Lumentum Holdings Inc. (LITE) Q3 2021 Earnings Report, Transcript and Summary

Good day, everyone, and welcome to the Lumentum Holdings Third Quarter Fiscal Year 2021 Earnings Call. All participants will be in a listen-only mode. [Operator Instructions] Please also note today's event is being recorded. At this time, I'd like to turn the conference over to Jim Fanucchi of Darrow Associates. Sir, please go ahead.

Thank you, operator. Welcome to Lumentum's Third Quarter Fiscal Year 2021 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 and our position in such markets; the impact of COVID-19 and responsive actions thereto on our business and continuing uncertainty in this regard; trends and expectations for our products and technology; our markets, market opportunity and customers; and our expected financial performance, including our guidance as well as statements regarding our future revenues, our financial model and our margin targets. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations, particularly the risk factors described in our SEC filings, including the Company's quarterly report on Form 10-Q for the fiscal quarter ended April 3, 2021, which the Company expects to file later today. 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 in this call are available on its website at www.lumentum.com under the Investors section and includes additional details about our non-GAAP financial measures and a reconciliation between our historical GAAP and non-GAAP results. Now I will turn the call over to Alan for his comments.

Thank you, Jim. Good morning, everyone. I want to first say our thoughts and prayers are with everyone affected by the continuing COVID-19 pandemic. While vaccinations and case rates are declining in the United States and a few other countries, in many places around the world, the situation is not good. What is happening in India is absolutely heartbreaking. Again, our thoughts are with everyone affected. Turning to our business. Our third quarter results highlight a product portfolio increasingly rich in new and differentiated products and aligned with favorable long-term multiyear market trends. Revenue from key new product lines that position us well for long-term growth were each up by double-digit percentages year-on-year. These include indium phosphide-based coherent components and modules, next-generation contentionless MxN ROADMs, high-speed EMLs and 3D sensing lasers. Non-GAAP gross margin expanded by 440 basis points year-on-year, driven by continuous improvements in our operations and product mix. The accelerating transition to digital and virtual approaches in all aspects of work and life is driving staggering amounts of data in the world's networks and cloud data centers. The proliferation of 5G wireless will remove bandwidth bottlenecks at the edge of the network and drive even more bandwidth in the core networks and cloud data centers. The computer and machine vision revolutions are in their early days, and we expect 3D sensing and LiDAR capabilities will expand to many more applications in multiple markets. These include augmented and virtual reality, 3D machine vision for industrial applications, frictionless and contactless biometric security and access control and automotive and delivery vehicle applications. Laser-based material processing is critical to the manufacturing of the devices that enable the digital transformation and transition to 5G wireless and electric vehicle and energy storage. These multiyear trends, combined with our product and technology leadership positions, bode well for us over the long-term. Recent discussions with market-leading customers gives me optimism. Customers have communicated that they are seeing growing end market demand for their next-generation solutions, where we have a wide range of design wins with highly differentiated products. Now it is about translating this growing end market demand into shipments and revenue. On this point, like others, we are seeing headwinds that may moderate near-term market growth in telecom and 5G-related components for the remainder of this calendar year. We believe the telecom and 5G components market will reaccelerate midway through our fiscal year 2022. These views are driven by the combination of a tight supply of critical semiconductors that we and our customers depend on, customer inventory build in anticipation of strong end market demand and potential delays in deployments in certain geographies more impacted by COVID-19. We expect the lasers market recovery to continue and our business to return to pre-pandemic levels by the middle of fiscal 2022. In 3D sensing, we believe the net impact of certain customer design decisions will reduce the overall global market for 3D sensing lasers in fiscal 2022 by approximately 20% to 25%. We expect laser-based sensing to expand to more applications, customers and markets in fiscal 2022 and 2023, setting the stage for reacceleration of market growth in fiscal 2023. As well, our product road maps include new designs for the future where we integrate additional functionality to help customers further reduce size and their cost of incorporating 3D sensing capabilities while allowing us to capture more dollar content over time. At this time, putting these market trends, supply constraints and customer forecasts together, we expect our revenue for the first half of fiscal 2022 to be down approximately 5% relative to the first half of fiscal 2021. These near-term external market headwinds do not diminish my optimism around our long-term multiyear market outlook. Our product portfolio and design wins and the positive changes in our business model and the industry over the past several years. I believe the future continues to be very bright at Lumentum. Turning to capital allocation. We are disappointed the Coherent transactions didn't turn out as we had initially hoped. We continue to believe strategic M&A will be a value creator for Lumentum over the long