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

All right. Great. Good afternoon, everyone. Thanks for spending time here at UBS' Tech Conference. I am David Vogt, the hardware and networking analyst, and we're excited to have with us Michael Hurlston from Lumentum, President and Chief Executive Officer. We're going to dig into the business.

But I thought maybe since you've been in the seat for 18 months, is that about right, 15 months?

Less than a year, David. Less than a year. Yes, less than a year. Yes.

But maybe just -- okay, so we'll go into each of the segments that I think investors are focused on in a second. But from your seat, from an outsider coming in, clearly less than a year. Maybe just level set kind of how you're thinking about the business when you joined to where we are today? I think a lot has happened in this less than a year period, and we'll dig into each of those products and categories separately.

Yes. Look, it was -- CEOs very rarely change jobs. You either get fired or you retire, right? And I've now been CEO of three public companies, one of which I was retired from, but then I made a switch. And I remember the Board of Directors sort of presenting to me their view of the forecast as they were trying to recruit me to come into the company. And I'm like, this is crazy. I mean, there's no way the forecast can look like this. Why would you possibly be wanting to make a CEO switch in the face of this forecast. And the reality has ended up much different. The forecast that they gave was understated probably by a factor of 2, which was already incredible to begin with. And it's been an incredible journey. I mean 10 months, I think the day I joined, the stock was like $70. And obviously, we've seen quite a bit of appreciation in the share price over that period of time. But we've had to do a lot of work on the company. I mean, I think the previous CEO did a great job, obviously, setting up the road map, but the Board wanted to see the ability to scale because the telecom industry, which is really where optics has been, was built on scales of thousands, right? And they could see that it was going to be semiconductor-like scales that were coming, and they wanted to get somebody who had seen a semiconductor cycle before and could scale thousands into millions and tens of millions and maybe even hundreds of millions, right? So this optics industry has never seen anything like this. And I hit it at exactly the right time. I watched my good friend, Jim Anderson, who is also a semiconductor guy, make the jump to Coherent, and he's done, obviously, a hell of a job over there, too. So you've got two semiconductor guys now in optical companies.

Great. Great time to be alive.

Yes, not too bad.

So when we think about the forecast that you talked about being really bullish and now obviously, magnitudes stronger. Let's talk about underpinnings of that. Let's start with sort of, I think -- not to deemphasize this business, but let's talk about the transceiver business first. So obviously, that business has seen tremendous growth, the market has grown leaps and bounds better than I think anyone had expected. Back in -- you're in this business because of an acquisition made back in 2023. So can we talk about kind of how you're thinking about that business long term? I know you've been pretty vocal about how you see that from a customer perspective, a volume perspective, an IP perspective. So as we sit here today, given just the demand trends that you're seeing, like maybe just refresh us on like how do you think that plays out? I mean is there really a cap on that business in terms of how you're thinking about the revenue opportunity? Self-imposed cap, I should say, not a demand cap.

Yes, David. Look, I mean we -- of all the businesses that we have in the portfolio, this has been the most challenging for us. We haven't executed, I would say, particularly well in the transceiver business. We are a minority player. We are behind several of the big Chinese names in terms of being able to supply transceivers and certainly behind Coherent. So we're trailing the play. And what we've said is given the margin profile of that business, which even in the best case, I think, is sort of a mid-30s, maybe high-30s type business, we want to get our overall corporate margins. We've given a long-term target of 42%. We think we have, obviously, room to expand above that. But that transceiver business will always be a bit of a headwind. And so we've communicated that today, that business is running about $500 million annually. We said, look, we have aspirations to get it to $1 billion annually, to add another $500 million of incremental revenue. But we don't want it to run much higher than that, just given the margin headwinds we see. We think we can manage our business up from a margin perspective if we keep the business to about $1 billion top line. If it gets beyond that, it will be more challenging. Now that being said, and you sort of alluded to it in the question, we've certainly seen pressure from our largest customer and other customers to ship more, right? Because the demand right now is very, very high. And so our challenge is going to be how to improve the margin of the business. We really need to do that and then how to kind of manage it probably in the face of a little bit higher than $1 billion of top line revenue over the capture period.

And that, I think you said publicly that's really targeted with three large existing customers that you've had a long-standing relationship with since you've gotten back into this business. And to get to that margin target, I know it's probably below that 35% today, what needs to happen? Is it vertical integration? Is it outsourcing? Like how are you thinking about driving that margin? I know it's the least exciting piece of your business today in your view, but just -- maybe let's get this one out of the way first.

