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

All right. Welcome, everybody. We'll get started 30 seconds early because I feel like there's a lot to talk about. I'm Meta Marshall. For those who don't know me, I cover networking and cybersecurity here at Morgan Stanley. We're delighted to have Lumentum, real star of the show today, Michael Hurlston, CEO. Maybe before we start with kind of all my prepared list of questions, you might have had an announcement this morning. And so clearly, kind of a $2 billion investment from NVIDIA. Just any kind of details you're giving around that would be helpful.

Yes. Look, I mean, first, we're super excited about the partnership. It's been many years in development. We've been working together with NVIDIA for a long time on our laser road map. And that's really what's -- the culmination of that resulted in their investment in us and perhaps more importantly, a multibillion-dollar purchase commitment that we're super, super excited about. We've been working on these lasers for a long period of time, and we think we have tremendous differentiation as it comes to high-powered lasers that would be used for optical scale out and ultimately, for optical scale up, right, whenever that particular opportunity hits and different people have different forecasts on that. But we think we've got advantages relative to the 400-millowatt high-powered laser that we've talked to you and others about. We think we have advantages relative to the reliability of that product. And one of the knocks on co-packaged optics as a technology has been the reliability of the laser. And we think we've solved that by virtue of reapplying a laser that we used for undersea pumps and undersea pumps are not something that you can lift out of the ocean every week when there's a problem. They have to be very, very reliable. And that reliability is, I think, something that NVIDIA and other customers as they start considering the transition from copper to optics, think about. And then the third piece is our capacity, right? So we have the most capacity in the world relative to indium phosphide today. As part of the investment from NVIDIA, we're going to go out and get another fab. We've actually identified and have that under negotiation at this point in time, but we haven't identified and where that is. But part of the commitment from NVIDIA will certainly go toward that Fab Meta, and it will enable us to step our capacity up yet another notch. And so obviously, this is, I think, the first agreement that NVIDIA has done with a supplier. They've done a number of different agreements with ecosystem, and we're honored and very, very thankful, frankly, that they saw the virtue and the scarcity of the indium phosphide supply that they felt it necessary to go out and do an agreement with us. Obviously, they did a similar agreement with Coherent. And I think it speaks volumes to that transition that we all see coming relative to copper moving toward optical interconnect and they've locked up jointly now between the 2 major suppliers, a significant amount of the world's capacity of indium phosphide. And we ultimately see this thing as a good thing, right? And the fact that we're working together with Coherent on this, hopefully, between the 2 of us, we can supply enough content that ultimately catalyzes the entire industry.

All right. Perfect. So it's been a little over a year since you came in as CEO. Over that time, revenue has almost doubled, earnings have gone up by 4x, and there's expectations of much more. Maybe to start with, what did you think you were stepping into this job a year ago? And just what has kind of surprised you about the last year?

Yes. I mean I'm just over a year anniversary you said. Now it's my second foray into optics. You and I spoke when I was with Finisar and Finisar, of course, now is Coherent and really the life of what Coherent is doing is my old group at Finisar. A lot's changed in the industry. I think we've gone from a telecom-driven industry and time scales are very consistent with telecom applications, meaning measured in years to a hyperscaler-driven industry and time scales that are measured in months and volumes that are measured in millions. So it's a much different situation than my last work as CEO in the optics industry. I think what's surprised me is obviously the rate of change, right? And it's only changing in one direction, which means up -- and also what surprised me is the company's receptivity to change. We've had to retool everything inside the company to meet a challenge that is far different than a telecom challenge, right, really retool the whole company to get it thinking on hyperscaler time scales, hyperscaler volumes. And the company has actually received that really well. I think we've been able to move the company forward in leaps and bounds while -- and really retool the culture to meet the challenge that we see in front of us.

Got it. We're kind of talking about this AI cycle has continued to ratchet up and the demands on the optics vendors increase almost exponentially. Just how are you continuing to judge what is the right amount of capacity expansions to bring on? How are you determining how much you want under long-term commitment? Just like where are you finding that sweet spot of your phone, which must be ringing off the hook and what's the right amount to bring on board?