run. We will be thoughtful in our approach and timing. That said, we believe very strongly in our organic opportunities for value creation. From a capital allocation standpoint, after analyzing alternatives, we believe investing in our own stock is currently our best opportunity. As such, Lumentum's Board of Directors has authorized a share buyback program for up to $700 million over the next two years. Now on to more details about our third quarter. Within Telecom and Datacom, revenue from indium phosphide-based coherent components and modules was up 28% year-on-year after adjusting for the extra week of the recent third quarter. We had strong ROADM revenue with record contentionless MxN sales. These products are increasing in our revenue mix due to their incorporation in our customers' latest systems, which they are just starting to ramp. The average selling price of these advanced ROADMs are significantly higher than the lower port count devices. This will help us accelerate revenue growth as new network deployments increase over the coming several years. In China, we are already designed into every major network equipment manufacturer or NEM with our MxN or high port count ROADMs. On our last call, we highlighted production shipments of MxN ROADMs to our largest Western NEM customer. And in the third quarter, we started production shipments to our next largest NEM customer in the West. We are designed in or in final qualification stages with many other customers with our latest advanced ROADMs. Revenue from EML chips was up more than 40% year-on-year, again adjusting for the extra week in the recent third quarter. These products serve the cloud data center market, which is increasingly transitioning to 200 and 400-gig speeds. At these higher speeds, our products are highly differentiated. We expect this differentiation will drive market share gains with non-vertically integrated and vertically integrated transceiver suppliers. We expect our growth will accelerate as cloud operators continue their transitions to higher speeds. Underscoring this, during the third quarter, we received $90 million of orders for EMLs primarily from web-scale cloud operators and customers serving them. seeking to secure our production output. This backlog will be delivered over multiple quarters as we are capacity constrained on EMLs. Our previously highlighted production capacity expansion is tracking well and will come online later this calendar year for significant increased output starting in the second half of fiscal '22. Due to continued delays in 5G fronthaul deployments in China, our third quarter DML revenue was significantly below year ago levels and fourth quarter DML sales are expected to be down by more than $20 million year-on-year. At this time, we expect 5G fronthaul deployments could resume this summer. This timing would drive increased demand for our products towards the middle of fiscal '22 once customers ramp up and burn through existing inventory. Looking to the fourth quarter, we expect Telecom and Datacom revenue to be up quarter-on-quarter. Third quarter industrial and consumer revenue was up year-on-year due to increased dollar content and higher volumes and declined quarter-on-quarter as expected, due to seasonality. In the fourth quarter, we expect industrial and consumer to be down sequentially due to normal 3D sensing seasonality but up by double-digit percentage year-on-year. Additionally, we have begun mass production of new laser chip designs for upcoming major customer new products. We recently had an important Android customer launch a mobile phone with time-of-flight 3D sensing camera capabilities enabled by our lasers. This is a notable design win as this customer is a large and leading supplier of camera components, and their features frequently proliferate to much higher-volume Android manufacturers. During the third quarter, we announced industry-leading advancements in VCSEL technology that position us well for future applications in the industrial and automotive markets. For example, we announced high-power, high-efficiency VCSEL rays, leveraging industry-leading five and six junction design. These multi-junction arrays are of particular interest to the automotive and LiDAR markets. They have strong traction in solutions for autonomous vehicles, including the major retailers who are looking to deploy fleets of autonomous delivery vehicles. As well, we continue to receive design-ins and initial production orders from other auto LiDAR and access control customers. Turning to commercial lasers. In the third quarter, we had a significant increase in kilowatt fiber laser sales after four quarters of decline. Historically, during market downturns, macro material processing was amongst the slowest segments to recover, and we are now cautiously optimistic that we have seen the worst of the impact of COVID-19 in this segment. We expect fourth quarter lasers revenue to be up quarter-on-quarter. Throughout my remarks, I've highlighted that our markets are driven by strong long-term trends and that we have invested heavily in differentiated new products, technologies and customer programs. With our latest products, we have secured key design wins and are on track for more with market-leading customers. Our product mix is becoming richer in these new products as customers are starting to ramp shipments of their next-generation solutions. We are seeing some nearer-term external factors that will moderate industry growth for the next few quarters but these don't diminish our long-term market outlook. Before handing it over to Wajid to review the numbers, I want to once again thank and acknowledge all of our employees around the world for their hard work and contributions. Our employees are absolutely the Company's greatest asset. I would also like to thank our customers, suppliers and shareholders for their continued support and partnership during these challenging times. With that, I'll hand it over to Wajid.

