Good day, everyone, and welcome to the Lumentum first quarter fiscal year 2019 financial results conference call. As a reminder, today's call is being recorded for replay purposes through November 7th, 2019. I would now like to turn the conference over to Mr. Jim Fanucchi of Darrow Associates. Mr. Fanucchi, please go ahead.
Thank you, Adam. Welcome everyone to Lumentum's first quarter fiscal 2020 earnings call. This is Jim Fanucchi from Darrow Associates, assisting Lumentum with its investor relations. Joining the call today from the company's management team, we have Alan Lowe, President and Chief Executive Officer, Wajid Ali, Chief Financial Officer, and Chris Coldren, Senior Vice President of Strategy and Corporate Development. Today's call will include forward-looking statements, including statements regarding the markets in which we operate, including potential market sizes, trends and expectations for products and technology, including product development and projected new product releases, purchasing trends, and demand for our products, our expected financial performance, including our guidance expenses and position in the market, as well as statements regarding our acquisition of Oclaro.
Lumentum encourages you to review our most recent filings with the SEC, particularly the risk factors described in our filings with the Securities and Exchange Commission, including the company's quarterly report on Form 10-Q for the fiscal quarter ended September the 28th of 2019, to be filed with the Securities and Exchange Commission later today, and Lumentum's 10-K for fiscal year 2019 ended on June the 29th. The forward-looking statements provided during this call are based on Lumentum's reasonable beliefs and expectations as of today. Lumentum undertakes no obligation to update these statements except as required by applicable law. Please also note, unless otherwise stated, all results and projections discussed on this call are non-GAAP. Non-GAAP financials should not be considered as a substitute for or superior to financials prepared in accordance with GAAP.
Lumentum's press release with the first quarter fiscal 2020 results is available on its website at www.lumentum.com under the Investors section and includes additional details about our non-GAAP financial measures and its reconciliation between our historical GAAP and non-GAAP results. Lumentum's website also contains our latest SEC filings and supplementary slides relating to today's earnings release, and the company encourages you to review these documents. In addition, a recording of today's call will be available by 11:30 A.M. Pacific Time today on our website. Now I will turn the call over to Alan for his comments and first quarter market and product highlights. Alan?
Thank you, Jim. Good morning, everyone. Our strong first quarter performance underscores our continued progress toward our long-term strategic and financial goals. A revenue mix richer in new and more innovative products, increased scale, and acquisition synergies all helped drive sequential and year-on-year improvements in gross margin and operating margin. In particular, improvements in telecom and datacom margins helped first quarter non-GAAP gross margins expand significantly to more than 45% for the first time ever. We believe we have sustainable technology and market leadership positions across the markets we serve. These have been attained through successful investments in R&D over many years, and more recently, enhanced by M&A. We have irreplaceable experience and learnings developing and ramping new and innovative products, and in some cases, years ahead of our competitors. We continue to invest strongly in R&D to extend our leadership positions.
Our increased scale resulting from organic growth, share gains, and the Oclaro acquisition allows us to invest more in new technologies and products. For example, our current investment in R&D is more than 30% higher than before the Oclaro acquisition, despite having reduced the number of combined product lines. This higher investment level helps us accelerate the time to market on key customer programs, including those in new, longer timeline opportunities, such as 3D sensing and LiDAR for the automotive market. For further details on the first quarter performance. Revenue increased 11% sequentially and 27% year-on-year. 3D sensing was the primary driver of sequential growth and contributed significantly to year-on-year growth. Our industrial and consumer product lines, which include 3D sensing, were up 92% sequentially and 26% relative to the prior year.
Year-on-year growth was driven by winning strong share in a larger market as customers are incorporating 3D sensing in a higher percentage of their product offerings compared to last year. During the first quarter, we saw multiple customers launch new products incorporating front and world-facing 3D sensing capabilities. These product introductions demonstrate the increasing appeal of 3D sensing for biometric authentication, computational photography, and augmented and virtual reality. We have shipped more than a half a billion 3D sensing lasers to date. This is an amazing accomplishment, and our experience is a valuable advantage that is difficult for our competitors to replicate. Customers around the world know they can count on our proven and unrivaled reliability and volume capability. R&D teams are very busy working with customers on their future generations of 3D sensing needs.
We expect that customers over the next 12 months will incorporate additional 3D sensing capabilities in their products, which should result in significant growth in our addressable market. Related to 3D sensing, since our last call, we have provided additional samples of photonic devices for the automotive market, including laser assemblies for high-performance LiDAR applications. While significant revenue is several years away from many of these applications, we are very optimistic about both the market opportunity and our ability to win customers with our unique capabilities. Looking to the second quarter, our guidance contemplates 3D sensing declining more than 20% sequentially, which is larger than the seasonal declines we experienced last year due to this year's earlier ramp. Turning to our telecom and datacom product lines. Transceiver customers who purchase our high-performance laser chips serve both the telecom and datacom markets.