Yes. I mean we're obviously -- we're trying to be measured. I think what we see right now is we have 4 indium phosphide fabs. We intend to bring on a fifth. And in those 4 indium phosphide fabs, we've given figures of merit to you that said we've probably quadrupled supply in the last year or 18 months. So we really put on a tremendous amount of additional supply in the existing properties that we have. We forecast in the existing properties that we have that we're going to be able to increase capacity another 20% over the next 2 quarters, which on balance means 10% increments over the next couple of quarters. And even in the face of all of that increase, we've fallen further behind in the supply-demand imbalance. And sort of tying back to the first remark, right, what I think what NVIDIA sees is a massive scarcity in indium phosphide, and they've been very strategic in making this first bet on the supply chain on something that is ultimately very, very scarce. So as much as we're adding capacity, we know our competitors are adding capacity. Our forecast certainly through 2027 and now probably into 2028, seeing the demands that are being placed upon us, we are sold out, right? We cannot make enough of these lasers. And even though we'd expect our competitors to continue to add, we're falling further behind in the supply-demand imbalance equation.

Okay. I've asked you this a couple of times over the last year. But with $1 of CapEx or $1 of R&D, just what are you deciding some near-term wins in terms of kind of building out additional indium phosphide capacity with just longer-term bets like OCS or CPO or maybe those aren't long-term bets anymore, they're medium-term bets. But just where are you judging where to spend that incremental dollar?

Yes. I mean we're excited about a couple of things, and we're trying to invest our capacity along these lines. I mean, first, and you hit on it, is CPO. We view our fab assets as incredibly strategic. As I said, we have 4. We're intending to bring on a fifth. We really feel like that's important for us to own. It's a differentiator for us. It's a competitive moat. OCS, right? As the world swings more toward optics inside the data center, OCS occupies an increasingly important play. And one customer uses it today, it's actually for optical scale-up. We see other customers looking to that for things like spine switch replacements. So OCS is something we're investing in heavily and really trying to shore up our road map because the demands on OCS are increasing. We see a world where the OCS can actually go in rack as opposed to being a rather big box that sits in a rack form factor, but sort of adjacent to the main rack. And then our other area of investment that you've talked about for a long time and has been really interesting for us is optical scale across. We've taken our telecom assets and we've repurposed those telecom assets to hyperscaler type of applications, things like our pump lasers, our WSSs, our wavelength selectable switches, our narrow linewidth lasers. We've reapplied all of that now toward the hyperscaler market, and we're seeing a lot of virtue there. So we're investing in all of these things and trying to defocus on things like industrial lasers. Industrial lasers is a nice business for us historically. We've taken a lot of the bets off the table there. We've tried to be very purposeful in these road maps in our laser road map, OCS road map, scale across road map to narrow down the amount of R&D we're doing and really focus on what we think are the winning opportunities.

Okay. So we've done a lot of alphabet soup so far. But maybe we could just take a step back and explain how Lumentum got to a place where -- how -- you talked about having the 4 fabs and that creating a competitive moat. But just where did you get to this spot where you could be kind of the leader at the high-end laser and just being able to keep that positioning for almost 30 years now.

Yes. I mean it's like anything in technology, and I see a lot of the Morgan Stanley people who have helped us so much through the years. Anything in technology is, I think, evolutionary, not revolutionary. You do have these successful companies that will come out of nowhere with truly revolutionary technology. But I think the big tech companies that do well are more revolutionary than anything else. And we've been able to really build upon a long heritage that was there way before me, right? The previous CEO, I think, did a terrific job in terms of building up a war chest of assets and a war chest of technology that we could evolve into what you see today. OCS is an evolution of WSS. Our lasers are an evolution of things that have happened really to drive long-scale metro transceivers, right, that we've now reapplied. We talked about our co-packaged optics being an evolution of our pump laser technology that we have now reapplied to a new application. So this is something I learned. I've worked for, as you know, many years at Broadcom. And I think what they did particularly well is focus on the core markets, evolve the technology and stay ahead. And I think if you look at the landscape that we're facing, there's so much differentiation now that's happening in optics, if we just stick to our lane, we have so much upside and so many derivatives that we can use on our core technology to expand our customer base and expand our footprint.

We've talked a lot about in terms of kind of demand on the EML front. Just how are you kind of balancing production needs of how much -- how quickly the industry is going to move towards 200 gig versus 100 gig? Even within these kind of 4 fabs, you have a lot of decisions that you're making.

