Good morning, everyone. Welcome to one of the first fireside chats for our annual tech conference. It's quite appropriate that from a hardware and networking coverage standpoint that we do the first fireside chat with the company we spend the most time talking with investors about for 2025, 2026. Michael, thanks for being here. As an introduction, Michael Hurlston, President and CEO of Lumentum. Thank you, Kathy. Thank you for the time at the conference as well. I'll start off with a few questions, maybe more broader and looking at the industry a bit more broadly. Historically, I go back to the time I started covering the sector- investors considered optical companies to be cyclical. What has changed in the industry to change that outlook? What's driving your confidence that it is not the same as the previous cycles?
Yeah. Samik, first of all, thanks for having us, and you and I are spending a lot of time together. Rumors are gonna start. We gotta be careful, okay? Look, I think everybody loves the phrase, "This time is different," it does feel like this time is different. Our customers historically in optical have been the telecom customers, AT&T, Deutsche Telekom, Verizon, the fiber build-outs were indeed very cyclical. There was a boom and bust period. We had a huge run-up in the 2000 periods. We had another good run in 2014, 2015, it was really driven by the telcos, this time it's driven by hyperscalers.
There was an email that one of our guys sent last night that the hyperscalers themselves have $2 trillion of backlog at the moment, and the spending that they're driving, obviously the capital expenditures that are well documented, I think the speaker before from JPMorgan was talking about that. I think that that is a sustainable cycle. It won't go on forever. I think you and I know that. We've been around long enough to realize that, but this feels like it's a multi-year run, and one that is very different in character from previous optical cycles.
Okay. One of the things you've done after you started is to improve the margins. How are you positioning the company to improve long-term margins related to the historical margins the company's delivered? What's your North Star in terms of where you want to get to on the margin front?
Yeah. I think people that have followed me know that margin is probably my most important metric. At my previous company, Synaptics, we ran margins from 39% to well over 60% in the span of 18 months. We're not doing that here. It's a little harder work to get the margins up. We feel like as an industry, optics didn't get properly valued for what we can deliver. The value we're bringing to our customers, the components, the subsystems are truly what makes these networks run. I don't think that we necessarily got paid. We've worked the portfolio, as you know. You've been very close to the company. We've worked mix. We've dropped some lower margin product lines out. We've focused a lot more on higher margin lines. We've worked cost, although I'd like to work cost more.
I think there's an opportunity on both yield and our manufacturing cost to get quite a bit more on the margin line. The last thing is price, right? We've gone out and we've repriced the backlog, as you know, and that's helped us move the margins from sort of low 30% to now, close to 50%.
Yeah. Okay. Great. Not to put a negative narrative around it, but the upside to your earnings over the last 18 months has been great. Great share price reaction reflecting that, but we often get the question from particularly investors who haven't looked at optical in a while is, "I want to take a three-year view, five-year view. Tell me the risk associated with how things have been going. Things just look like they're going to the right in everything that you touch. It's almost like everything you touch turns to gold dust, right?" Like, what's the risk here? Just help us think about what are you paying the most attention to when you think about what your internal plan is for the next three years. Where do you see the most risk?
You know, I mean, the demand is clearly there. If we look at the signals that we're seeing from our customers and our customers' customers in some cases, there's no demand problem, which is an enviable situation to be in. Our issue is execution, right? It's building out the right capacity, finding the right balance to keep under-supplying, to a certain extent, the market, but growing our supply line to a point where we can keep capturing a lot of that demand, executing in that envelope, delivering products on time. That's, again, historically been a problem for the company because the company is dealing in scales of thousands when we're talking about the telecom customers, and now we're looking at scales of tens, in some cases hundreds of millions.
We've got a lot of work to do to get our business in tow to hit that demand line. Execution is our primary issue. You know, obviously, over a five-year horizon, Samik, we're worried about technology inflection points. You have speed changes. We're going from 800G to 1.6T. We'll go to 3.2T. We're looking at, you know, different technologies around our OCS franchise. I mean, I think that's a very, very strong part of our business. We're looking around corners to make sure that we've got technology protection there. On co-packaged optics, again, we're in an enviable position on CPO, and we think that's gonna be a long, long-term driver for the business. We're always watching. Where is it from a technology inflection standpoint?