Because of this, starting with the first quarter, in our commentary on this call, our earnings slides, and in our 10-Q, we are now combining our telecom and datacom product lines. In the first quarter, telecom and datacom revenue was down 8% sequentially, but was up 40% from the prior year. More than half of the sequential decline was due to the discontinued low-margin product lines we've previously discussed. The remainder of the sequential decline was primarily due to lower shipments of non-ROADM products to Huawei and the expected decline in submarine revenue we highlighted on our prior call. Sales of ROADMs were flat sequentially, as on the net, supply and demand are in equilibrium for the time being. With that said, we remain constrained on many of our highest-end ROADM products. Revenue from telecom and datacom products that are being discontinued totaled $19 million in the first quarter.
We expect this revenue to effectively decline to 0 over the next two quarters, with the majority of the remaining decline occurring in our third fiscal quarter. Excluding these discontinued product lines, telecom transmission revenue was up nicely on a sequential basis and demand is strong. First quarter revenue was impacted by our ability to increase output on coherent modules to meet customer demand. We have previously highlighted that strength in telecom transport is often a leading indicator of future strength in demand for transmission products. We are now seeing an increase in demand for telecom transmission products after a lengthy period of telecom transport strength. Sales of chips to transceiver customers grew 13% sequentially to a new record level. We have strong engagement from new and existing customers for chips, including for 5G wireless network applications.
Based on the continued strong growth expected in global network and data center traffic and optical infrastructure needed to support 5G wireless networks, we believe the market for our telecom and datacom products should be strong on a multiyear basis. We are well positioned with our industry-leading products and deep customer relationships. We believe from global bandwidth expansion, regardless of who builds or supplies. We benefit from global bandwidth expansion, regardless of who builds or supplies the networks. Our next-generation products are critical to our global customer base and include high-performance DML, EML, and VCSEL products, enabling high-speed optical transceivers, including 400G and above, and next-generation wireless front haul and access solutions. MxN and high port count twin ROADMs. A range of high-performance DCO transmission modules and underlying highly integrated components. Finally, high baud rate indium phosphide components, including those for 800 Gigabit transmission.
Looking to the second quarter, we expect telecom and datacom revenue will be up sequentially, driven primarily by growth in telecom transmission and transceiver chip sales. On to lasers. First quarter laser demand softened more than projected due to elevated customer inventory levels, resulting in revenue dipping to $33.8 million. Looking to the second quarter, we expect lasers to rebound to the mid to low $40 million level. Over the long run, because of our investments in unique new product and technologies, we believe we have good opportunities for growth driven by new laser product introductions in addition to market growth. Our commercial lasers business is important to our long-term strategy. It provides us with significant addressable market to grow into and provides us with a level of customer and end-market diversification. Throughout my remarks, I've highlighted the significant progress we have made toward our strategic and financial goals.
Over the past several years, we have made significant investments in new products, markets, design wins, and M&A. We believe these investments position us well for the future. At Lumentum, we are releasing the power of light to create a brighter future, and it is a very exciting time for all of our stakeholders. I would especially like to thank our employees for their hard work that has put us in such a great position. I will now hand it over to Wajid.
Thank you, Alan. Good morning, everyone. I'm pleased to be discussing our strong first quarter results. Net revenue for the first quarter was $449.9 million, which was up 11% sequentially and 27% year-on-year. GAAP gross margin for the first quarter was 37.3%. GAAP operating margin was 13.3%, and GAAP diluted net income per share was $0.61. Again, GAAP results include the impact of restructuring, write downs, amortization of intangibles, and other charges related to the acquisition and our actions to attain acquisition synergies. First quarter non-GAAP gross margin was 45.8%, which was up 690 basis points sequentially and 550 basis points year-on-year. As Alan noted, the strong year-on-year gross margin improvement was helped by improvements in telecom and datacom margins as well as acquisition synergies.
Non-GAAP operating margin for the first quarter was 27.3%, which was up 830 basis points sequentially and 340 basis points year-on-year, driven by higher gross margins. Non-GAAP operating expenses totaled $83.3 million or 18.5% of revenue. SG&A expense was $37 million. R&D expense was $46.3 million. Non-GAAP net income was $111.4 million for the first quarter and includes $2.6 million of net interest expense and tax expense of $8.7 million. Non-GAAP diluted net income per share was $1.44 based on a fully diluted share count of 77.6 million. We ended the quarter with cash and short-term investments of $831 million, an increase of $62 million relative to the prior quarter. This week, we made a voluntary $150 million principal repayment under our Term Loan B facility.
The impact of this prepayment will be an improvement in our other income of approximately $4 million or $0.05 at the EPS level on an annualized basis. Turning to segment and product line details. First quarter Optical Communication segment revenue at $416.1 million increased 17% sequentially. Within our Optical Communication segment, telecom and datacom revenue at $248.1 million was down 8% sequentially. Industrial and consumer revenue at $168 million was up 92% sequentially due to higher 3D sensing revenues. Optical Communication segment gross margin at 46.1% increased 780 basis points sequentially and 580 basis points year-on-year. Our Laser segment revenue at $33.8 million decreased 29% sequentially. First quarter Lasers gross margin was 42%, a decrease of 150 basis points due to lower revenue. On to our guidance for the second quarter.