Thank you, Alan. Good morning, everyone. Turning to the third quarter's numbers. Net revenue for the third quarter was $419.5 million, which was down 12% sequentially and up 4% year-on-year. Out of an abundance of caution, we deferred $14.8 million of revenue due to delays in 5G fronthaul deployments in China. However, despite the lower revenue, and due to the strength of our financial model, we achieved approximately 50% non-GAAP gross margin and strong non-GAAP operating margin and EPS, which both were within our guidance ranges. GAAP gross margin for the third quarter was 44.1%. GAAP operating margin was 63.6% and GAAP diluted net income per share was $2.85. GAAP results include the impact of the $217.6 million we received in connection with the termination of the Coherent transaction. Third quarter non-GAAP gross margin was 49.9%, which was down 350 basis points sequentially as expected but up 440 basis points year-on-year due to our improving model with a better mix of products and lower relative manufacturing costs. The sequential decline relates to the seasonal change in product mix and volumes, while the year-on-year growth was driven by improved gross margins in the Optical Communications segment. Third quarter non-GAAP operating margin at 27.9% and decreased 760 basis points sequentially but increased 290 basis points year-on-year. The sequential decline was driven by the expected gross margin decline and increase in operating expenses quarter-on-quarter. The year-on-year increase was driven by the gross margin improvement year-on-year. Third quarter non-GAAP operating expenses totaled $92.1 million or 22% of revenue. SG&A expense was $40.8 million. R&D expense was $51.3 million. The sequential increase in operating expenses was primarily driven by the extra week of the 14-week quarter and the annual reset of benefits rates and payroll tax that occurs at the beginning of the calendar year. Third quarter non-GAAP net income was $110.6 million. This includes $0.5 million of net interest expense and $6 million of tax expense. Other income and expense was a net expense of $0.5 million as interest income declined to levels lower than our expense due to lower interest rates on our cash and short-term investments. Non-GAAP diluted net income per share was $1.40 based on a fully diluted share count of 79.2 million. On the balance sheet, we ended the quarter with approximately $2.1 billion in cash and short-term investments, up $354 million quarter-on-quarter, including the $218 million Coherent transaction termination fee paid to us. We have $1.5 billion in aggregate principal convertible notes and no term debt. As Alan mentioned, Lumentum's Board of Directors has authorized a share buyback program of up to $700 million over the next two years. Over the past 12 months, our cash balance has increased by more than $600 million, and we are confident in our future long-term outlook. Given relative valuations in the industry, we believe this is a good use of our growing cash. Now turning to segment details. Third quarter Optical Communications segment revenue at $387.9 million increased 14% sequentially due to seasonally lower revenues in Telecom and Datacom and industrial and consumer and the deferred 5G-related revenue I discussed earlier. Optical Communications segment revenue was up 8% year-on-year due to the extra week in the quarter and higher industrial and consumer revenues due to the increased dollar content and adoption of 3D sensing and consumer electronic devices. Optical Communications segment gross margin at 50.1% decreased 370 basis points sequentially primarily due to lower industrial and consumer in the revenue mix but increased 510 basis points year-on-year due to a more favorable revenue mix with newer and more profitable products and the benefits from operational improvements. Our Lasers segment revenue at $31.6 million increased 6% sequentially due to the ongoing recovery from the impact of COVID-19 but is 27% down year-on-year as the recovery isn't complete. Third quarter lasers gross margin was down 30 basis points sequentially at 47.2% and down 250 basis points year-on-year due to significantly lower revenue levels. Now onto our guidance for the fourth quarter of fiscal '21, which is on a non-GAAP basis and is based on our assumptions as of today. We expect net revenue for the fourth quarter of fiscal '21 to be in the range of $360 million to $400 million. Despite industry headwinds, this revenue guidance is consistent with our historical seasonality when normalizing for the revenue we deferred and the recent 14-week quarter. I'd note, over the past four years, the mean seasonal revenue decline from the third to fourth fiscal quarter has been about 7%. Our revenue projection assumes Telecom and Datacom increasing quarter-on-quarter, industrial and consumer declining due to normal seasonality and commercial lasers increasing quarter-on-quarter driven by further market recovery from COVID-19. Based on this, we project fourth quarter operating margin to be in the range of 22.5% to 25% and diluted net income per share to be in the range of $0.92 to $1.14. These projections also assume an approximate share count of 79 million and estimated other expense of $1 million and an estimated tax expense of $9 million. With that, I'll turn the call back to Jim to start the Q&A session. Jim?

Thank you, Wajid. Before we start the question-and-answer session, I would like to ask everyone to keep to one question and one follow-up. This should help us get to everyone before the end of our allotted time. Operator, let's begin the question-and-answer session.

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Samik Chatterjee of JPMorgan. Please go ahead.

Hi, this is Joe Cardoso on for Sam Chatterjee. Thanks for the question. My first one here just wanted to touch on the first half guide you provided for fiscal 2022 starting with Telecom and Datacom. You're calling for moderate growth before reaccelerating in the second half of the year. Just wondering, if you can parcel out the details there a bit? Where are you expecting to see the greatest trend? Where are you expecting to see the greatest weakness? How much is supply-related? And then in terms of the recovery into the second half, can you kind of rank order the drivers that's kind of giving you confidence that we see that recovery in the second half? Thank you.