We can either introduce products to capture more of the margin or more of the opportunity, or we have to do something defensive to protect the franchise.
Got it. Maybe I'll follow up on that, phrase the question the same way I get it from investors is. They say Lumentum's leading in every technology that they have right now. Talk to me about the risk that there are a lot of these optical companies in China that start to get into the same markets Lumentum is in, and the market looks a lot more competitive, a lot more commoditized, a lot more price competitive in two- three years. How do you think about those risks?
I mean, I think you know, what people don't realize is that these products that we're doing right now are not new. They didn't come in overnight. If you look at our OCS, and Kathy speaks of this extremely well, it's been a 10 or 15-year development cycle, right? It's the WSS and the field-proven MEMS product that has made that a raging success. The concern always with OCS has been reliability, and we've solved for that, but it hasn't been an overnight solve. It's been a 10 to 15-year solve. Our laser business, you look at the CPO, these high-powered lasers, again, didn't come out of thin air. It's been a long development cycle to get there. These are products that go in undersea amplifiers, right?
The same products that are dropped into the Mariana Trench are what's being used in some of these co-packaged optics opportunities. I think the simple answer is there's been a long, long development cycle. I think if people started today, it would take multiple years for them to catch up on our core technologies, and we feel pretty good about our position.
Okay. Okay. Going back to OFC this year in March, you laid out a $2 billion quarterly revenue target with 40% operating margins in 18-24 months. The June quarter guidance, you're implying you're almost 50% of the way there already. Can you walk us through the key sequencing of growth drivers, the margin inflections that investors should expect from here on?
Look, I mean, we've talked about this. We have very little contribution as yet in our numbers on any of the big growth drivers. You've covered the story for a long time and know it as well as anybody. We have four big growth drivers that start to layer in in the third quarter of the calendar year and a little bit more in the fourth quarter of the calendar year. Those are OCS, right? We've got small contributions now from OCS. We've started shipping. We have small contributions for optical scale-out, and we would expect to see much more significant contributions starting in the fourth quarter. Optical scale-up clearly isn't happening yet, but we'd expect big inflection points in 2027. Those three are not really kicking in.
I think the underappreciated part of the portfolio is our transceiver business. Our transceiver business is there. We're shipping transceivers to a good degree, but we think we have an opportunity to double that revenue line over the next four or five quarters by virtue of the fact, as we were talking about last night over dinner, we've kind of got to the front of the line now, right? We were really trailing from an engineering perspective, and suddenly we've figured out the engineering part of the paradigm, and we've got to the front of the line. We'd expect significant growth from our transceiver business again over the next four to five quarters. A lot of good things I think are in the company's windshield.
Okay. Going back to, a question that you got yesterday as well, and I'm expecting you'll get this same question multiple times today. What's changed since OFC? Where have you seen the biggest inflections in customer engagement and broadening out of the demand drivers since OFC in March?
Yeah, I'd say a couple of things, we had a good discussion over on dinner. First is scale-across, right? We tried to highlight this in the call. Kathryn Ta did some work last night because we got a question from the team over dinner. You know, just the number of build-outs right now that are new. You've got Ciena talking about five customers. You've got Cisco talking about three customers. You've got Nokia talking about a significant presence now in these scale-across opportunities, that was something we obviously had a sense for. I mean, you probed on that last night over dinner, we didn't know how big it was gonna be. I think in the two months since OFC, the pump laser business, narrow linewidth laser business, WSS, these multi-rail opportunities have really been a surprise.
I think, we have a bit more upside since OFC than we talked about. I think the second thing that's been a surprise is, our transceiver business.