The projections we are providing today are on a non-GAAP basis and are based on our assumptions as of today. We project net revenue for the second quarter will be in the range of $445 million-$460 million. This revenue projection includes telecom and datacom increasing sequentially, primarily driven by telecom transmission and chip sales to transceiver customers. Industrial and consumer declining significantly due to a greater than 20% expected seasonal decline in 3D sensing demand. Commercial lasers increasing sequentially as customer inventory levels are more normalized. We project second quarter operating margin to be in the range of 24%-26% and diluted net income per share to be in the range of $1.20-$1.35. These projections incorporate an approximate share count of 78 million. With that, I'll turn the call back to Jim to start the Q&A session. Jim?
Thank you, Wajid. If we're turning the call over to the operator to start the question and answer session, I would like to ask everyone to please keep to one question and one follow-up. This should help us get to everyone before the end time of this call. Operator, let's now begin the question and answer session.
Yes, sir. Once again, ladies and gentlemen, if you would like to ask a question, that is star then the number one. Your first question comes from the line of Rod Hall with Goldman Sachs.
Yeah. Hi, guys. Thanks for taking the question. I guess my opening question is with regards to the telecom demand. You had said that outside of the discontinued products, you've seen good demand growth. Could you elaborate on what type of demand there you've seen? I know you're talking about transmission, can you give us any more color regionally or project-wise on that that might help us understand what's going on out there in the telecom world since CapEx generally has been pretty weak?
Yeah. Rod, thanks for the question. This is Alan. I think as you said, the telecom transmission demand's very strong. data center interconnect's very strong. 10G tunable is very strong as well. I think it's pretty broad-based globally. It's hard to tell where that product ends up, I think data center interconnect is a key driver for a lot of that. I think metro build-outs, as we've deployed all those telecom transport nodes, the metro build-outs are filling out those transmission lines with coherent ports that drives both coherent ACO modules as well as our components.
Okay, great. Thanks, Alan. My follow-up is with regards to handsets terminals. I know that you had commented that non-ROADM shipments to Huawei were down, but I'm wondering if you could talk a little bit about the handset shipments there and how the dynamics are going. I know that they lost share in Europe, but then they've been refocusing on China. Just more broadly, what's going on with Android in terms of 3D? Are you seeing others coming in to fill that void that exists now because of Huawei in Europe and so on, with 3D models of their own?
Yeah. Our comment regarding non-ROADM revenue being down was specific to telecom and datacom. Our 3D sensing with Huawei was actually up, I believe, slightly. We're seeing broad adoption and very active design-ins for next generation of Android handsets using 3D sensing. We're pretty optimistic with the outlook on Android as a whole.
You guys, the share loss that you were, I think, anticipating in December on 3D, it doesn't seem like that's materializing in this guidance, but just double checking that.
Yeah. We're very comfortable with our share, both in the short term as well as in the long term. We've done a good job making sure that we get our customers what they need, when they need it, with the reliability they expect, number 1. Number 2, a lot of new products are going to get introduced throughout next year, and we're extremely well-positioned with our customers' design teams to make sure we're leading the way there. I think share is a good thing for us right now. In the future.
Okay, great. Thank you, Alan.
Thanks, Rod.
Your next question comes from the line of Alex Henderson with Needham.
Thank you very much. I was hoping to talk a little bit about what your expectations are as we go into the new year in terms of pricing, given you normally see 10%-15% price reductions in the first quarter. It seems like the constraints around ROADMs and pumps may result in that being less of a pressure point this year than traditionally. Could you give us any color on that?
Yeah. I think there's been, at least from my perspective, some transition with respect to having these annual biddings in some cases that we are now working so closely with our customers that it's not abnormal to have a multi-year agreement with our customers that have price reductions over time to make sure that we're working with them to ensure that they get what they need. I think from a standpoint of expectations for the March quarter having a huge reduction in the area of 10% to 15% on telecom and datacom, I don't think that's the new normal anymore. I do think that there's going to be continued reductions, but I'd say on the low end of the scale from the normal, would be my expectation.
If I could follow up, one more question on the shift to transmission seems a little bit of a surprise to me. I would've thought you had seen more on the ROADM and pump side driving the upside to the business. It sounds like your former Oclaro DCO, ACO products are doing quite well. Can you just give us a little bit more granularity around those two? Because they're harder for us to track.
You mean on the ACOs and DCOs?
Yes, please.