Sure. I'd say first half going through the different product areas. As we said, Q4, we see Telecom and Datacom growth in Q4. We expect Telecom to continue to grow in the first half, but moderately from the exit rate of Q4. Datacom is going to continue to be hampered, from our perspective and expectations, around 5G rollout in China. And one of the reasons we had that revenue deferral in the third quarter is the inventory in the various stages of deployment is moving very slowly. So we don't expect that to pick up. And as we said, the DML year-on-year reduction in Q4 is about $20 million. So we expect that to continue to be a drag on our Datacom business. Offsetting that is the increased capacity we're putting in place on EMLs. And so we should see modest increases in EMLs but overall Datacom will be down in the first half. Commercial lasers is continuing to see a recovery from the pandemic. And as we said, we expect that we will, by the middle of our fiscal year, be back to pre-pandemic levels. So we'll see moderate growth in lasers, and then as we said also, our expectation, given the 3D sensing market being smaller by 20% to 25%, mainly due to design decisions that some of our customers have made around smaller chips, and smaller chips lead to smaller average content per device. And so that's probably the bigger drag on the first half expectations. As far as second half and why we're confident that we'll see a rebound, I think, if you look across our product portfolio, our design wins are phenomenal. Our team has done a fabulous job on our high port counted contentionless ROADMs. Those are designed in and we talked about new designs in the West. And so from our perspective, we are very much poised for a rebound. Now that might happen before the end of the calendar year, but our expectations are that this is modest, and then in the second half of the fiscal year, that picks up. Also in the second half of the year, our capacity will be coming online for our EMLs, and that is going quite well. We talked about that two or three quarters ago, that's in motion, and we expect that our EMLs due to our highly differentiated products. And the orders that we talked about in Q3, we expect to capture major market share on our EML business on the 200- and 400-gig products and then, again, continued growth in lasers. And then the 3D sensing is, again, a market issue that I think we'll all see on that one.

The next question comes from Rod Hall with Goldman Sachs. Please go ahead.

Yes. Hi, guys. Thanks for the question. I guess my first question is back to 3D sensing. I think it has been pretty well telegraphed that chip size is going to go down, but I had also been assuming that you guys would have higher share as a result of the redesign. So I just wonder if, Alan, could you comment on your share position in H1 and how you see that going. And then I've got a follow-up.

Sure, Rod. Thanks for the question. We're highly confident of our ability to satisfy our customer. And for the last 3.5 years, we've been the partner of choice. We continue to execute, deliver almost 1 billion units of 3D sensing. And so I think from our perspective, we're the design lead. We're doing very, very well. Our market share -- we've been saying for 3.5 years that our customer needs security of supply and that we would see a shift, and we had -- we saw that last year. So I don't want to make expectations that we're going to go back to the kinds of share that we had over the last three years because that was uncomfortable for our customer and for us, quite frankly. So I think having two suppliers in our leading customer is a good thing and one that gives us a comparison of how well we performed compared to our competitor. And I think we're continuing to perform very well from a quality, delivery, cost perspective. And so our expectations are that we're going to continue to have a solid share, especially at the front end of product launches.

Okay. Great. And then for my follow-up, I just wanted to check on -- I know that there's additional ROADM capacity planned for the summer. Just wanted to check that's still on track that you guys are going to expand on capacity. I guess now, well, maybe you could comment on what you think that means for ROADM revenue trajectory post that. Are we still -- are you still expecting to be short? It sounds like probably not given what's going on in the market, but I'd just be curious on the supply versus demand balances as you bring that capacity online and whether it's still on track.

Yes. We have added ROADM capacity, mostly on the high end for the MxN as well as a very high port count ROADMs. And so as our Western customers have added our MxN to their mainstream product portfolio, we are not going to be short from a capacity standpoint. So that -- because we're the sole source, we cannot let them down and from that perspective, we're adding capacity in anticipation of them continuing to grow that business in the first half of our fiscal year, but really ramping it dramatically in the second half. So that's on track. I'd say the other thing that's causing some angst is the semiconductor shortages. And so I have been a keen expediter of semiconductors more than I'd like to be, but that is also putting some pressure on our ability to meet our customer demand on the high end.

The next question comes from Alex Henderson with Needham. Please go ahead.