Yes. And the way we think about that, Meta, is actually to sort of now allocate by fab the technology that we use. You and I discussed, I think, 6 or 7 months ago, this idea of sort of virtualizing the fabs to a certain extent. We are not doing that anymore. We're sort of purposely applying our fabs to different technologies. Our Japan fabs, and there are 2 in Japan, those will be used for EMLs, CW lasers that are more transceiver and scale-out focused. And -- our -- obviously, our opportunity here is to increase our output, but then to increase the mix of 200-gig EMLs. To the extent we can, we want to prioritize that better ASPs, better margins on the 200 gig. And so one of the things that people are forecasting is we switch from 100 to 200. We want to lead that, and that helps us on both margin and revenue. We have a fab in the United Kingdom, which is a little bit of a flex fab. We originally thought that we would use that for EMLs. CW lasers and actually PD open up a new front for us on the photodiodes and have some received technology that is an incremental opportunity for us. We're now going to reapply that fab in the United Kingdom to CPO. So the CPO ramp that we're facing is so very high and so considerable that we've decided now to shift that fab to CPO. We'll still try a little bit of PD because we think that's a good incremental opportunity for us. It's not getting a lot of attention. And then our last fab actually is in San Jose in the U.S. just down the street from us, and that fab is entirely dedicated now to CPO. So we've cleaned everything out of that fab to get ready. And we've already started production, as you know, and are shipping our high-powered lasers for the CPO application, but we would expect really to use all of that fab. And it's actually, at this point, it's relatively underutilized. We'd expect all of that now to be consumed very quickly within the next couple of quarters on CPO.

Okay. Got it. That's helpful. Early 1.6T demand weighing heavily towards EML-based transceivers, we expect to kind of move more towards CW lasers later on kind of in the 1.6T cycle. You recently kind of are testing some of your CW lasers externally kind of for this datacom purpose. Just how do you see kind of being able to time that switch?

Yes. I think right now, we don't think we're going to need to switch. In the face of sort of 2 things. One is to the extent that we believe CPO is going to take off, right? That CPO does replace transceivers, at least in scale out. The discussion around scale-up is something totally different where you're actually replacing copper. But the scale, scale out, you're -- we're cannibalizing ourselves as an industry. But in the face of a certain amount of scale out and in the face of exactly as you characterized, we think more CW lasers and silicon photonics transceivers will ship at 1.6T than will EML-based transceivers. In the face of all of that, our forecast is that our EML capacity is totally sold out and the number of EMLs across 100 and 200 gig will be completely consumed. So we don't think here that we would need to shift any of our capacity to CW lasers other than for our own internal consumption for our transceivers. Our transceivers are all CW-based, silicon photonics-based. So there's some dynamic that plays there. But we would expect to be almost entirely consumed on EMLs.

Okay. We've talked a lot about EML, CW lasers. You've been talking more about kind of the ultra-high power lasers more. Just where do you see kind of this biggest -- or the biggest opportunity here developing?

CPO is clearly the highest volume. I think as we start, we're seeing big impact for us on scale out. But again, that's a cannibalization, right? I think the interesting thing -- and again, depending on how it hits and how it feathers in, scale up is huge, right? This is all of the backplane of a rack that eventually, right, through time. It's not an instant thing. It's not a tomorrow thing, but you're going to see more and more optics creep into that rack, and that is a massive incremental opportunity for the entire industry. And I think this is why, again, some of the things that NVIDIA sees as they start thinking about getting their supply chain secured on co-packaged optics and on indium phosphide.

Okay. We've talked a little bit about the transceiver business. Cloud Light gave you access to kind of a very large hyperscaler customer. You've mentioned in the past kind of wanting to cap this business at $1 billion annual scale. You've said that, that clearly is not going to be the case anymore. Just how are you thinking about kind of growing the Cloud Light portion of the business?

Yes. I think -- so you got it right. I think what shifted for us in terms of the thinking is $1 billion cap turns out it's not possible, right? Even with my charm and silver tongue, I cannot convince the customers to not give us business. So it looks like it's an all or nothing, meaning if we say to a customer, look, we don't want your business, then they'll find somebody else. I mean the transceiver market is commoditized. You've talked about it for a long time. There are 7 people lined up to take our place if we were to back away. What we found is, look, we're actually pretty good at the silicon photonics designs. We have, I think, a leading engineering team. And what we have to bring along is our manufacturing. We've struggled -- first, we struggled a lot with our design. We were really not doing a good job on the design. We seem to have addressed that. And now it's about our manufacturing, scaling our manufacturing. We recently brought in a new manufacturing lead from a contract manufacturer who understands volume at scale. And I think that's helped. So we're optimistic we can get this turned around. But the way we're approaching it now is, look, we have 3 customers, 2 of which drive most of our volume. And the previous administration, I think, talked a lot about let's get customers 6, 7, 8, right, bring a lot more customer diversity on board. The way I'm thinking about it is, hey, we're good with these 3. They're driving plenty of volume for us. The transceiver business, even if I can get it to operate better, and I have to say that it's not operating well for us at the moment, even though the design side is going better, it's still going to be a drag on margin, right? I think you look at our competitors, they're 40% margins. I would hope to push this company considerably above that. And I think we can do that as long as we keep executing on lasers, on OCS and things like that. So we try to balance a bit of what we see from revenue growth on the transceiver line against the margin, right, and the margin headwind that it will invariably present. So we're trying to do that by let's focus on a couple of customers. We have 2 great customers. We have a third one that is a good customer, smaller customer. But if we can focus on those, I think we'll be just fine, and that will kind of give us that balance on the margin and revenue lines.