Yeah. ACOs, we just can't make enough. As we said in the past, Alex, transport is a leading indicator of transmission strength, and we're seeing that in spades right now. In fact, we saw it last quarter. We weren't able to fill our ACO demand. A little bit to our surprise, we weren't able to fill our tunable 10G demand. We're continuing to see a broad range of demand for ACO, and we think there's a long tail in ACO as well as demand for our DCO products as we start to introduce those into the marketplace.
Okay, you're starting to see that the impact of rolling out a lot of ROADMs is driving an acceleration in global demand for transport. Is that what I'm hearing?
For transmission, yeah, absolutely.
Perfect. Thank you very much.
Thanks, Alex.
Your next question comes from the line of Samik Chatterjee with J.P. Morgan.
Hi. Good morning. Thanks for taking my question. You mentioned seeing strength in the telecom group and demand for telecom products. I just wanted to clarify, because you also mentioned ROADMs you think are in supply and demand is in balance. Relative to your expectations specifically to ROADMs for the remainder of the year, are you expecting that to largely remain sequentially flat, or are you expecting that to continue to ramp up? You mentioned differentiated products. Just wondering if you can give us the breakdown of what portion of your ROADM portfolio do you think-differentiated and drives higher growth versus maybe the remaining portion of that?
Yeah, sure. I think, as we said in the prepared remarks, our supply-demand on ROADMs has reached more of an equilibrium as a whole. I would say that we're still constrained on the very high end in some specialty products where we have a sole source position. We just haven't been able to keep up with the N by N demand, and in some cases, the very high port count twin demand. I think that we're adding some capacity there that should allow us to continue to get our customers what they need. Those are the differentiated products we're talking about. We're going to continue to invest. We have a whole pipeline of new ROADMs that are going to come out in the next couple of years that I think will extend our leadership position there. I think we're in pretty good shape with our ROADMs.
I think in the short term, ROADM demand is still robust. I'd say that our expectations are that it's probably flatted down slightly in the December quarter, but that's more than offset by strong demand in the telecom transmission, including ACOs and 10G tunables as well as DCOs in 2020.
Got it. Just on datacom, you guiding to sequential improvement there as well. I'm just wondering if chip sales are ramping up faster than you earlier expected, because I think at least on our part, the expectation was that maybe one more quarter of sequential declines before you start chip sales overwhelming the declines on the modules. Can you just help me with that?
Yeah. Just for clarity, in the first quarter, we had $19 million of what we call discontinued products, which are our lithium niobate modulators and our datacom transceivers. We expect that to go to zero over the next couple of quarters, again, with the bulk of that reduction coming in the March quarter. Datacom chips, our expectations are that it continues to grow both in the December quarter and through 2020 as we are no longer a competitor to our customers in the transceiver market. We've seen a broad range of customers coming to us to take advantage of our leading-edge EML, DMLs, and VCSEL technology and products. I think we're going to continue to see strength in the chip sales through 2020, especially as the 5G rollouts become more meaningful next year.
Thank you.
As a reminder, ladies and gentlemen, please limit yourself to one question and one follow-up question. Your next question comes from the line for Blayne Curtis with Barclays.
Hey, guys, this is Thomas O'Malley. I'm for Blayne Curtis. I just wanted to ask quickly on the margins, you guys have clearly undergone a transition here to more high-quality business, and you saw a substantial increase here in the September quarter. Can you talk about how you see that going forward? Is this a sustainable level for margins? Longer term, is this the right area to think about you guys from a margin profile?
Hi, it's Wajid. I'll take that question. On the margins, you've probably seen that our margins have improved quite well, both year-over-year and sequentially as well. We talked at our last conference call about moving our gross margins levels up to the upper portion of 40%-45%, and we felt that it was both our product differentiation as well as the synergy work that we've had with the acquisition flowing through and executing and improving our gross margins. Generally, we have better gross margins in the back half of the calendar year than in the first half of the calendar year, primarily because of 3D sensing. Year-over-year, Q2 over Q2 and Q3 over Q3, we do expect to continue to see improved margins primarily because of the synergy work that we continue to execute on.
Great. My follow-up. For your largest customer in the quarter, do you guys give a percentage out? I know that you give it out in the filing, but could you give it to us?
We actually don't give that out in the 10-Q. We only name them, but we don't actually give the percentages.
Thanks.
Your next question comes from the line of John Marchetti with Stifel.
Thanks very much. Alan, I wanted to go back to the comment that you made about transport leading transmission sales. I'm curious, as we're looking out over the next several quarters or year or so, do you actually see transport starting to lag and transmission growing faster? How do we think about that maybe in the overall mix of the business, and does it have a margin impact?
Well, it's a good question. I don't have a crystal ball. I'd say we're going to see continued growth in transmission through 2020. As new networks get deployed or new network architectures get deployed with things like M x N or the very high port count twins, we're going to see ROADM growth return from what may be a flat period here today. Our expectations are as we continue to introduce new products in ROADMs that those will be adopted by our network equipment manufacturer partners as well as the service providers. I think while there may be a flat period today, our expectations are that ROADM growth continues through 2020. At the same time, transmission now is building out those transmission lines that the transport networks have deployed.
