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

All right. I think we'll get started here in about 10 seconds, if everyone want to take their seats. And welcome to Barclays tech conference. I'm Tom O'Malley, [indiscernible] semiconductor capital equipment analyst. Lucky enough here to have Lumentum CFO, Wajid Ali. Thank you for joining us.

Thanks so much, Tom.

So a lot going on. First off, it's a pleasure to have you here. There's been a lot of changes here a year ago. And I think most of you [indiscernible]. We just want to start maybe taking a step back [indiscernible] of you. Can you talk about the strategic rationale for the acquisition? And then financially, what do you expect the contribution to be in that asset?

Yes, sure. So I mean, I think if you look at many of the investments that we've made as a company, we strengthened our position both inside the data center and outside the data center. And the acquisitions that we've had in the past have been outside of the data center within our [ Kinect ] solutions. But with Cloud Light, we're really kind of strengthening our position with [indiscernible] and high-end transceivers to be able to take advantage of growth that's there. And so our thinking around Cloud Light was really the fact that we're going to be able to get into a market that's growing quite quickly. I mean if you take a look at some of the data, demand for greater than 400G transceivers is growing 4x over the next 4 or 5 years. And so there's a lot of business to go around in that space. You add to that some of the vertical integration opportunities that we've got from some of the prior acquisitions that we've done, and it really gives us an opportunity to improve the operating profile of the business. And so that was really the thinking around the Cloud Light acquisition, to take advantage of developing our strength within the data center and also to improve the operating margin profile of that business through some of the vertical integration opportunities that we've got. Even without that, the acquisition itself from a financial standpoint is accretive to us from an operating margin standpoint in the quarter that it closed, and it's accretive to us on an EPS standpoint as well. So kind of all the financial tick marks are there for us as it relates to Cloud Light.

What can you do to scale a business that has such a small OpEx footprint? How do you integrate it? Like when you're looking at it, you have my CFO hat on for a second, what levers can you pull when you have such a lean business already that's maybe levered to a particular customer? What buttons have you pushed to help scale that and keep the cost profile of what it is while you're scaling each other?

Yes, great question. So from a manufacturing capacity standpoint, one of the things that we're looking at is how can we really look at the footprint that we've got, especially from the back-end standpoint, to be able to leverage the revenue growth that we're expecting to see in that part of the business. And so the operating leverage, even with its existing capacity, is quite good. But as the business is expected to expand, some of the back-end availability that we've got at our Thailand facility or at our Futian facility, allows us the opportunity to expand that part of the business without actually increasing our overhead expenses. The second part of it is really the vertical integration. I think what we're taking a look at from that standpoint is really the opportunity for us to integrate our CW lasers into the transceivers that Cloud Light provides. It's the opportunity to bring in our own VCSEL technology into the AOCs that Cloud Light sells and then eventually also have the ability to have our own EML technology to not only improve the operating margin profile of that business, but really to enable the transition to 1.6T, which we expect we're going to be at the forefront of. So I think kind of those things combined really allow us to bring up the operating margins of Cloud Light probably better than they could on their own or anybody else owning that asset.

I guess another aspect that we hear a lot, particularly over the last 1.5 years, is just the importance of domestic supply chains, particularly in areas that are sensitive to the U.S. government. Is there an angle here where owning this asset gets you into a position with certain customers that you weren't in before? Maybe talk to customers or conversations with customers and/or what you've seen already since you...

Yes. I mean it's been less than a month. It will be a month tomorrow of us closing the deal, and the activity on the customer front has probably been better than we expected. And whether it's a domestic reasons or it's because Lumentum has been a secure supplier for many of the hyperscale customers already or we're engaged with them already, certainly, I think that there is a confidence that having Lumentum as part of the success of Cloud Light ensures that the technology road map moving forward will be invested in at the appropriate levels. And so I think that the hyperscale customers know that about us in terms of some of the success we've had in the past. And then them allowing us to be part of their long-term road maps also gives them a lot of confidence as well. So I think that will be the main reason why we've seen a lot of customer interest in the last 30 days, and a lot of the time where our business unit leaders are spending in order to accelerate that part of the business, because that was also part of the thesis of purchasing Cloud Light is that under the umbrella of Lumentum, we would be able to expand the customer base and really take advantage of that market growth opportunity [indiscernible].

And I want to rewind the process a little bit. And I think it was several years ago, you guys have started to move on from your data transceiver business. And the decision at the time was, hey, we can be competitive here on the chip side, but the business was a [ low averse ] margin profile. And you said, "Hey, as a business, we want to move gross margins up." I understand from the Cloud Light angle that operating margins can improve very drastically. But can you talk to me about why you decided to get back into that business? And what can you do from a gross margin perspective?