Right? We really have been surprised because, again, for the first time, we're seeing what it means to be first to market on 1.6T, and that's put a lot of pressure on our factories to produce the transceivers. We see a lot more upside by virtue of our position now. The third thing is just the demand from our large customer on co-packaged optics. You know, we talked about it in Los Angeles at OFC and said, "Look, seems to be getting better," but I think there's been a step up, both a step up on scale-out, but perhaps more importantly on scale up, the intra-rack connectivity and the cross-cluster connectivity that I think really will drive our numbers in 2027, 2028, and 2029.
Okay. Got it. Maybe let's dive into scale-up a bit. You've talked about the scale-up opportunity, that it's doing better even relative to where you left things off at OFC. What as an industry do you need to do in relation to manufacturing or even sort of the scaling up of the supply chain to address that demand? How much is sort of the broadening out of the customer base is contingent on being able to supply the adequate volume that the industry needs?
Yeah, I think, you know, this is the question that we certainly got with the co-investment investments with us and Coherent. We can't supply enough. I mean, we are not gonna be able to meet the demand of NVIDIA alone, right? Let alone these other set of customers that seem to be going this direction. You've got Amazon clearly talking about NPO, CPO. You've got Meta talking about it. You've got other chipset guys talking about it to a huge degree. It really is an inevitable phenomenon, right? It's a matter of when, not if, and all these guys seem to be tipping in the 2027, early 2028 timeline toward at least some part of their portfolio being optical connectivity. We are not gonna be able to scale to meet that.
I mean, we are trying everything we can in the fabs we have. We obviously bought another indium phosphide fab, our fifth indium phosphide fab, to try to meet that demand. Even with that fifth fab coming online, we are not gonna be able to meet demand. You know, Coherent is obviously gonna have to play a role, and, you know, I think we're gonna need others probably ending up to come into this market. The challenge is, back to your first question, it just takes a long time to qualify these high-powered lasers. You know, I think the market is gonna be ours for quite some period of time, and that's gonna put a lot of pressure on us from a manufacturing standpoint.
Okay. Good. Well, moving to on the laser capacity or EMLs in particular, I think you've noted that the supply-demand imbalance has grown to greater than 30% or maybe even higher. I mean, this is in the context of your output going 8x since fiscal 2023. You're also targeting another 50% unit increase over the next few months here. At what point does this imbalance self-correct to some extent? What could be the drivers that this imbalance self-corrects, or do you expect this imbalance to grow, widen even further? Maybe I'll have a follow-up, but maybe let's start with that.
Yeah, you know, I think at some point it's gotta correct. I think that, you know, It's interesting, and you and I have talked about this. At 800G, the sort of the current predominant node for optics, EML is the dominant technology. At 1.6T, we do think that silicon photonics is gonna come in in a more meaningful way. It hasn't as yet. Most of the transceivers that we see are still EML-based, we would expect that silicon photonics is gonna come in in a meaningful way. That doesn't mean that our EML numbers are gonna go down. It means still we would expect in the face of that the EML numbers go up.
The interesting problem is that at 3.2T, our smart people would say that silicon photonics no longer works. Just the noise properties of silicon photonics are such that they can't carry a 3.2T signal. At that node, we have a reversal back toward the EML-based transceivers, which is gonna again put pressure on us because at each node, the numbers seem to go up pretty considerably. I don't know. I mean, it seems, Samik, that there's sort of no end in sight to the supply-demand imbalance. Nothing ever persists forever. I mean, there's gonna be some creative solution that I think comes up that ends up solving for the indium phosphide shortage, but we don't, we don't see it as yet.
Okay. Yep. On that front, just help us think about what are the things you're deliberating internally when you invest in capacity, particularly relative to indium phosphide when you have these alternate technologies relative to EMLs like silicon photonics or VCSELs that can emerge and that do impact eventually demand for EMLs. As you said, like EMLs probably in the foreseeable future keep growing, but you're taking decisions for capacity that are much more longer term. How are you taking those? What factors are you deliberating upon?
Yeah, I mean, again, you know this well, but to give you a perspective, with our latest fab, we bought that early this year. We don't expect to see production out of it for two years. It's a long cycle to put in this capacity. You know, we have pretty complicated models that predict our output capacity, look at what we think competition is going to do relative to capacity, and, you know, we look at all the press clippings that you do relative to Coherent, Chinese, anybody else that might be putting in capacity. We look at demand, right, the demand signal. You know, if we factor all of that in when we make these capacity decisions. You know, we've been asked, and I think you asked it, over at OFC, "Hey, when's the next fab?" Right?