Maybe just as a follow-up on the chip business, it seemed like it grew a little bit sooner than you were expecting, that demand has come in a little bit more quickly. I'm curious if you can just talk a little bit about how much of that is maybe serving existing customers that you used to be sort of a transceiver provider to or selling versus maybe some new customers that are coming in now and buying chips, given that you don't compete with them anymore.
Yeah, I'd say it's a mix of both. I'd say we're getting sales from customers, frankly, we didn't even know existed. I'd say it's a broad range of customer interaction, and a broadening of our customer base in the chip sale that is pretty exciting.
Thank you.
Thanks, John.
Your next question comes from the line of Meta Marshall with Morgan Stanley.
Great. Thanks, guys. A couple of questions. Just what, on the commercial laser business and kind of expecting that business to bounce back, is that better industrial conditions that your main customer is seeing or just a little bit of context as to why that would improve in the next quarter? Maybe the second question, I'm noting that the Huawei shipments at the low end were a little bit lower than expectations. Is that inventory? Is that some insourcing? Just any color there would be helpful. Thanks.
Yeah, I'll take the lasers question. I don't think that we're seeing the light at the end of the tunnel with respect to industrial demand. I think we're seeing that last quarter, there was a significant inventory correction at not just one customer, but at several customers that had the laser shipments being significantly down, actually more than we had expected. I'd say that it was just an inventory correction, and now we're starting to ship more in line with our customers' shipments out to their customers. I think that's the only thing we're seeing on lasers.
Yeah. I'll take the Huawei question. I think the best way to look at our sales to Huawei is, in general, where we're sole source and have a very unique product or capacity has been constrained for a long time, those sales generally are continuing on flattish, not growing. We've seen some decline in products where there may be other suppliers, and perhaps they may have built some inventory over time. We'd also highlight that they were a significant datacom customer for transceivers, and with the exit of that business or ramp down of that business, that is also causing Huawei revenues to decline.
Got it. Thank you. That's helpful.
Your next question comes from the line of Tejas Venkatesh with UBS.
Can you talk broadly to China demand beyond Huawei, what you're seeing from a tender activity perspective and maybe how other customers are reacting?
Yeah, I think there's a tremendous amount of activity in China on the tender side. I do think anecdotally, there's a lot of deployments going on as well. We're seeing a broad base of demand from not just Huawei, but from other customers, both in telecom and datacom product. I think it's broad-based, and it's a strong period of deployment of networks today in China.
Thank you. As a follow-up, where are you with the synergies?
It's Wajid here. At our last conference call, we had said that we were targeting a new synergy level of approximately $100 million, as we had already achieved the original target of $60 million. We continue to make progress towards that $100 million synergy target. If you remember, we had said that it would take four or five quarters to get there, and we thought that many of the synergies would come in during the tail end of that time period that we had outlined. It was part of the reason why we felt confident that our average gross margins on an annual basis would move to the upper half of 40%-45%, some of which we're already seeing the benefit of in this quarter, as well as in our guide for next quarter. We're continuing to track to that.
We're quite confident that we'll be able to achieve those targets in the time period that we've outlined.
Thank you.
Your next question comes from the line of Simon Leopold with Raymond James.
Great. Thank you very much for taking the question. Two I'd like to ask. One is just if maybe we could double-click a little bit more on the telco datacom trends as we go from December into March. I think one of the things I suspect may be helping December, and I want to clarify, is maybe some purchases related to the end-of-life that may be that is part of the factor boosting December and leading to a more than seasonal decline in March. If you could help with that aspect, then I've got a follow-on. Thanks.
Yeah, let me try to answer that, and Chris can correct me. I would say that, again, $19 million of discontinued sales in the September quarter
It's going to go down in the December quarter, then go down even further in the March quarter. I'd say that we're seeing strength primarily in the telecom transmission side of that as well as the datacom chips. We went from one record last quarter in datacom chips. We're expecting new records this quarter. I would expect that in the March quarter, we're going to see continued growth on datacom chips. We did not satisfy the demand on our telecom transmission business in the September quarter. We're adding capacity. We're still not meeting the demand today of our customers. I think we're going to continue to see that in the March quarter.
Yeah, I think the way to think about it is, the datacom transceivers are burning off somewhat linearly, but we have some telecom products that are a little bit more of, I wouldn't say are helping necessarily the end-of-life products in December, but they drop off much more precipitously in the March quarter. I think also looking to the March quarter, I know Alex asked the question about ASPs, and ASP declines. I'd also add, there is another driver of seasonality in the March quarter. Generally, folks are manufacturing in Asia and many in China at our customer level. Therefore, their output in that quarter can decline. I think even in a more moderated ASP environment, we are still going to see seasonality in the telecom, datacom world, in the March quarters driven by holidays in the March quarter in Asia.