Thank you very much. You've made a couple of comments around 3D sensing that I just wanted to get some clarification on. So clearly, there's been some share shift going on. There's a reduction in your share and an increase in your competitor's share. Your comment that you expect to have solid share is not very definitive in terms of whether you think that rate of change in share's been altered. Can you talk about whether you think you've gotten to a point where shares have stabilized? Or do you expect to continue to have share erosion? How should we think about share trajectory as opposed to -- whether it's just simply solid, solid's not very descriptive?

All right, Alex. I think our track record speaks for itself. As new products have been announced, we are the dependable supplier that our customer counts on. And if you want to have a different word for solid, that's how I'd describe it. And so my perspective is the share equilibrium that has been reached in the last quarter is probably where we're going to end up. And I think, over the long-term, now every quarter is going to be different based on new products and the models that get built and where we are versus our competitor. But I think, overall, our numbers speak for itself. And I think if you talk to our competitors, do the comparison and see where we are. I mean we're pretty transparent with our 3D sensing numbers in our press release and in our earnings.

So the conclusion is that your share has stabilized relative to where it has been in the most recent couple of quarters. Is that a fair statement of what you just said?

I think so. I mean from my perspective, I'm extremely -- all the time, and that keeps us on our toes, make sure that we're attentive and responsive to our customers' needs. And we don't want to give them any reason or excuse to move any more share than they already have. And I think they're comfortable with it. I'm comfortable with it. And I think from that perspective, we're just continuing to work on next generation and next generation for our customer to make sure we're there for them.

Your next question comes from Simon Leopold with Raymond James. Please go ahead.

I've got two. I want to ask the sort of more complex one first and that. So on the 3D sensing market decline that you've talked about, there's obviously two key dimensions. One is volume and the other is ASP. I appreciate you can't be specific on the values, but could you help us get a better understanding of how we should think about what's going on with ASPs with the smaller chip other than the fact that they're less?

Yes, Simon, I'd say that just like any semiconductor, the cost of that device scales with both chip size as well as yield. And so our customers' expectation is that ASP scales with chip size, and we're working on yield. And I think we've done a great job and our team has done a great job in getting to yields that I think our competitor and our customer never thought we could get to. So I think, from that perspective, you can imagine that the discussions with our customers around, hey, the chip is x percent smaller in price -- in size, and therefore, it should be x percent smaller in ASP, and I think that holds true for the most part, given any different complexity of processing or testing or any yield variation. But from our perspective, wafer size is a good indicator of cost, and therefore, it becomes a good indicator of price. And from our perspective, we price for a given margin and the market dynamic. And we're very confident, even at lower ASPs that our margins will continue to maintain where they have been.

But that implies gross profit dollars are lower then?

Yes. I mean, absolutely. I think on a percentage basis, the margins are going to be stable. With the top line coming down because of market shrinkage, the dollars at the bottom will be lower.

Okay. And then the easy question I had, hopefully, is just trying to unpack the datacom products a little bit. It sounds to me that the DML chips and the 5G exposure China is pretty decent-sized, probably bigger than I was guessing and maybe EMLs, maybe a little bit smaller. So can you give us a little more color on how to think about the proportions coming from different products within Datacom? So help us think about this trending.

Sure. I'd say that our EML business grew 40% year-on-year. So the growth in Datacom is coming from EMLs. And we sell DMLs to the 5G fronthaul. We sell DMLs to transceiver suppliers that sell into hyperscale data centers, although that is starting to soften as well as those hyperscalers are moving from 100-gig transceivers to 200 and 400 gig transceivers. And so we're going to see a rapid shift not only from the reduction in 5G deployments but also the shift from 100G in the data center to 200 and 400G. So our focus and pressure is really on how do we add capacity or shift capacity from DMLs to EMLs, and it's not straightforward as you might think because there is difference in complexity with respect to the processing of an EML compared to a DML. I think you can assume that pre-5G slowdown, it was probably around 50:50-ish, and I think you can model that in the Datacom business. But if you look at Q4 business, I'd say it's dramatically EML-heavy, and that will continue to grow through the first half of the fiscal year.

The next question comes from Meta Marshall with Morgan Stanley. Please go ahead.

Great. Thanks. Maybe a couple of questions for me. Just one on just the Coherent deal and deciding to do a share repurchase. Just kind of what is kind of your current appetite for M&A, particularly given Silver Lake had been a potential partner when you were looking at the Coherent acquisition? It would seem as if by opting for a share repurchase, you were looking to be maybe less active in the near term. And then on the second question, just as you look at your telco forecast kind of going forward, have you incorporated what could potentially be an incremental slowdown due to kind of what we're seeing in India right now?