Yes. No, no, I appreciate it. Look, it's a good business for us. I mean I don't want to minimize it. I just think that other parts of our business have incredible growth opportunities with better overall margin profiles. Look, you guessed it right. I mean we're operating meaningfully below the mid-30s in terms of margin. We have a couple of levers. First, we are not manufacturing at any kind of scale. Getting the business to $1 billion allows us to amortize units over our manufacturing footprint, that helps the cost. We have to improve our manufacturing. Our manufacturing is substandard right now. We brought in a new person that comes from Jabil to run our factories, and he really knows what good looks like, and I think he can improve our automation levels, he can improve our throughput levels, he can improve our scrap and yield, all of which are contributing mightily to our problems. So I like how he's thinking about that business. And then you and I have talked about it, we also don't in-source. So none of our transceivers use our own components. That can be a margin benefit by taking our lasers in particular and bringing them into our transceivers. And so we intend to do that as well, all of which, I think, moves us much closer to a sort of a mid-30s margin profile over the next handful of quarters. It's still going to be below sort of corporate margin targets. And we have other levers, of course, across the portfolio that I think help us on the margin line.

Okay. Got it. So as an extension of transceivers, maybe let's touch on EMLs, right? So EMLs have been an incredibly strong business for you, supply is incredibly tight. Indium phosphide is an incredibly short supply. I think you've added 40% capacity year-over-year this year. So how are we thinking about -- how are you thinking about as we go into '26? I'm pretty sure I know the answer to this, but it kind of feels like you're sold out for '26 on EMLs, if I'm not mistaken, and you have long-term agreements with customers. Is that how investors should think about the EML business in '26? Or is there room for incremental sort of capacity additions from your existing footprint at this point?

Yes. Let me talk a little bit about the capacity. You've got that a little bit wrong. We have Kathy Ta, who's here with me today, our Vice President of Investor Relations, talked about before I joined doubling our EML capacity in a 12-month period and a backward look, that happened, right? We actually out-executed that road map. And then I think she and I thought we were sort of going to see very asymptotic improvements in our overall capacity. We brought in, again, sort of a new person to look at our fab strategy and that person has figured out ways to squeeze our existing footprint fairly considerably. And so we gave in the last earnings call a new benchmark saying, over the next 3 quarters, meaning our December, March and June quarters, we expected to add that 40%. So that's a forward-looking statement where we'd expect an increase in capacity of 40% on what already is a doubled number. So we're outputting a ton, and then we expect to increase that by another 40%. Then on top of that, as we look at the next 6 quarters, we've also talked about a strategy that's a very unique strategy that this person, our new leader for our fabs has come up with, and that is to virtualize. We have four indium phosphide fabs, which gives us a very unique purview on the industry. One of them is largely dedicated to co-packaged optics, which I'm sure we're going to get to in a minute. But the other three, one is really stretched to a maximum capacity. That's where our EMLs come from. Two are relatively underutilized. And this guy has come up with a really a strategy to use all three as sort of a virtual single instance of a fab. And in so doing, we would expect to get another step-up in capacity over the ensuing 6 quarters. It's such a unique strategy in this virtualization. We don't know what it ultimately leads to, how big that number is. So we -- Kathy and I haven't characterized that as yet. But you can imagine now if we can really take advantage of three factories as opposed to one, we should get a pretty nice step-up in our output. We just haven't quantified that.

So along those lines over the next 6 quarters, it sounds like there's obviously additional capacity. One of your relative competitors, partners in the industry is adding 6-inch capacity in indium phosphide. So how do you think about -- on a couple of lines, how do you think about the industry supply-demand balance longer term? I mean is this a let's get through '26 into '27 and then we'll kind of revisit? Or is the demand existentially strong for multiple years where you still have to consistently look at ways to drive more capacity to meet the underlying demand that we're seeing, which seems to be unwavering.

Yes. Look, I mean, again, a really good question, David. I think we're seeing Broadcom has indium phosphide capacity they're adding. You're referring to Coherent. They're doing a really good job adding capacity. Our Japanese competitors are adding capacity. We're adding this 40% we've stated over the next 3 quarters. In the face of all that, we've also said we see the supply and demand imbalance increasing we're falling further behind. And that accounts for all this other capacity that's being built out here or there and everywhere by our competition. So at least through 2027, we don't believe we catch up. We think we're still behind on supply given the demand levels we're seeing. We are facing a decision now, certainly in the next quarter to maybe invest in a much larger footprint and that's one that we're weighing. And we're just trying to really gauge where our customers and our demand profile is before we really go and invest in breaking new ground or investing in new clean room space that would really inflect our capacity another level.