Great. As my follow-up, I wanted to see if you could talk a little bit more about your expectations for the 3D sensing market in calendar 2020, specifically comments on 5G as a driver for mobile devices, as well as world-facing elements in mobile devices in calendar 2020. Thank you.
Yeah, Simon, it may be a little easier for me to think in our fiscal year, so I'll think in fiscal 2021. Certainly, we think that there's going to be an inflection point in the market as we go from fiscal 2020 to 2021, which is a combination of everything you said, right? We've got world-facing coming in in a much more substantive manner, so that expands the dollar content addressable in a phone, as well as it may be a driver of customers transitioning from having no 3D sensing to 3D sensing to have that computational photography capability. On top of that, certainly, the expectation that 5G could start a broader spending cycle, as certainly, I know many of us sitting in the room here have a December 2017 phone and hear that something great's coming in 2020.
I think there'll be some pent-up demand that'll drive a cycle there. Then as well, the sort of the maturation of the technology and the software in manufacturing ecosystems to enable customers that may not be as vertically integrated or as advanced in the 3D sensing technology in-house find the technology more accessible. I think we start getting out into our fiscal 2021 where the market for 3D sensing can start having a B at the end of it.
Thank you very much.
Your next question comes from the line of George Notter with Jefferies.
Hi, guys. Thanks very much. I guess, obviously the thing that really stood out here in the quarter was the gross margin upside and, certainly, I would imagine the mix of 3D sensing was a big piece of that, obviously other elements too. You mentioned the synergy piece from Oclaro. Certainly the discontinuation of certain transceiver products. Can you walk through exactly where the upside surprise on gross margins came from? It'd be interesting if you could kind of piecemeal that out for us to some degree. That'd be great. Thanks.
Yeah, I'll start it off and then I'll pass it to Chris or Alan if they want to continue. I don't really think that there was much of a surprise. We expected that synergies would start flowing through in the first quarter from some of the activities that we had. Our operations team executed better than we had expected on those synergies, that certainly had a benefit for us. In the normal part of our business outside of the acquisition, we did see some material cost benefits that were better than expected, that helped us as well. The continuation of some of the product mix items that Alan talked about with us shipping more datacom chips and obviously the 3D sensing products that you mentioned earlier, both of them had upside for us from a gross margin standpoint.
I think it was all within the realm of what we thought would happen, but we certainly executed better than we expected, that did lead to some upside. Moving forward, we mentioned earlier that we continue to expect to see gross margin improvements year-over-year. If you take a look at our Q2 guide, it's not like it was just a one-time event year-over-year. If you take a look at the midpoint of our operating margin guidance, that points to higher gross margins versus last year. Even into fiscal Q3 and Q4, as we take a look at some of the synergies that are about to flow through in terms of us getting to the $100 million target we've laid out there, we continue to expect to see gross margin improvements year-over-year.
We're executing to our plan, and I think it's that execution that's leading to what is viewed as an upside surprise.
Got it. Sorry, just as a quick follow-up, I wanted to ask about ROADMs also. I think, Chris, you had something to say there. Maybe Stifel wants to do it.
I would still like to highlight that the 3D sensing as a percentage of the overall revenue was not necessarily changed a whole lot year-over-year. I think we did well in holding margins on 3D sensing, but it was really everything outside of 3D sensing that, particularly in the telecom, datacom space between synergies, as well as the percentage of revenue from newer and more differentiated products year-over-year was greatly improved. There really is the worst products going down significantly and the good products going up significantly in the mix within telecom, datacom is a big factor. Sorry, you were talking to Rod.
Got it. Yeah, you mentioned, again, the supply-demand equilibrium in general there. Obviously, that's a real change from the experience you guys have seen over recent years. Any concerns about an inventory correction potential with customers there? Thanks.
I always have concerns about inventory corrections. I don't think in this case, because we still are constrained on the very high-end product lines, and that's going to become a bigger percentage of our ROADMs at significantly higher ASPs than the low end. I'm not so concerned about the long-term outlook for our ROADM business or if there's a buildup of inventory. I do think, in talking with our customers, there are new metro tenders going on throughout the world, and I think that there's going to be new greenfield transport networks deployed in the coming years. I'm not concerned whether or not the December quarter is a down quarter for ROADMs or not. I think long term, there's a demand for ROADMs, especially our highly differentiated ROADMs. I think it's a good market to be in.
Your next question comes to line of Michael Genovese with MKM Partners.
Thanks very much. I'm looking ahead to the March quarter for 3D, considering the guidance for December, which I think is down more than seasonally normal, and it seems like the unit picture is pretty good. There's not a lot of inventory out there, and your share position is pretty good. Wondering how we should model 3D for the March quarter, if it could be not down as much as we would normally think March would be down.
I think, Mike, it's a little early to be talking about March on 3D sensing, given how dynamic the 3D sensing market certainly is. We share your optimism around units and how our customers are doing. With that said, we've got a long way to go to get through our December quarter and see where customer demand lands. Based on history, we know it's difficult to predict 3D sensing that far out.