Yes. I mean a few years ago, the transceiver business was a lot different than it is today. I mean it was really enterprise customers that are leading the demand for transceivers, and now the world is completely changed with really hyperscale customers that are leading consumer demand and the secular nature of that demand is much stronger than it was at the time when we have brought in [indiscernible]. Now I think us having the amount of experience that we've had with the EML, part of that actually enables us to [ broaden ] the transceiver business that much better. For example, we're already -- we've already launched and are qualifying our 200G EMLs that are part of the EMLs that came with the Oclaro transaction. That is going to enable transceiver demand not only for 1.6T but also for designs that have 4 by 200 and for 800Gs as well. So I think from a timing standpoint, us having an asset with Cloud Light and being able to really change the way the transceiver designs are completed because of some of the vertical integration opportunities that we have is much better than they could do on its own. Now you're right. From an operating margin standpoint, that's really how we're looking at it because the gross margins can only improve to an extent given the amount of BOM cost there is. But really, it's us going out and making sure that we execute vertical integration opportunities to ensure that we can get the gross margins up from where they are right now as well.

So you talked about 18- to 24-month cost synergies. You're highlighting some revenue synergies here now. Can you talk about what those -- the size of that? Maybe obviously, it's not an enormous acquisition, but just helpful from a relative size perspective, what can you get out of that?

Yes. I mean so what we've talked about is the fact that Cloud Light is operating on -- and low-teens operating margins, and we expect to be able to get it up to the high teens operating margin. So let's call that 500 to 600 basis points kind of this is the delta between the two. So if you multiply that out by its current revenue level, that gives you about $10 million to $12 million worth of synergies. If you multiply it out by a future revenue level, let's call it, an annualized number of $300 million, then that would give us $15 million to $18 million of synergies that Cloud Light wouldn't have been able to achieve on its own. And so that's really probably the opportunity set for us.

And then in terms of spend, when you look out into next year, does it require more CapEx investment on that side? And I think that there is a view if you have a confidence with a customer and you're looking to broaden that, often, there's a lot of design activity that needs to take place that often ends up on the OpEx side. But from a CapEx perspective, what does that take?

I think the team at Cloud Light did a great job of investing in the capital that was needed not only to enable the 800G demand but also to eventually move to 1.6T. So I think kind of at a very high, probably the CapEx requirements will be very similar to what the Lumentum type of a stand-alone 5% to 6% of revenue. And so at least in the next 24 months, it shouldn't exceed that.

I think a good case study, not exactly the same, but something similar is when you did the NeoPhotonics deal. You saw a good technology asset that was well positioned, that was at a gross margin profile that maybe at the time was below where the corporate average was that around. But can you talk about what has happened with that deal so far? And have you been able to -- you expected out of it? And talk about maybe where that gross margin profile is trending. I know you can't give specifics, but just generally, how has that deal gone? And the -- what lessons have you learned that you can apply here to Cloud Light?

Yes. So I mean the acquisition of NeoPhotonics has gone very well. I mean obviously, I don't think any of us expected the telco downturn that happened and certain NeoPhotonics transmission products were also affected by similar to what our transport products were. But our narrow-linewidth lasers products that go into 400G ZR and ZR+ modules are very low. We're quite excited about the transition to 800G ZR as well. As part of NeoPhotonics, we recently demoed 800G ZRs and we had very, very positive reduction around that product line as well. So I think from a product road map standpoint, NeoPhotonics has done very well for us, and we've been able to invest in it and we expect to grow that part of the business, especially because we believe the -- and this is part of our thesis for NeoPhotonics, that we felt that the market was moving to pluggables. And pluggables, especially from NeoPhotonics, have lower latency and things of that nature. So that certainly is playing through, and so we see a lot of market demand there. From a synergy standpoint specifically, we have put a stake in the ground when we had completed the acquisition that we would see $60 million of synergies annualized. And I'd say 9 months after that, we came out that we thought it would be closer to $80 million. So we're very much on track for that. I think we're probably at the 2/3 mark in terms of realization of the synergies. So we still have some to go as we move through some of the back-end consolidations that are happening right now as well as some of the product in-feed opportunities that we're still working through that are going through the normal design times from our R&D team. So I think those are the 2 pieces that are still left, but we were able to up that and we realized about 2/3 of it so far.