Well, you mentioned earlier, given your background from a semiconductor perspective and Jim's background and you used the word cycle, doesn't feel much like a cycle right now, right? It feels like an elongated demand backdrop. I mean how would you characterize where we are in this particular part of said cycle versus like your historical perspective? I mean I don't think there's an analog that I've seen in 20, 25 years. Just kind of love to get your perspective because we get questions from investors all the time, do you have visibility into '27, visibility into '28? Jim made reference to '28 orders -- or not orders, basically comments and potential commitments from customers into '28, so how are you thinking about that maybe at a higher level?

Yes. I mean we're -- we have commitments certainly through 2027 in our business. I'm sure it's not dissimilar to how Jim is seeing it. I lived through probably the biggest wave of demand in semiconductors, which was WiFi, right? WiFi was in nothing and grew to a massive technology wave. And that was very, very sustainable, obviously, right? It's a technology that continues to live on. But this dwarfs even the WiFi cycle. I mean just crazy in terms of the amount of demand that we see, the changes in the demand signal, and by the way, those changes are only in one direction, right? So it feels very sustainable. We see no slowing down we're asked the same question you are, right, on a daily basis. Well, what if, what if, what if. And at least right now, the what-if is, can you please manufacture more.

Got it. All right. So let's just move to CPO since you mentioned CPO. Obviously, that's, I think, a unique -- you have a unique position in CPO from a laser perspective. The market, I think, is still kind of debating in terms of scale and scope of how big CPO from an industry perspective can be as we move through '26, more realistically '27 in terms of more volume. I think you said you expect your CPO-related business to start ramping in late calendar '26 or the second half of '26. Maybe kind of give us a sense for how you see that sort of demand curve playing out or that cadence playing out as we move through '26 into '27 where volume should ramp more materially?

Yes. Look, we're shipping today. I mean the good news, there's -- as you're correctly saying, I think there's been a lot of debate on CPO. We see that debate waning simply because there's enough proof points out there that it is, in fact, happening. And of course, we're participating in a very material way. So we're shipping today. I think we've been surprised at the robustness and the performance of the solution that we're out there with, obviously, our leading partner, they've done very well with it. But we expect an inflection point on Ethernet-based switches. That's where we see the real step-up where our revenue would become more material. Today, you can't really see it because it's relatively small, shipping on one switch platform. What we've said in the second half of 2026 is we'd expect a pretty big step-up in the revenue, and it would become something much more material. And I think since the last time we talked, we have a lot better confidence in that timing. That timing seems to be holding very consistently and more confidence in the vector, the magnitude vector of that -- the revenue. We expect that to continue through 2027. And then we're actually engaged with multiple customers. So it's not just the one leading customer that has made a lot of noise about co-packaged optics. We see engagements now from other switch companies, from other people that are deploying switch silicon themselves, from other GPU and CPU vendors. So it's a little more broad-based than the one customer. And obviously, that's given us pretty good confidence.

And what -- and just maybe [indiscernible] straight on this, what you're seeing, this is an opportunity largely in scale-up, right, near term. So does the Ethernet consortium or ESUN, is that a longer-term opportunity by the time they set standards, by the time protocols are determined. Like how do you think about that as an opportunity outside of that large very vocal customer that you're working with today, particularly on Ethernet switching?

Yes. Look, it's scale out. So the opportunity that we're addressing today is a connection to the top of rack switch. So that, of course, is scale out. We do see opportunity. ESUN is really a scale-up type of technology, and we see opportunities for the first time in a much more appreciable way on optical scale up. I think the conversations today have really been about optical scale up. I mean, people are starting to see signs of that. Still too early, right, to really call how optical scale-up feathers in but it certainly seems that the laws of physics are playing now much more in our favor where CPO had been talked about for years and years, it's happening. It seems like in a similar vein, now optical scale up is being talked about, but there's enough trials, enough activity around it that it looks like it will happen, whether that's in '27 or '28 remains to be seen, but we certainly are much more bullish on optical scale up than we have been in a while.

Maybe just touching on competition in CPO. You mentioned CBO has been talked about for a while. I think if we went back to like OFC in '22, '23, players like Marvell are making a big stink about it, Cisco is maybe a little bit less optimistic. They don't -- Cisco doesn't sound as optimistic on CPO being sort of a mainstream solution that they're going to participate in, how do you see the competitive landscape today and how that's evolving and the relationship between some of the other optics players in the space right now?