I think, you know, we're really at a point where we need to start considering that, right? The demand signal is so very high. I think what's underappreciated with the investor base is just how much of a shift it represents to go from copper to optics inside the rack, right? The pressure that that's gonna put on the indium phosphide supply chain is immense. Right? We are talking about, again, for optical scale-out, we have said, "Okay, let's consider it X," which is already big. We would really be chasing our tail relative to just the optical scale-out opportunity. If you then factor in optical scale-up, it is somewhere north of 10x more. That we're going to need. Again, we simply can't produce all that output.
Yep. On that front, you recently outlined that you do want to transition some of the capacity to 6-inch, which for us was a bit of a shift from your position probably, six months ago. What drove that change? How should we think about the timeline regarding the transition to 6-inch?
Yeah, I mean, look, we still think 6-inch is a risky proposition. We've been running 6-inch wafers, as you know, in our fab to look for avenues to get more capacity. We're doing everything we can to work yield, work cost. 6-inch definitely has benefit, right? It's, you know, pi r squared relative to the amount of units that you'd get out of it. It's not as easy as, let's say, a CMOS wafer. The edge effects that you get at 6-inch are pronounced, that's why we've seen other people struggle so mightily to bring up 6-inch capacity. It's simply not that easy. What is happening for us is in Greensboro, the new fab in North Carolina, that fab is already a 6-inch fab.
Our intention is to keep it on 6-inch, to certainly try, right, to not have the disruptions that we would have in our fabs in Japan around transitioning from four to six and having unpredictable output and things of that nature. Keep that running on four, and then transition Greensboro to 6-inch, start it as 6-inch right out of the chute. We think we can get it right, but if we don't, we always have a retreat path. All of our 6-inch tools are 4-inch compatible, so we can go backward if need be. We're going to give it a shot and let's see, right? We think we have an idea, but, I have to admit, it's proving to be a lot more challenging than we might have expected.
Okay. Indium phosphide capacity, staying on that, can you give us a sense of how much effectively is committed to NVIDIA and what flexibility you retain to serve other customers in relation to your indium phosphide capacity?
I mean, look, they're smart, right? They moved quickly. They saw this trend, I think, before anybody else did. They came in, and they locked up a considerable amount of our supply. They locked up a considerable amount of Coherent supply. They moved very, very aggressively. I mean, we're trying everything we can to create some room for additional customers. The good thing for us is that it's created a little bit of a, you know, gold rush to get what's remaining of our capacity. A very, very significant chunk of it is now spoken for in this long-term agreement. NVIDIA has the option to take more should they so desire. You know, our job right now is to lock up additional customers as quickly as we can. We're working on that.
We would like diversity in the fabs, but, you know, you could see a world where NVIDIA ends up with all of it if they push hard.
Okay. On that topic of other customers also in being interested, are you seeing opportunities for signing deals that were similar to what you signed with NVIDIA in terms of involving investment, prepayments, and some kind of take or pay structure as well? Do you see conversation with the other customers framing out to be on a similar structure?
Yeah, very much so. I mean, I think, you know, do we want more investment? Probably not. We're okay. I think the balance sheet is in decent shape. I don't need to take on another $2 billion from anyone else. Prepay is very much part of the discussion. You know, some sort of pricing arrangement to give us some upfront advantage is very much part of the discussion. Those are super active. I mean, we are really pushing hard to get those types of deals locked up before, you know, NVIDIA, you know, invokes options to take more of that capacity. Our job is to get deals locked up as quickly as we possibly can and to try to do so probably before, you know, next quarter.
Okay.
Okay.
Let's maybe take it a bit higher level, above indium phosphide and not to stay on the substrate here, but ELS. You've talked about the opportunity with the ELS package. Where do you stand today in terms of engagement with customers, and how should we think about gain, about timing relative to when you see some orders on that front?