Very helpful. So as part of the closing of the Cloud Light deal, you re-bucketed into 2 new segments: Cloud and Networking and Industrial Tech. For those who don't know in the room, could you just remind us which of your previous businesses are going into those 2 businesses? Where does the new business come? Then maybe a helpful way to talk about it, I know that you have some of the growth rates that you've given historically. But what do you expect in terms of growth rates for those 2 businesses just so people can level set where the next couple of years can go?

Yes, sure. So our historical telecom and datacom businesses as well as our 3D sensing business that was in our OpComm segment basically got pulled out. And our 3D sensing business and the lasers business got moved into the industrial segment. And our telecom and datacom as well as our most recently acquired Cloud Light acquisition will go into the Cloud and Networking platform. So that's really how we've broken the two out. And the real reason for that is because that's how we see the market in terms of the customers growing as well. So we do think that there is a clear delineation of kind of growth rates in kind of those markets and what each of those platforms require. So on the Cloud and Networking side, the historical datacom business, the chip business is probably a low double-digit grower from our perspective. And the telecom part of the business, obviously, a mid-single-digit [ over the long term ]. And the Cloud Light, part of that business is communicated, we think it's expected to grow at about 30% over the next few years. On the industrial side, we almost think of lasers as a GDP plus-type business. And so it's very much related to the macro economy and the overall GDP of the global economy at this point. And then on the 3D sensing side, it really depends on what type of innovation is happening at our large mobile customer. There's a lot of innovation happening, then we're certainly either there and we get tapped a lot, and so there's opportunity for growth. But if there isn't, I mean, there is generally kind of the classical ASP reduction that happens every year. And so it can be a flat to slightly down business depending on what's happening with the large customer and the designs that they're working on. So that's how to think about the different growth [indiscernible].

Helpful. I want to dive into a little bit more of the demand trends in some of the sub-segments that you just talked about. So I think one that you highlighted already is clearly, we're going through a cyclical downturn in the telecom business. Now there's two parts to that, right? There's the inventory build, which clearly happened that some of the -- and there's also the demand profile. Can you try to distinguish between the two? Where do inventory levels sit today? Is demand okay now but the inventory problem side? Or is demand [indiscernible] with the inventory?

Yes. I mean so all the feedback we've been receiving from our customers is that demand seems reasonable and inventory levels of our products within their supply chain is working its way down. And based on that, we get this question a lot, our thinking, at least sort of base cases that the demand recovery really kind of happens in the middle of calendar 2024. And by that point in time, it will be 4 or 5 quarters of inventory digestion. And so by that time, we expect to see some type of normalization in our shipments into customers being more equal to the shipments that they have out. And right now, there's been a mismatch for the last 3 quarters or so. So that's really the timing that we expect for that. We haven't really seen much from a demand standpoint in terms of it going down or it's staying flat. We think that is fairly normal.

If you look at your largest customers, which you guys break out, you had a couple of quarters of very elevated build. You actually saw that percentage kick up in the last quarter. Is this just different programs that they're running that they need different types of your products because I know you sell multiple products to that customer? Or are there different customers that maybe have inventory positions that are different from one another? [indiscernible] the largest...

Yes. No, I mean, it is very much across the board, especially as you take a look at it between transport and transmission. I haven't seen a lot of differences in terms of maybe ROADMs being higher than products in our transmission group. They basically come down at very similar levels.

Okay, across the board. So I just want to pivot to the datacom side. You guys had previously been pursuing a chip-only strategy. I think there's kind of a long road where originally, there was market declines, then there's been capacity constraints on the upswing. Where does that business sit today? I know you're selling primarily to the large hyperscalers. Is that trending as you expected? I know that there was a period of congestion. Or what you saw through the rest of the fiscal year, where are things there?

Yes. So primarily, we've been selling 100G EMLs in that space and probably the last two, and we saw a bottoming of that business. And what we saw coming back to us was a lot of demand for 100G EMLs, primarily because of the demand for 800G transceivers going up quite quickly at our customers. And that business, every single quarter, has been increasing sequentially. And those increases have really been driven by the capacity that we had to back in into that business. And I'd say probably exiting this fiscal year will be at a more normalized run rate where the supply that we have equals demand. What we're really excited about in the datacom side of the business is the transition to 200G EMLs. We believe that we are going to be a market leader in that space. And what that will do for us financially, that will effectively increase the revenue capacity of the fab that we've got because we'll be able to get a higher ASP in a market where we are leaders. And we're going to be enabling 4 by 200 800G transceiver designs as well as being the only ones to enable 1.6T designs because they require 200G EMLs to really operate. And so we've seen that story before when we were the leader in 100G EML, competition hasn't caught up to us. That benefit flow through how well we were doing in the datacom business. And we're quite excited about how all we can do with 200G EMLs as well because we're going to be first to market.