Got it. You've alluded to the scale across and kind of DCI opportunity. Can you just say just how you see kind of ability to participate today? Are there other ways in which you can kind of increase your content within those opportunities?

Yes. This is a way I'd say that we're probably pulling back from an integration standpoint, right? So we're focused on the components end of this. We -- when you started getting involved with the company, there was a big move to participate like in ZR modules, right, and do the DSP, for example, in the ZR module. We're proven unsuccessful in being able to do that DSP. And as such, competing against good companies like Ciena, Cisco, Marvell to a certain extent, we're never going to be able to catch them on a fully integrated ZR module. So we said, look, we'll kind of finish out our string there and focus our resources on the component side of it, meaning the narrow line with lasers that all of these guys are buying from us at good margin. We would want to see our pump lasers continue to do well and scale across WSS. I mean it's become a smaller part of our business because of success elsewhere, but it's a high-margin, high-value piece of the business that we continue to focus on. And we can think we can continue to differentiate here in the face of some of these guys bringing in vertical capacity on, for example, narrow linewidth lasers. So we feel pretty good about our ability to compete here long term, continue to drive really good gross margins, drive a lot of growth. It's the business has grown for us quite a lot. And we know that some of our customers are working on vertical integration and that's fine. There's still plenty of room for us to play.

Yes. Got it. Moving on to the optical circuit switch opportunity. Just what are you seeing in terms of -- I think you obviously talked about kind of one customer who's already deployed this for years, a lot of customers kind of trialing it. Just where are you kind of judging where people might be kind of doing lab trials, need some time versus like who's ready to go and you can prioritize them in your scaling operations?

I mean, look, the OCS has been a big surprise. I mean, we've had a series of surprises, right? Today is one in a long series of surprises. But OCS has been a huge surprise for us, right? We talked to you not 3 months ago about aspirationally getting to $100 million of revenue -- incremental revenue on the OCS line in the fourth quarter of the calendar year. And then on our last earnings call, I think we surprised a lot of people said, "Oh, no, that's going to actually be something more like $400 million across the last 2 quarters of the calendar year." So effectively sort of tripling the volume and revenue that we saw coming on the OCS. That's actually coming from 3 customers, 2 of which are driving the majority. And one of them is really interesting in that it's a spine switch replacement. So we see -- if you subscribe to this thesis, which obviously we believe strongly in that more of the world is going to go in an optical direction, more of the data center is going to go in optical direction. Why switch between electrical switches and optical domain? Why switch between the electrical and optical domain? Why not leave everything as optics? And so in the spine switch, spine switches are lower -- a longer latency, so you don't need that fast switch time. They are typically traffic-based rather than packet-based. And so you can actually replace that entire layer if you're intelligent in it and offset some of the power budget that is going to come as people start thinking about optical scale up, that is a power hit, as you know, right? That's a power and a cost hit. You can offset a good amount of that by deploying OCS at the spine. It's a power savings. It's a cost savings in terms of the total cost of ownership. So we really like what's happening on OCS. There's one customer that obviously is deploying it today a great effect. in their data centers using it to scale up. And look, we think we can compete there, right? But that's a TBD. I think where we're most excited is on this optical -- the spine switch replacement application. We see a lot of other use cases now starting to occur, right? You're seeing it potentially deployed in rack at really high volume as sort of a fail-over mechanism. You're seeing it on a DCI application. So as we've been able to prove the maturity, the reliability, the scalability of our manufacturing, we're seeing a lot more use cases for OCS.

Got it. We have all been talking about CPO for many years and probably the biggest hurdle has just been that kind of supply chain ecosystem to kind of turn out what is as reliable as kind of the transceiver ecosystem today. So just where are you starting to see kind of the steps be taken not only by you guys, but there's kind of a whole ecosystem that needs to come together to kind of make CPO more realistic I guess?