We feel very confident we're going to be able to take a portion of our lead customer's volume on ELS. We're shipping our high-powered lasers to other ODMs at the moment, right? That has some margin stacking principles and things like that. If we are able to deliver an ELS ourselves, obviously there's some cost benefit to NVIDIA. We feel like that's a good opportunity for us. We have not as yet closed that business. You know, again, I think it's a matter of when, not if. I think we'll get a good portion of that business because they want to have somebody who's totally vertically integrated for cost reasons, for time to market reasons, and it's just a matter of sort of working out the economics.
Got it. Okay. Let me ask you one more, but just a heads-up to the audience. If you have a question, please raise your hand, and we'll get a mic over to you as well. While we wait for that, cloud transceivers, you mentioned the strong demand signals. How should investors think about the structural margin ceiling for this business long term? What scale and vertical integration will be required to achieve those margins?
Yeah, look, I think the cloud transceivers, there's, you know, we've spent a lot of time, you and I have spent a lot of time talking about it. It is a gross margin headwind, right? There's no question about it. We are struggling with our margins. As well as we've done on the engineering side, we haven't done that well on the manufacturing and margin side. Where we're left with is a business that's well below industry standards. You know, our guess, it's hard to tease it apart, but we would guess, you know, Coherent is in the mid-30s on their margin. They do a pretty good job with the Chinese. Eoptolink and InnoLight are probably in the mid-40s. Their, most of their businesses is in those segments, and you can see their reporting.
There's some funny business in China relative to depreciation. The depreciation rules are a little bit different to the U.S. rules. You know, maybe it's low 40s in the end if you apply like for like. Our business isn't close to that, right? We have work to do on the margin line with the transceivers. What our job is to do is to keep margins moving up in the face of a transceiver business that is growing pretty appreciably. We, as I said, expect it to double over the next four to five quarters. We've got our work to do. We've taken the first step, as you and I discussed, which is now we're integrating our own lasers. A piece of our own laser output is now going into our transceivers.
Some of Photonic ICs, our PICs, are going into our transceivers, which is helping the margin line. You know, we would hope to be close to Coherent in the end, right, but we're trailing them quite significantly. Definitely there's margin headroom in that business.
Any questions?
Hi, thank you. Are the hyperscalers trying to develop internal optical capabilities to any extent? If so, how are you thinking about that from a risk perspective?
You know, obviously the hyperscalers have different degrees of engineering capability around optoelectronics. NVIDIA is probably the best. They can take a bag of parts from us and from others, put it together, you know, do a blueprint, for example, for an optical transceiver and hand that to a Fabrinet or somebody else to go and build out. You know, Google has great engineers on optical. I don't see anybody, for example, getting into lasers. I don't see anybody, for example, getting into laser drivers, TIAs, anything like that. They can certainly understand the ecosystem. They can certainly put together components and make an end solution. That's predominantly why we want to stay on the component side of things.
I think if we start moving up into systems, you know, perhaps outside of OCS, I think that's where the hyperscalers are gonna run into us. You know, as long as we stay on the component side of the business, I think we're in pretty good shape. Good question.
Maybe I'll move on, and if you have any question, please feel free to raise your hand in the meantime. OCS, You've noted multiple new OCS applications that are emerging that include new port counts, new configurations that customers now want. Maybe address kind of what you're seeing in terms of the broader applications that customers want service, but also what does it mean for your R&D expense to support those new applications or use cases?
Yeah, I mean, this has been really incredible for us, right? We've seen just since OFC, the number of opportunities for our OCS product go up significantly. Doesn't mean we have design wins, doesn't mean there's any new revenue to talk about, just the number of customer engagements around OCS has gone way up. As you correctly point out, that's higher port counts than 300, that's lower port counts. There's a bunch of new use cases. I think, you know, you and I have talked about it. The most interesting one of those is sort of going in rack and being able to steer traffic around a GPU that might be failing. We are very, very excited about that, and obviously we're now tooling our engineering to meet that demand.