Yes, that looks like three questions, Meta. But okay, let me take the M&A. I'll have Wajid talked about the share repurchase. We still believe that M&A is strategic for us and will create inorganic value for our shareholders, and we're still focused on doing that. I think we have a track record of successful M&A, and that's what we're looking for. I think we are disappointed that Coherent went the way it went, although I think it also is an opportunity for us to step back and say, what is the next acquisition. And at this point in time, management and the Board believe that the value of organic value creation is the best place to put our cash. I'd say Wajid can talk about the cash generation we've had and the decision on the share repurchase, and I'll come back to the to the telecom question. Go ahead, Wajid.

Yes. No, I think we've struck a perfect balance in terms of our capital allocation strategy. As you know, we've historically invested heavily in CapEx to support our growth as well as in selective M&A transactions. And the beauty of the $700 million share buyback that our Board has authorized is that it's just a little bit larger than the amount of cash we've generated over the last 12 months, and it still leaves us with a lot of firepower to go ahead and do M&A transactions as we choose to. So I think it gives us optionality, and it allows us to maintain flexibility moving forward as well. So we're looking forward to putting some cash to work in order to be able to buy back some shares, especially at current levels.

And then on your third question on telecom forecast and incremental impact of things like what's going on in India, it's hard to say. I think our perspective is that we've seen a continued slow ramp-up of telecom even through this time. Our expectations are that, that continues. And if it doesn't go to India -- and I think in talking to our customers, they're still deploying in India today. And so if things get much worse, which I -- hard to believe or hard to imagine, that could be impacted. But so far today, it's still deploying but not at the rate it would otherwise if there had not been such an influx of cases.

The next question comes from John Marchetti from Stifel. Please go ahead.

Maybe just following up for a minute, Alan, on the telecom comment. With some of the new wins that you have for the MxN with some of the western vendors, on your sort of first half fiscal year outlook, do you expect those sorts of deployments to continue to ramp? And I guess, has your expectation for that ramp slowed relative to maybe where you were a quarter or so ago?

I'd say no. I'd say we're pretty much tracking to where we expected. I mean I think we had expected that there would be muted growth as a result of challenges of deploying during the pandemic. But we are very, very happy with the progress of the design cycle of our product in next-generation systems for not just Chinese NEMs, but also the Western NEMs that we talked about in the script. So I think from our perspective, we're poised by MxN, indium phosphide, coherent components and modules, and so as or if the deployments accelerate, we'll be ready.

And then maybe just as a follow-up, on the 5G deferral side, is it your sense that inventory levels got way ahead of themselves because of some of the risks associated with all the prior administration's efforts to hamper some of that growth there? Or is this a result of the delays in some of those tenders? And just curious where you think maybe those inventory levels are right now. And if it's a couple of quarters to move that out or if we still have to wait and see what some of these new expected tenders actually deliver.

Yes. I mean I think if you go back in time, last year, there was expectation that there'd be 1 million base stations in China or some number like that. There was approximately 60% of those deployed. Same kind of outlook was for calendar '21, and I think similar kind of disappointment, if you will, in that 600 million to 680 million base stations look like they're going to be deployed. But not a lot have been deployed in the first half. And so our belief is that, that starts picking up this summertime but won't have meaningful impact on our business until the middle part of the fiscal year. So that's where we think the inventory throughout, whether that's at the radio base station supplier or at their transceiver customer supplier or in our WIP, I mean there's that much inventory where I think that it needs to ramp up and needs to start deploying before we see any meaningful deployment. And I'd say it's solely due to the U.S.-China geopolitical issues and their ability to get chips for the base stations. And so that redesign is happening. And our expectation is that, that will start picking up in the second half of the calendar year.

The next question comes from Ananda Baruah with Loop Capital. Please go ahead.

Yes, two for me, if I could as well. Really, clarification is the first one. You guys talked about on 3D sensing, there both being a market down component and then the price mix -- and then the pricing component. How much of the guidance is market down versus the pricing on the smaller design? And then also, are you seeing pricing pressure, you call it pricing pressure? And then I have a quick follow-up.

This is Chris. Good morning. I think -- well, the market down is the combination of normal price erosion and the smaller chip size, which reduces the dollar content, if you will. We've made no -- to be clear, and I think Alan mentioned this in the prepared remarks, we're not opining on anything around volumes or mix within the market, if you will. This is purely sort of normalizing for those factors, just about lower dollar lower dollar content than normal price erosion. I would say that. Pricing environment is normal. There's not unusual pressure, right? We've provided price-downs for our customers every year since we got into this business. And then we've seen price increases as chip sizes have gone up and prices come down with normal price erosion or, in this case, when there's a redesign and the chip is smaller. That said, we also have a product road map well aligned with our customers that includes designs that integrate additional functionality, enable lower cost, higher performance, maybe integrate other optical capabilities, reduces packaging costs, package sizes, et cetera. That will help us capture more dollar content over time as those products are launched. But going back to the question about the market in fiscal '22, there's other customers coming online in other markets and other applications. But they won't come online fast enough to offset the impact that we're seeing at some of the major customers with the dollar content and normal price erosion. So -- but as they come online through fiscal '22 and into fiscal '23, then we believe the market will reaccelerate.