I'll give you just one data point. We're working on more programs now than we've ever worked on 3D sensing across a broad range of customers. I think that's usually a pretty good indicator that customers are counting on us and are going to deploy 3D sensing, both in front and world-facing in calendar 2020 and 2021. I think long term it's a good situation.
Okay, thanks for that. My follow-up, I'm not sure if someone's already asked this. I don't think you want to answer it. I'm going to ask. It seems important since this is the first quarter you're combining telecom and datacom. If you could give a more precise breakout for what it was in 1Q, the mix of telecom, datacom.
Well, as we've combined them, I don't think we're going to give that level of detail. I guess maybe qualitatively, the easiest thing to say is that certainly datacom continued to decline and was consistent with the commentary that we provided on our last call in terms of the magnitude of the expected declines in datacom, driven by the exit of datacom modules.
Was the $19 million all in datacom, or some of that was in telecom?
Yeah, some of that was in telecom on the lithium niobate modulators we talked about on prior calls. It's a mix of datacom modules and lithium niobate. I'd say the other data point that we gave was that datacom chips were up 13% to record levels. That's our future in datacom, and we're pretty bullish on the outlook of datacom chips.
All right. Thanks for that, guys.
Thanks, Mike.
Your next question comes from line of Tom Diffely with D.A. Davidson.
Yes, good morning. Another 3D sensing question. It sounds like the competitive environment hasn't really changed that much. I'm just curious, though, when you go in and you win a new slot, are you winning mainly because of your proven volume capabilities, or are there specific technology advantages as well?
Yeah, I'd say there's really three factors that go into winning the business. One is what you indicated, not just capacity, but the proven reliability of shipping a half a billion units with no field failures is pretty phenomenal and not easily replicated by our competitors. I'd say number 2 is our R&D team and their ability to meet our customers' expectations and requirements and timing as we're working on products today that will be released in 2021 and 2022. I think our pipeline of new products is phenomenal. Third is the technology that we're able to provide to our customers. As they continue to push the applications to do more with 3D sensing, we're enabling them to do that through the advancements in technology that we bring to market.
That differentiates us even further from our competitors as they've been trying to catch up in 2017 products. We're working on 2020, '21, and '22 products.
Okay, that's helpful. As a follow-up here, what's your current view of the LiDAR market? When does that become a real meaningful opportunity?
I think in terms of being meaningful, we're still looking out at least several years. I think as we highlighted in our prepared remarks, we are shipping prototypes and samples to customers, and a wide range of customers at a wide range of levels. Meaning we have partnerships with folks where we may be supplying laser chips or low-level packaged lasers, all the way up to selling a much more sophisticated, essentially a coherent LiDAR module, where we leverage a lot of the photonic integrated circuit capabilities we have, as well as leverage our ROADM switching technology for beam scanning. The way to think about the LiDAR market is it probably doesn't start contributing significant revenue until we're out in the fiscal 2022, 2023 timeframe.
On the other hand, it's a market where the seeds are planted now, and you get designed in because the auto manufacturers have very long product development cycles that may sort of freeze their product requirements and their supply base in the now timeframe. Revenue appears several years later.
Okay, thank you.
Your next question comes from the line of Tim Savageaux with Northland Capital.
Hi, good morning, and congrats on the great results. Looks like optical comm gross margins might have been up 500 basis points plus sequentially. That's an observation, not a question. First question is on the optical comms side. You look to be guiding December up kind of solid double digits here, this in the face of some exits in product lines and flattish ROADM revenue, which suggests a very strong increase on the transmission side. I guess my question there is, what are you seeing out of Huawei in particular, or China in general in that guide? Do you expect that to continue to be flattish, and what does that imply about demand, I guess, across the rest of the world?
You're talking about telecom, datacom, right?
Correct
Is 3D sensing.
Oh, sorry. Yeah, telecom, datacom.
Yeah. We're expecting transmission to be very strong as we add more capacity that's trying to keep up with the growth and demand for our coherent components, coherent modules, as well as I said before, 10G tunables. I would say that the September quarter was at a very low point for our submarine shipments. We're seeing that pick up a little bit more. That's a result of our transition out of our CM in China and into our own factory. Our customer took inventory to make sure they had it during that transition. That is well on track, we're going to be back to shipping submarine product at the same rate as they're shipping to their customers. I think it's transmission, it's submarine, and passive products, as well as datacom chips.
We're going to continue to see datacom chip growth offsetting some of this end-of-life product we talked about.
I think as trying to not dig down into datacom detail, but we do expect that that portion of the telecom and datacom will turn the quarter in terms of growth this quarter. Meaning that the chip sales will overwhelm transceiver declines. That headwind that we had in prior quarters will now start to turn to a tailwind on the datacom side. I think on the telecom transmission side, another point to add is we have a lot of design wins on our coherent modules. Customers continue to sell and market those systems, so we've had customers that maybe have been pretty successful and some new customer opportunities that are also driving the tailwind we're seeing in transmission.