Look, I think it's sort of a matter of timing. I think these first high-volume shipments that we'll participate in with our customer, we think that, that helps them differentiate their solution against the Cisco, against the Broadcom. They're excited about the power savings that it brings. They are excited about the cost savings that it brings. And they've obviously done very well in their networking business, right, over the last couple of quarters. They've really been able to differentiate there. So I think that depending on the success, and we're obviously super optimistic, I think they're very optimistic about the success, we would expect other people to fall in behind. I mean, Broadcom makes a lot of noise about it with their platform, and they have the ability to deliver a turnkey solution on CPO. We'll see how the landscape plays out.

Got it. So since you mentioned your large customers switch portfolio, maybe it makes sense to touch on OCS, right? Obviously, this is a new TAM for you, relatively new TAM for you, talked aggressively about it 6, 9 months ago. How do you think about your technological road map in OCS versus the incumbent road map? You have -- like Google has their own technology, you're MEMS-based, competitor's liquid crystal, maybe talk through like why you think MEMS -- your MEMS solution is technically the right solution, and as you, two, three customers that are ramping as we speak and will probably ramp aggressively as we move through '26?

Yes. Look, I mean, OCS is an incredibly exciting opportunity for us, right? I think we have not given TAM sizes. There's a third-party data point out there that says it's a $2 billion TAM in 2029. Based on what we see, we can say that, that is way off.

Probably too low.

Way too low. We deploy, as you correctly said, a MEMS-based solution. The one existing OCS that's out there that ships in very, very high volume is also MEMS-based. MEMS has the advantage of being effectively lossless, right? Because it's a mirror. You're basically shining light on a mirror and that mirror is redirecting traffic from one port to another. Remember, OCS is really a traffic management system. It's not a packet-based switch. It's a traffic-based solution. And having no loss is really a key technical advantage. The opposing camp, there's solutions that are based on liquid crystals, as you correctly said, you're passing light through something, so there's inherently going to be loss. You also have a band dependency, when you're using a mirror, you could operate in any frequency band, any wavelength, you're just moving light around, whereas a liquid crystal is by its definition, going to have to have different SKUs to handle C-band, O-band, whatever it might be. And that again gives us a distinct technical advantage. The knock on MEMS is the fact that there's moving parts, right, that there's a reliability concern. And the way we answer that is, look, we've shipped these things in telecom solutions for years. They've had to exist under the ground in fiber backhaul networks for 7, 8, 9, 10 years, and they haven't failed. So we think we've got that part of the solution [ linked ], the reliability piece.

Got it. And so when you -- I know you haven't given a TAM, but I think it's my understanding, and I think you might have said this publicly, your initial foray with three large customers sort of mimics or overlaps with your three transceiver customers. Is that fair?

We have not said that but...

Okay. So I'll throw that out. I'll state that with maybe different rank orders in terms of maybe the revenue opportunity within that portfolio versus transceivers. How do you think about -- so I mean, is it -- is the volume ramp dependent upon the speed at which sort of AI data is driving training environments and then ultimately, inference environments, where bandwidth latency, to your point, is critical. And so as we see more customers, these three customers that we think are your customers ramp 800G and then faster speeds, 1.6, that is sort of the tailwind to think about how quickly OCS gets deployed in those environments?

I think this is a great situation. I think the limiter on OCS is ourselves, right? The demand numbers that we're seeing from OCS are numbers that we simply can't meet. And so our challenge is building out our infrastructure, our manufacturing capability, the supply chain as quickly as we possibly can. There are a number of different use cases, as you know. And each of our three customers deploy this differently. You have a TPU, that's really an optical scale up inside a cluster. You have an optical spine switch replacement use case. You have a GPU or XPU kind of protection mechanism, whereby you're trying to steer traffic away from a failing or overloaded GPU. We're shipping to all three of those use cases. We've given a revenue road map, as you know, David, saying, $10 million, which will be our first real appreciable revenue from OCS, $10 million incrementally in Q1 of this year, ramping to $100 million in Q4 of this year. Our limiter, we could do quite a bit better than that if we could actually make the stuff, right? It's really a limiter again, on the supply chain and our manufacturing capacity.

