there's certainly opportunity from there.

Got it. And so I know you've been getting a lot of questions on that. Maybe can you talk about the competitive landscape in that market right now. So you weren't in the market, now you're kind of back in the transceiver market. How do you sort of think about or characterize the competitive dynamic in the marketplace right now for the transceiver business?

Yes. I mean, so the transceiver business really just has a couple of U.S.-based companies that are involved in that growth. And there's probably one major competitor that's outside the United States that's involved in the growth of 800G transceivers. And so right away, you've got to kind of make a separation between the two types of competitors, right? So that's kind of point number one. And then I think point number 2 is we believe that, that market is growing quite fast and quite rapidly. I mean if you just take any kind of publicly available data and take a look at how much 400G, 800G and 1.6T is expected to grow between now and the next 4 or 5 years. I mean it's 4x or 5x, but it is now at a transceiver-unit level. And generally, those data points don't get the inflections right. I mean the inflections are later than probably they're going to happen. So when you put that all together, what that really means is that, that market is growing and we have a real opportunity to participate in that market and gain market share as that market is growing because we believe we've got the right capability from an 800G standpoint. We believe we have the right capability to transition to 1.6T, we believe we've got the right EML technology and this right CW laser technology to support those transitions in that growth. So I think that bodes very well for us in order for our ability to grow that part of the business. So -- but like I said, it's been a couple of weeks since we've had the...

Yes, I know. But it's -- I would imagine -- I'm sure the calls that you're getting, it's like every e-mail, every call that we get is this is a market that should be growing 30% a year for the foreseeable future. Obviously, that sort of turbocharges your datacom business and potentially pulls in the VCSEL business and helps...

And we've said this earlier, we think it's steeper in the next 12 months than over the longer term. So...

Got it. And so when you think about -- you were careful to call out competitors locally or domestically versus outside of the U.S. Do you think there is a blurring of the lines from a competitive standpoint between outside the U.S. and the U.S. I'm just trying to think about the risk of having a relatively fast-growing competitor outside the U.S. maybe derailing some of the growth that we're talking about here?

So the competitors that are outside the U.S. are customers of ours and they're very important to us. And we view them as partners, and we wish them success. And I think that there is an opportunity for all of us to enjoy the growth of the market with each competitor providing their own unique transceiver designs and capabilities and diversification to hyperscale customers. There's only a handful of hyperscale customers out there, and I'm sure that they want to have suppliers, partners that they can count on and not just one of them, especially given how much growth that there is expected to happen there.

Got you. Since you talked about migration 400, 800, 1.6 slightly related. When you think about the optical industry today, there still seems to be a healthy amount of inventory out in the field. And it's hard to disaggregate whether it's at customer, whether it's in distribution channel. What do you see today from the best of your sort of position in terms of -- I know that goes back to the telecom question earlier, but I'm just trying to get a sense for where we stand today versus maybe 6 months ago versus 12 months ago and...

Yes. I mean all indications are that the customers are drawing down the inventory they have of Lumentum products. And there is -- in line with that, there's also some visibility into kind of what's out there into the field. And we've been spending a lot of time focusing on how we migrate the two to really map out to our own MRP plans. But like I said earlier, David, it is -- we've got our base case scenario but we're looking at the data regularly with our customers because we want to make sure that we're there for them when that uptick happens again not just for our own financial benefit, but to make sure that we're a good partner to them.

I mean -- I'm sure it's changed a lot over the last couple of years given supply chain and COVID. How do lead times work today, right, versus pre-COVID, during COVID and where we sit?

Yes. No, lead times have come down quite significantly throughout the supply chain. Just even in terms of our own ability to procure raw materials, the discussions are no longer 52-week lead times. And what that's allowed us to do is to really bring down our safety stock levels. And I think that us bringing down our safety stock levels is probably no different than what other customers or suppliers in the supply chain are doing overall just because there's more of a comfort level around how quickly folks can be supplied by their own vendors.

Got it. And can I maybe ask this question maybe a little bit differently. So when you think about the margin profile of your current portfolio today, obviously, you're undershipping to demand, which I think you would echo as kind of what your view is. When volume comes back, given your integration, your manufacturing, consolidation that's gone on over the last couple of years, is there a way to maybe frame kind of what the margin opportunity -- putting aside the Cloud Light part of the business, what the margin opportunity could look like over the medium term, right? So gross margins, my view, probably don't go back to where they were because of the sensing dynamic. But we're undershipping to demand today, so margins are depressed. What's the next step?

Yes. I think really, the next step is us getting back to double-digit operating margins. And so I think over the last couple of quarters as well as what analysts have for us from a consensus standpoint is still low to mid-single-digit operating margins. And as the demand starts picking back up from a telecom standpoint, how do we get back to double-digit operating margins while continuing the heavy investments that we're making in R&D, and so I think really kind of that step 1 before we start talking about, "Okay, how do we get back to the midterm model that we talked about at the OFC presentation last year during our Investor Day." So step 1 is really just getting back to double-digit operating margins. And then...

Does that step 1 require that improvement in the telecom market by June, let's say, of next year?

It does, it does, it does, yes.

Got it. Right. So I know you guided margins this quarter, again, sort of in that low to mid-single-digit range. So that's kind of the trajectory that we should think about until the telco margin recovers. And then when you start to lay -- at OFC, I think the business, obviously, at the time didn't have Cloud Light, we also didn't have I think the reduction in imaging and maybe even lasers, I think maybe the expectations were a little bit more robust.

They were a little bit more robust.

A little bit more robust. So how does that again factor into -- I don't want to -- obviously, I'm not going to ask you change your midterm model, but I would imagine that means just back of on the envelope...