Yes. I mean I think the knock on CPO for a long time, and you've been around this business for a while and understand it to a level of detail that probably even I don't, you really have a good handle on this thing. The knock has been reliability of the laser, right? There's been this concern that the laser will fail. And if you put the laser down next to a switch chip or next to a compute, it's going to cause a yield problem for the entire box, right? Nobody wants that. And so the way at least these first instantiations are solving it is, one, to use a very, very reliable laser, right? As I said a minute ago, we're reapplying pump lasers that are used for undersea pumps in this technology. And nobody wants to pull an undersea pump out of the Pacific Ocean, right? You better not do that because that costs millions of dollars. So those lasers are already robust and built not to fail. Two is the amount of testing that we have to do on our CPO solution, right? We're burning in each -- lasers have an infant mortality problem. They typically will fail early in the cycle. We're burning these things in for 24 hours, each laser. And so that goes to an additional bulletizing or ruggedizing of the solution. And then the third thing, frankly, is the initial approaches are in these pluggables, right? So you're not putting the laser right down next to the switch chip or the compute. It's going in a pluggable that can ostensibly be removed if you so desire. That ELS represents another area in which we think we can compete. Today, if you look at our business, it's all these numbers that anybody is talking about, just the laser content. But we think we can start competing in this ELS. And that becomes important to us as the number of customers on scale up right? The conversations are broad-based. I mean we just have a whole host of customers now that realize that the laws of physics are beginning to run out for copper, and you're going to have to have optics in a fairly prevalent way, and that is working very much to our advantage, but most customers are not optics experts. And so they need a more turnkey solution to apply this, right? You have a certain class of customers that are used to dealing with lasers on a stand-alone basis, NVIDIA being one. They have a great engineering team. But most of the other customers that we talk to, hyperscalers, other chipset guys do not have that capability, and therefore, you need an ELS for us to really engage. So something that's -- there's a lot of things, I think, that are beginning to be understood about the opportunity for us, but the optics industry at large. One thing that's really not appreciated in our numbers is the opportunity for us to compete in a broad way on that ELS, right? That's a really incremental revenue opportunity that we have that we think can be a differentiator for us over the very near term.

So you noted on the last call, production capacity would potentially be through M&A. You kind of alluded to that earlier. Just how are you thinking on capitalizing on the position with M&A? You were very successful with Oclaro, NeoPhotonics, Cloud Light. Just how are you thinking about kind of other -- is it largely going to be kind of these additional fabs or any other areas we should expect on the M&A front?

Look, I mean, I'm fundamentally a deal guy. [ Wally ] knows that very well. I like deals, right, a lot. And we built my previous company largely through M&A. The beauty here is we don't need M&A, right? I mean we actually don't need it because there are so many growth drivers right now. Our most important area of focus is on our own execution, right? We have to be able to deliver and meet a series of huge ramps, precipitous ramps that the company is facing. But that being said, right, I think there's an opportunity for us to continue to consolidate the industry. I like components. I think components are very strategic for us. OCS aside. OCS is obviously a system, and we've done phenomenally well with that system because it's differentiated and high margin. But if we could bring in more components, we'd like to do that. We have a relatively strong currency at the moment, so we'd like to use that to our advantage. And we're going to do some things, I think, to clean up the balance sheet here, some of this injection of capital that we've seen from NVIDIA will help us in that context, obviously help us as we try to scale out the fab. But hopefully, we'll be in a better position to really get our M&A engine firing.

Got it. We have a couple of minutes left. So any questions from the audience? Tom, I can repeat it.

Might be [indiscernible] they work in the space.

That guy uses our products. Yes. I saw the speaker as I was coming in and they use our products. I mean it's much smaller volume, right, because the application is still very nascent, but you need a sort of a similar thing, high-powered lasers that are going to go over a long distance, and they're a big customer of ours. We see that as an opening front, but nowhere near the volumes that we're talking about and Meta is referring to with respect to scale out, scale up and these kinds of things.

How are you dealing with geopolitics, particularly around China's export restrictions to Japan?

Good question, right? So as I mentioned a minute ago, we have 2 fabs in Japan. What we've been able to do sort of skate around that is form a long-term agreement. One of the concerns in the company a couple of weeks ago was around substrates. So we buy indium phosphide substrates from a third party. Fortunately, for us, that third party is not in China. And we've done a very strategic deal with that particular supplier, a 7-year deal, right, that we think covers us out through mid-2030s that assures us of supply. Again, in the face of all these extreme forecasts and all these numbers going up, we think we're really well positioned. So we sort of work with them to kind of corner the supply of their indium phosphide substrates, which certainly mitigates, I think, a lot of the concerns that existed previously around China and the Chinese substrates coming into a Japanese fab. Good question.

Got it. All right. With that, a very exciting day for you guys, and I'm glad we were able to have you here. So Michael, thanks so much.

Thank you, Meta. Thank you. Yes.