So maybe I'm not as familiar with what the bottleneck is from the supply chain. Is it manufacturing capacity? Is it substrate? Like is there a golden screw, if you will? Like what is sort of the gating factor that's limiting how quickly you can produce, your partners can produce for you?

Yes. I mean I'd say the long pole is our manufacturing capability. So we're going from a standing start, right? We've never seen demand on our OCS. It's been something that we've sort of had as a science project on the back shelf. We're now making sort of limited production quantities. And to get to the levels that our customers want, we have to get to a whole different set of manufacturing capacity. So we're -- we've already spent the money on the CapEx, it's a matter of deploying it. The next limiter, there are certain components in the system that are tough to get. The MEMS, back to your point, we are overdriving our MEMS supplier. They've, again, never seen volumes like this. They're not used to this kind of scale.

They're used to the telecom market.

They're used to the telecom market. There's power solutions. We have a very specialized DACs that go into the product to drive the MEMS. It's a voltage-driven MEMS solution. So there's several key components that we need to have come in place as well.

Final question on OCS. So obviously, it comes up in questions, and so I'll run this by you. When you think about MEMS versus liquid crystal, that voltage dynamic that you mentioned, obviously, since you're actually mechanically moving mirrors, how are your customers thinking about that sort of voltage dynamic difference between liquid crystal. I know it's lossless versus not -- with-loss issues, but how is that sort of reconciled by your customers? And how do you think about that dynamic?

Yes. Look, I mean, I think from a competitive standpoint, we've shown, first of all, that we have a pretty appreciable lead on a 300-radix switch. The majority of the deployments are on a high-radix switch. There are some that are 64 by 64, that I would see to our competition. I think they're doing a better job on the lower-radix switch. The MEMS argument, as we discussed a second ago, is that, that is a concern that comes up over and over again, but we're able to show data that we've had these MEMS-based solutions deployed in the field for 5, 10, sometimes 15 years without any reliability problem. So we're able to overcome that objection pretty quickly with -- on the backs of good data.

Got it. All right. Just in the few minutes we have left, I'll talk about your telecom business, components, obviously, that's a bit different than sort of what it looked like 3, 4, 5 years ago. I think the outlook is considerably stronger. So when we look at the portfolio today, within your component business. What are you most excited about that is not only supportive to the gross margin targets that you're aiming for, but sort of growth rates, maybe not on par with what you're seeing in some of the other parts of the business, but really, where you're seeing sort of a step-up in demand from a component perspective in that vertical?

Yes. I mean it's -- we talked with you and with other people that are involved in the stock in the last earnings call, the other surprise -- we had two big surprises. One has been our ability to increment the EML demand. We talked about that. The second is just the broad-based nature of the scale-across opportunity, and that's affecting all of those traditional telecom type components, our ROADMs, our pump lasers, our narrow-linewidth lasers, all of these things are seeing unprecedented levels of demand. And it's now -- our traditional telecom customers, Ciena, Cisco, Nokia, these are great customers of ours. They're now -- their customer now has gone from AT&T to Horizon, to Google, to Meta, to Amazon. And they've done a great job really capturing that scale-across opportunity, but we're selling components into that, and that really has been a catalyst for our...

And I know you're the component provider, so this isn't directly kind of in your purview, but like there's a subtle difference between scale across and traditional DCI, right? So in scale across, we're connecting -- effectively your products or -- your components are going into products to connect sort of dedicated links between AI clusters. Is that how you're seeing your -- I mean, you're [indiscernible] from it, I guess, one step.

Yes. But you're right. I mean I think that Kathy used the example of a Venn diagram earlier today. DCI is the large circle and scale across the smaller circle. Specific scale across is, I'm trying to run an inferencing model over multiple sites, right? So you're actually transferring data -- actively transferring data across multiple clusters within multiple sites. And that's the portion of the business that has done super, super well.

And as an outsider looking in, should we view the opportunity set driven largely by kind of the regional distribution of data centers because of power considerations and other sort of nimbyism? And so the more we have, more distributed data center infrastructure that's just a fairly meaningful tailwind for your component business, particularly in scale across?

Yes, 100%. I mean, I think it's driven predominantly by power. I've not heard the term nimbyism, but that is an issue, right, where you're just not going to get these massive data centers in somebody's backyard. And that's been a great tailwind for us. I don't think that, that's going to decrease anytime soon.

Great. So I think -- we're out of time.

Okay.

I want to thank you, Michael, for joining us. Thank you, everyone, for joining, and enjoy the rest of your stay. Thank you.

Appreciate it. Thank you very much.