I would say from our perspective right now, that's a significant challenge, is trying to come up with the right SKU set now to address that. In general, and this has been a philosophy of mine, for a long time, we want to use our engineers on high-value opportunities. What we've done, I think, very creatively, is we've shifted away from investments, you know, like industrial lasers, right? We've had a industrial laser business for quite some time and moved a lot of the engineers toward opportunities that make more sense. You know, you and I talked about our scale-across. Scale-across and trying to service that opportunity is largely being done by folks that were formerly working on industrial lasers.
OCS has been a different part of the portfolio, where we've taken some of the investments down and moved engineers over to service OCS. It, you know, if you look at our OpEx, we've actually kept that in pretty good control over the last year in the face of all this growth. You know, we talked about it over dinner. The one place I think we are probably gonna grow that won't show up in OpEx, it'll show up in as gross margin pressure, is putting some more people into the fabs, right? Just to service all of this demand, you've got to have more workers in the fab, which is a gross margin headwind. We think, again, we can work through that with price and mix and the other things that we can offset that pretty well.
Okay. Okay.
Thank you. Emanuel Zareh from 1789 Capital. Quick question. How do you view embedded optical approaches versus your transceiver architecture? Are you seeing hyperscalers scope both of them, or is one winning?
I mean, by embedded optical, I think you mean NPO or CPO. That's kind of how I'm going to take the question. You know, NPO and CPO first will put pressure on the transceivers, right? To this extent that optical scale-out happens, that is a cannibalization of transceivers at the end of the day. Obviously, it's a huge mega trend for us and very beneficial because our transceiver market share is relatively modest, and our transceiver business is heavily weighted toward the one customer that's shown no interest in going with NPO or CPO because they use an OCS, right? That sort of dulls the need for NPO and CPO.
Optical scale-up, which is by far the bigger optical mega trend, that's now putting pressure on copper because instead of replacing transceivers, you're now replacing either retimed copper or general copper links. That's just all upside for the optical industry. For us, you know, we talked about it over dinner last night. We would see, even in the face of that pressure, we would see the number of optical transceivers still going up, maybe not as fast, but going up through 2030. Certainly, the competition on scale out, the scale out opportunity is definitely supplanting transceivers.
Let's take one last question.
Thank you. Two parts. One would be, how much do you think supply is gonna increase in the industry in the next three years, and where's the limiting factor on your end? Are you finding there's gonna be any supply constraints in terms of manufacturing? Is that even on the horizon, or you find on your side it's just production?
I apologize. The acoustics are not great, so I didn't.
You-
I'm gonna guess.
I didn't get the first.
Yeah
question, I think.
I think I got the first question. The first part was how much do we think capacity is gonna increase?
Are you facing any inventory issues on your side? Are there any inventory problems in terms of someone supplying you that you need product that you can't get?
I mean, you know, our models show world capacity of indium phosphide going up, you know, somewhere between 2x and 4x. I mean, it depends on where it is that you're talking about. There will be a significant increase from where we are, and obviously, that doesn't scare us at all. We think that that's gonna be necessary, and there's still gonna be a supply-demand imbalance as you start adding all of this capacity. That Our challenge right now is interesting. One, it's been talked about a lot, is substrates, right? We think we have that mostly under control, but any indium phosphide wafer starts with a substrate, and there is definitely a well-documented substrate shortage. We think we've solved for that by virtue of locking up a long-term agreement, but every day the numbers go up.
It certainly puts more pressure on us to find alternate sources for substrates. The other one that's interesting is equipment. I mean, the equipment is affecting us not only on the wafer side, but it's also affecting us in our factories. We have a significant demand now on things like reactors in the fab, on etch in the fab, and then in the factories. I mean, it's surprising that that's ultimately been an inhibitor. It's just our ability to get equipment in there. You know, if I was to point to two things, it would be that. It would be substrates, which again, I think we have under control, but it's certainly tighter than I'd like to see, and then equipment.
Okay. Good.
Great. We'll wrap it up there. Thank you to the audience, and Michael, thank you for coming to the conference.
Thank you.
Have a good conference.
Appreciate it.