Sorry, maybe just one other thing to add on the market outlook that's different than where we were on the last earnings call, which was our expectation is to have a major Android customer incorporate 3D sensing. And recently, they made the decision not to do it in this generation of product. And so that also puts pressure on expectations around the market when the major Android customer decided not to incorporate 3D sensing. And so that puts some pressure on our outlook for the market in fiscal '22.

That was actually my follow-up. Do you think just -- to that end, do you see other opportunities sort of in the Android space aside from that, that one vendor that still could be included in what was your thought process 90 days ago?

Yes. I mean I think we continue to be very excited about the Android adoption. It's obviously been slower than we've expected and I'm sure everybody has been -- expected. But this year has, I think, been rough for Android suppliers overall, given it seems like COVID-19 has really impacted them compared to our largest customers. I think Alan -- well, there's strong interest across the board for kind of a LiDAR-based approach or time-of-flight-based approaches for world-facing for photography, AR/VR applications. And Alan highlighted in the script what we think is a very positive data point that we had a customer launch a great smartphone with world-facing capabilities really focused on photography. This is a customer who also sells components, if you will, image sensors and others to the Android universe en masse, and therefore, their technologies or their designs frequently proliferates much larger Android manufacturers. And that's really been one of the technical barriers to the Android world, is that this is harder technology, and then some of the more low-cost Android manufacturers need help with the technology. So it's great to see a leading technology, maybe not a leading volume manufacturer of phones adopt it so that, that technology will proliferate a bit further.

The next question comes from George Notter with Jefferies. Please go ahead.

I guess I wanted to kind of keep going on the 3D sensing discussion here. Any changes in the performance characteristics that you're seeing out of the marketplace either through world-facing or front-facing, is that driving the ASP and chip size changes? Or is this more of a sort of natural evolution in the market?

Yes. George, I think it's more of a capability that we've been able to provide to our customer, and jointly, these are chips that we've talked about with our customer two and three years ago. And so as our capability and technology improves, we can combined, develop a product that has more functionality at a smaller size. And I think Chris talked about our ability to then go from that stage of the game to adding more functionality on the chip that now our customer needs to go to third parties and add different types of components. As we roll out those types of functionalities that are embedded in the chip at a lower cost, we will capture more dollar content. So I'd say this is no different than just the evolution of driving lower-cost solutions at higher functionality and features.

And one thing to add to that, I think that maybe got lost as chips may be smaller, there's still a lot of lasers in fact, as many lasers, if not more, than in the past. So that presents a lot of technical challenges to accomplish that. But as Alan said, that's why it's taken us several years in working with the customers to achieve that level of density on the chip. The reason I highlight that, it also provides a level of differentiation and barrier to entry for other folks in the market. So it's not like the chip's getting smaller and dumber. It's getting smaller and more complex, if you will.

The next question comes from Michael Genovese with WestPark Capital. Please go ahead.

So there's a lot of handles on this call about the market share, but I feel like you answered it better in the prepared remarks. And I want to make sure I understand correctly because you're saying that the market is going to be down 20% to 25% in the second half of the calendar year, and your revenues are going to be down 5%. So doesn't that suggest some share switch as bringing back to you as this new chip of this new smaller chip is rolled out? Doesn't the math just tell us that you're gaining share?

Well, keep in mind, 3D sensing is a portion of our business. And so as we look at our different other businesses, Lasers is going to grow. Telecom is going to grow. Datacom is going to be under pressure. And so our commentary was around the market and the market being down 20% to 25% in the fiscal year, not just the fiscal first half in the fiscal year, our belief due to the chip size and the lack of adoption by a major Android customer that the market itself will be down 20% to 25%. Now how that translates into our revenue is hard to say, but it's going to have a negative impact on our revenue, assuming we maintain the share that we have today. And I think that's what you can model into your first half model. And it turns out that we gain a bunch of share, then great. But our expectations and our guidance don't count on that.

Got it. Okay. Great. And then I just wanted to ask for your perspective. I mean the indium phosphide news is good news. As we track that market, there's a lot of interest in pluggables and 400ZR and ZR plus. And so what's your perspective on that market? Does momentum need to play there? Is it going to inhibit or drive the growth rate of indium phosphide going forward? Just any general commentary there would be appreciated.