Yes, that's a little bit -- yes, that's a bit of a headwind for us because our lasers business, one of the reasons that the gross margins have historically been so good is because we have our own internal manufacturing from a fab standpoint, but also from a back-end standpoint as well where a lot of the lasers are produced in Thailand. And so all of that manufacturing capacity is still there as we're going through a correction with lasers as well. So you're absolutely right. The thinking around the lasers business was a little bit more robust when we had talked about that last year.

And maybe can you just kind of help us understand like what are the drivers of that business going forward? Like what recovers -- what does the recovery look like? What are sort of the signposts that we need to see to get a little bit more robust?

Yes. So I mean there's kind of two parts to that business. There's a kilowatt lasers fiber business, kind of the classic business that we've had with a large customer. And then there's the ultrafast part of the business. And the ultrafast part of the business has been growing quite well sequentially. It's been growing quite well. But it's really the kilowatt fiber laser part of the business that's gone through a bit of a downturn for us. And it started later after the telecom business downturn, and so it will probably end later from a downturn standpoint in terms of when we can actually get that to a more normalized revenue level. But when it does...

Was it a function of inventory digestion...

It is. Correct.

Okay, got you. And so when that normalizes, maybe if we -- thinking from a sequencing perspective, telco maybe June quarter, lasers because of that particular dynamic a quarter or 2 later.

Might be at the end of the year.

Great. So then as we get into, let's say, calendar '25, by that point, let's hope that the macro remains stable, and we should have a more indicative prediction of what the business looks like holistically with the tailwind from Cloud Light on a margin perspective.

Yes. I mean, the tailwind from Cloud Light from a margin perspective. But I think more importantly, our datacom EML business really growing and transitioning to 200G. I mean that is really going to be a nice tailwind for the overall business, and it's something that we have control over, executing on that. We're already providing qualification samples to customers on 200G, and so enabling that transition to 200G will be ahead of -- we believe we'll be ahead of the competition on that, and that could give us a nice margin tailwind as well.

And those are well above corporate gross margins.

Those are well above corporate gross margins and it's a chip based -- it's a chip-based sale. So it inherently has got chip-based type margins.

Got it. Maybe just in the interest of time, I know there's a lot of crosscurrents going on in the business that we just talked about. When you think about balance sheet, inventory, cash flow, how are you thinking about framing sort of managing this dynamic over the next 12, 18, 24 months, given all of these crosswinds that we just talked about. Obviously, you just did the deal for Cloud Light, so that consumes some cash. That was cash on the balance sheet.

That was cash on the balance sheet.

Cash on the balance sheet. So kind of what is the thought process here going forward, cash flow conversion and priorities?

Yes. So priority #1 is to be free cash flow positive every single quarter. And so with us being in the low single digits from an operating margin standpoint, we have to be very careful about the CapEx that we're investing in the business. Now I think that the decision we made around taking ownership around -- for Caswell was very critical, and we did that in Q1. So I think we really got a big portion of the capital spending out of the way for the next 9 months, and it should be more maintenance related and then any investments that we need for Cloud Light. So just managing that dynamic is extremely important. And the second thing is really inventory management. So what are -- what's happening with us from our customers, ensuring that we can get our safety stock levels down so we can manage our inventory in a way that helps us generate cash is extremely important. And I think the third thing is we still got a third stool of synergies related to the NeoPhotonics acquisition, we had originally communicated $60 million of synergies. And then we re-communicated $80 million of synergies.

But that's split between OpEx and CapEx, right?

Yes, that's split -- well, it's between OpEx and gross margin. Not CapEx. And so as those synergies flow through, those should be cash positive as well. And so really kind of those 3 dials are what we got to focus in on.

Got it. And when we think about the business from an inventory perspective, one last question, managing that inventory safety stock. Is that a tailwind to working capital this year over the next, let's say, 4 quarters?

I think so. I think that, that will be a tailwind to working capital. But if -- and this is the good part is that we will probably have to invest a little bit of working capital in Cloud Light just because of the way the mechanics worked on the financing of the transaction. And if business picks back up, we might have to invest in accounts receivable. So I think that, that's probably the way to think about it.

Got it. Okay. One last thing, I'd like to ask the company, what did we miss? What are you getting questions on? What's topical that maybe we didn't cover that you think maybe the market is missing or there's not clarity on?

I think we talked about Cloud Light, we talked about our full product portfolio really serving hyperscale customers, which is a growth area for us. We talked about our margin profile and really the expected growth around datacom with our 200G EMLs and some of the vertical integration opportunities. And so I think that's kind of 80% of the story around how we get back to growth.

Can I ask one final question on sensing?

Sure.

So other applications, LiDAR, et cetera. How are you thinking about that business now that I would imagine share normalization has happened. Volume has -- volume units have normalized. Sort of what's the prognosis for that particular...

We're looking to continue to innovate with that large customer, and we're actively looking at opportunities to how we can improve that business over the next year or two. As there's innovation around phones, there's certainly an opportunity for us because we're a proven partner when there's changes. When there isn't changes, then everybody kind of goes through an ASP reduction, but when there are changes, Lumentum is the first to be tapped on.

And when you say changes, is that just changes in kind of the capability that we're talking about?

Yes, there's the capability, the quality, the performance, the design, things of that nature when those things happen, then we're the ones that get tapped on.

Got it. All right. Great. I think we're good there. Thank you, everyone. Wajid. Thank you for your time. Thank you for your time. Thank you, everyone, for attending, and we'll hopefully see you here next year.

All right. Thank you.

Great. Thanks guys.

Pleasure.