It could be not just market growth, but some unique situations where we have some customers that have won some good business that are using our products where maybe the prior versions that our customers' customers were not using our products, and that enables us to get strong growth.
I want to follow up on that point precisely, which is we're hearing a lot about a pretty sharp increase in qualification activity around your CFP2-DCO module, really post this allocation to some degree. I don't know how long that would take to translate into revenue. I wonder if you could discuss when you talk about coherent module demand, to what extent that might be playing a factor in this stronger demand outlook and what sort of opportunity that represents for you guys throughout the balance of fiscal 2020 on the CFP2-DCO front.
Yeah. I'd say that we're certainly seeing a broad base of interest in our CFP2-DCO over the last few months as a result of what you said. I'd say we'll see a pickup in DCO revenue in the December quarter, and then a real meaningful ramp-up throughout calendar 2020 as we get qualified at our customers and ship more meaningful volume. We're putting capacity in today in anticipation of that type of growth throughout 2020.
I think some of the strength we're seeing today is still ACO-based, and that gives us confidence that ACO has perhaps longer legs than many think, if you will, in that their customers are winning new business with ACO-based systems that I think will extend how long the ACO business will remain strong for us.
Maybe just to add one thing. In order to make a DCO, you have to be able to make an ACO and the components that go into an ACO. It is actually more complex. I'd say that we have credibility in the DCO market. We have components that our customers are designing into 400G and even higher data rates in the indium phosphide high bandwidth products. I think from that perspective, our customers can count on us, and they are counting on us to be able to ramp up the DCO modules to meet their demand.
Your next question comes from the line of Jun Zhang with Rosenblatt Securities.
Thanks for taking my question. I think you're facing a lot of capacity constraint of the ROADM pump laser and also your laser fab in Japan. What kind of a plan, the CapEx you're looking at for next year in order to increase the supply? Thanks.
Yeah. As we said, today, we're facing supply constraints on the high-end ROADMs. pump seems to be okay as we've completely transitioned out of our CM in China. We had to add extra capacity last year to make that transition smooth and seamless to our customers. I don't think we have a whole lot of CapEx needs for pump growth, and we can produce a whole lot more pumps today than we could produce a year ago. We are spending money in our fab in Japan to grow that output as we've seen strong demand. I wouldn't say it's anything abnormal to our historic CapEx, and I'd say that our calendar 2020 CapEx plans are probably lower than our calendar 2019 CapEx plans, given we had to spend a bunch of money to make that transition from CM in China to our own factory in Thailand.
I think a lot of that heavy lifting is done.
Okay, thanks. In the past, you normally gave the guidance for the 3D sensing business, the revenue. Do you still provide that guidance or it's not?
I don't think we've ever provided guidance numerically on 3D sensing per se. What we did highlight in our prepared remarks was that sequentially we expected a greater than 20% decline in our 3D sensing. I think that's reasonably explicit given we break out our consumer industrial business. I think it's common knowledge that the industrial piece is substantially less than the consumer piece.
Okay, got it. Thanks. That's all my questions. Thanks.
Your final question comes from the line of Richard Shannon with Craig-Hallum.
Well, great. Thanks for taking my questions and fitting me in here. I guess I'll follow up on a couple topics you've had some questions for. For the December quarter, you talked about some strength in the telecom part of your business, and just want to make sure I caught correctly that it's largely from ACOs and 10G tunables. Did I catch that correctly?
Those are two main drivers, but I would say that we are also seeing coherent components demand increase as we are supplying those components that are in our ACOs and DCOs to customers who are building their own DCOs or line cards for higher speed coherent transmission.
Okay. The strength in the coherent makes sense, and you just already discussed the ACO here. The 10G tunables is interesting here. Maybe if you could discuss where that demand is coming from, breadth, regional usage, and maybe a little bit of understanding of why you think you're seeing strength, and will it sustain?
Yeah. I think that there's a couple areas. First is certainly in a telecom network, as you upgrade the core of the network to higher speed, 100G and above, the edge of the network also gets upgraded, using DWDM technology at 10G using our tunables. When we say tunable 10G, these are in very compact SFP+ form factors. They're finding a lot of applicability at the edge of the network, as well as we're seeing an emerging opportunity as we look to both the cable MSO and wireless markets, where they are also finding use for 10G, and eventually that the same 10G platform in a sense being turned up to 25G.
Okay, great. That's all the questions from me. Thank you.
Great. Thank you very much.
Okay. I'll now hand it back over to Alan Lowe.
Great. Thank you, Adam. Just to close, we want to update you that we regularly discuss our business at investor events. These events are listed on our website in the investor relations section and are regularly updated. This concludes our call for today. We would like to thank everyone for attending, and we look forward to talking with you again in another few months. Thank you.
This concludes today's conference call. Thank you for your participation. You may now disconnect.