Yes. Thanks, Mike. Yes. I mean, certainly, we're very excited about our opportunities for our indium phosphide platform, very differentiated capabilities. We are already supplying high performance indium phosphide components into 800 gig applications as an example. We're also very focused on 400 gig pluggable modules. There's a whole range of performance requirements all the way from metro long haul then down to DCI and ZR type modules, working on all of them. Some of them are in production. Others are in the sampling phase. And we're kind of prioritizing our investments based on our ability to differentiate our products and size the opportunity and customer feedback. So it's a great opportunity for us given the unique indium phosphide platform we have.

The next question comes from Christopher Rolland with Susquehanna. Please go ahead.

I guess my first thing is pretty broad. I guess looking out into the next year, kind of with the best crystal ball you guys have, do you expect to grow revenue year-over-year? And then secondly, you talked about the reacceleration maybe in the back half. Maybe talk about what this looks like, how it kind of manifests itself for your various segments as well.

Yes. Christopher, maybe I could comment and Chris or Wajid can chime in. Our focus is to give you what we know when we know it, and our outlook for the first half of the fiscal year changed. And so that's why we made the exception and gave you guidance for the first half so that you knew as soon as we knew. And I think that's why we gave first half guidance. We're not going to talk about the year. I think it's too hard to predict, let alone what's going to happen two quarters out as opposed to four or five quarters out. So I think what we can comment on is our progress on new products, new design wins with customers, and that's going extremely well. And so as the market picks up or as deployments pick up, we'll be there for our customers. And we'll be really focused on making sure we get them what they need. That said, we are investing in capacity for those key products. ROADMs, we talked about. We're investing in our wafer fabs, both in Datacom as well as our indium phosphide capabilities for coherent components. So we are investing in anticipation of that picking up, and we'll be ready for our customers.

The next question comes from Fahad Najam with MKM Partners. Please go ahead.

I have a clarification first. The deferred revenue from DML is a few million dollars. Is that accounted into your guidance? Or is that completely out of your guidance for 4Q?

Yes, Fahad. It's Wajid here. So the impact of the $15 million was on fiscal Q3. And any type of recovery we see of that, whether it's in Q4 or whether it's in the first half of fiscal '22 has already been incorporated in our guidance that we provided.

Okay. And now to my question. So Alan, it's not surprising that ASPs were coming down. Our checks had indicated that ASPs will come down as share gains? Or is that based on an assumption that there is primarily more proliferation of 3D sensing across more SKUs with this customer and also, generally speaking more broader adoption by Android, if you could pass that comment about reacceleration in fiscal 2022?

Sure. Well, I think from reacceleration in fiscal 2022, what we had intended to say or what we had expected to really message was a lot of design wins happening now for different industries, whether that be automotive, security, biometrics and access control and things like that are happening now that should accelerate through fiscal '23. We're still hopeful that Android comes online in fiscal '23. But I think our outlook is really more around added customers, added markets. And as far as next generation of devices for our lead customers, we're working on many, many different things. And until they get close to deciding what's the plan of record, we're working on many, many different things without knowing what is actually going to be the plan of record for fiscal '23. And so we're just making sure we're the design source for them, and we will leave them whether that's a continuation of existing designs or new designs when they choose to put them in.

We have time for one more question in our allotted time. The next question comes from Tom Diffely from D.A. Davidson. Please go ahead.

Yes, good morning. Thanks for squeezing me in here. I had a question on this, the nice margin expansion on a year-over-year basis. Based on the cost reduction and some of the new products that you're rolling out, has most of the benefit now been realized? Or is there a runway for extending the expansion going forward on a margin basis?

Yes, I'll start off. It's Wajid here. So on our gross margins, you're right to point out a lot of the year-over-year improvement that we've had across our Optical Communications products. Our Lasers margins have come down year-over-year primarily because our volume levels have been lower. But as Alan noted in his remarks and even in the Q&A session, we're expecting our Lasers business to continue to improve not only in Q4 but throughout fiscal '22. That should have a corresponding positive impact on the gross margins as it relates to Lasers. Now within Optical Communications, we're continuing to expect margins to hold quite well primarily because of some of the product mix benefits we'll start seeing as EML capacity comes on board. We talked about our 50% gross margin model a couple of quarters ago as we put it out there. And as you can see, even with our fiscal Q3 actual results year-to-date, as well as what we're forecasting for Q4, our current expectation is that fiscal '21, we'll end up with gross margins north of 50%. And we're targeting a 50% margin model for fiscal year '22 as well despite some of the puts and takes that we've talked about during the call. So I think that, that continues to be our target and our product and our customer deployments that we're seeing support that.

This concludes our question-and-answer session. I would like to turn the conference back over to Jim Fanucchi for any closing remarks.

Thank you. This concludes our call for today. We would like to thank everyone for attending, and we do look forward to talking with you again when we report the fourth quarter fiscal '21 results. Have a good day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.