Do you have a view on how far ahead of the competition you are in that 200G EML?

It's tough to say. On the 100G EML, we had probably 12- to 18-month advantage. On 200Gs, it's tough to say how much advantage we have. But I would say that probably there is clarity between the two now.

When you look at the universe of companies that are here at the conference, I think the consistent theme that we saw over the past year as well is supply constraints, very abnormal lead times, input cost skyrocketing often affected the gross margin profile of the business. So can you talk about what you're seeing today? Are you still having trouble with any supply? Is there any abnormalities that you think will correct themselves by next year? Just walk through all the moving pieces you have to deal with.

Yes. I mean overall at a company level, we've been trying to bring our inventory levels down and we've been able to do that partly because demand has come down, but also because our requirement for safety stocks have come down as well. And that happened because there has been a loosening in the supply chain overall just in [indiscernible]. And so I think that I don't really see any bottlenecks in terms of our ability to provide product. If there is a ramp up in demand, that's quick. And also, we just don't see the same type of pricing action happening from an input standpoint that we were seeing before as well. I think that, that was a COVID-driven era that was driving abnormality in pricing from a raw material standpoint and a supply standpoint, which caused us to balloon our safety stocks as well. But that has been reversed and we're just working that through the system. And hopefully, it should be more normal moving forward.

Grant me one more on broader tech side I think discussed still frequently, that's probably [indiscernible]. But the 3D sensing side, so you've basically derisked the entire model, talk about it being pretty insignificant in terms of the out-year. You just mentioned that how that business trends is highly correlated with how your lead comes towards being. There's talk about potentially somewhere down the road there being additional technology opportunities with the front-facing [indiscernible] glass. And today, you see increased competition on the back side of the phone, share has moved around on the [indiscernible]. Can you talk about, to your knowledge, what you guys can do in a world in which that technology transition occurs? And financially, just given the fact that, that gross margin profile has always been the best of your business, what does that mean for you? Is there any expectation or development with that as well?

Yes. So I mean, obviously, we can't talk about some of the R&D projects we're working on with not just that customer, but also with other customers that we've got. But in our most recent quarters, we've generally seen that customer were around 10% of our sales. And we're continuing to stay engaged with that customer in their R&D road map as well as their new product development, whether it has to do with their mobile phone or whether it has to do with the other -- their iPads of that nature. So as their technology changes, I can say that they like to tap on us because they know that they can work with our R&D teams to come up with innovative products that will have good time to market and be able to ramp as [ their demand comes ]. But beyond that, there's not really much I can say about that. But you're right, we have derisked the model in terms of what our expectations are, at least at a steady-state level.

Just want to use this opportunity, we have a couple of minutes left here. If anyone in the audience had a question, if they would want to raise their hand, we can get them a microphone. I have a couple more so [indiscernible] being today. All right. Capital allocation. Not a crazy question right now just because you just did the deal, but you still have a lot of cash. When you look at where your cash priorities are over the next 1 to 3 years, can you talk about how you're doing this, you bought back some shares. Any color there?

Yes. So I mean even after the Cloud Light acquisition, we've got quite a bit of cash on our balance sheet, and we've got a convertible debt that's due in the middle of March. And so our plan for that is to use the cash on the balance sheet and pay that up. We do still have some authorization left for share buybacks. That's something that we're always considering. And I think that a lot of the CapEx investments we needed to make in the core part of the business has been made, and I think we're investing appropriately from an R&D standpoint as well. So there is still sufficient cash on our balance sheet to go back and take a look at whether there are other opportunities that enable a strengthened product portfolio across either one of our product set. So I certainly think that there's an opportunity to continue to do some acquisitions that continue to strengthen [ product ].

Yes. I just wanted to offer one final question, and this is one we ask some of those companies here is when you look in '24, clearly, we spent a lot of time on this fireside talking about the new acquisition. But what are you most excited about as a company? And what would you point to investors as to why they should be looking at [indiscernible] today.

Yes. I mean we're -- clearly from the competition we've had, we're quite excited about the opportunities presented from the Cloud Light acquisition. But we're also very excited about the fact that our classic datacom EML business could see a nice inflection with what we believe we will have a competitive advantage on with our 200G products. And we could see a very good cycle again with that product set. And the amount of activity that's going on with hyperscale customers and the opportunity to vertically integrate into hyperscale transceivers, it just really provides us with a great opportunity to continue to grow our business.

Very helpful. Thank you so much for being here.

Thank you.

Have a nice couple of days, and thank you all for joining.

Thanks, Tom.