Semtech Corporation (SMTC) Q2 2020 Earnings Report, Transcript and Summary

Greetings. Welcome to Semtech Corporation's Fiscal Year 2020 Second Quarter Conference Call. [Operator Instructions] Please note, this conference is being recorded. I will now like to turn the conference over to your host, Sandy Harrison, Director of Investor Relations. Thank you. You may begin.

Thank you, Devon, and welcome to Semtech's conference call to discuss our financial results for the second quarter of fiscal year '20. Speakers for today's call will be Mohan Maheswaran, Semtech's President and Chief Executive Officer; and Emeka Chukwu, our Chief Financial Officer. Our press release announcing our unaudited results was issued after the market closed today and is available on our website at semtech.com. Today's call will include forward-looking statements that include risks and uncertainties that could cause actual results to differ materially from the results anticipated in these statements. For a more detailed discussion of these risks and uncertainties, please review the safe harbor statement included in today's press release and in the Other Risk Factors section of our most recent periodic reports filed with the Securities and Exchange Commission. As a reminder, comments made on today's call are current as of today only, and Semtech undertakes no obligation to update the information from this call should facts or circumstances change. During the call, we will refer to non-GAAP financial measures that are not prepared in accordance with generally accepted accounting principles. Discussion of why the management team considers such non-GAAP financial measures useful, along with detailed reconciliations of such non-GAAP measures to the most comparable GAAP financial measures, are included in today's press release. All references to financial results in Mohan's and Emeka's formal presentations on this call refer to non-GAAP measures unless otherwise noted. With that, I will turn the call over to Semtech's Chief Financial Officer, Emeka Chukwu. Emeka?

Thank you, Sandy. Good afternoon, everyone. For Q2 of fiscal 2020, net sales increased 4% sequentially to $137.1 million. This was above the midpoint of our guidance. In Q2, shipments into Asia represented 74% of net sales. North America represented 16%, and Europe represented 10%. Total direct sales represented approximately 28%, and sales [ through ] distribution represented approximately 72%. Our distribution business remains balanced with 52% of the total POS coming from the high-end consumer and enterprise computing end markets; and 48% of total POS coming from the industrial and communications end markets. Bookings grew sequentially and resulted in a book-to-bill above 1. Those bookings accounted for approximately 41% of shipments during the quarter. As expected, Q2 GAAP gross margin was flat sequentially at 61.9%. Q2 fiscal '20 GAAP tax rate was 63.4% and reflected discrete $6.5 million tax provision impact resulting from finalized [ trade-free ] Regulations related to the 2017 U.S. transition tax. We expect our GAAP tax rate for the rest of fiscal year 2020 to be in the range of 13% to 17%. Moving on to the non-GAAP results, which exclude the impact of share-based compensation, amortization of acquired intangibles, acquisition-related and other nonrecurring charges. Q2 non-GAAP gross margin was flat sequentially at 62.2% as expected, and we expect our Q3 non-GAAP gross margin to decline 20 to 80 basis points due to lower absorption of manufacturing overhead as we work to bring inventory down to target levels. In fiscal year 2021, we expect non-GAAP gross margin to return to normal levels as overall demand strengthens driven by our higher-margin growth engines. Q2 non-GAAP operating expense was $53.8 million, slightly higher than Q1 and in line with expectations. In Q3, we expect non-GAAP operating expense to be flat to down 3% sequentially as higher new product expenses are offset by lower supplemental compensation expense. While maintaining our investments in our key growth drivers, we expect our non-GAAP operating expense for fiscal year 2020 to be approximately flat or only modestly higher compared to the prior year. We expect our fiscal 2020 non-GAAP tax rate to remain in the 14% to 18% range. In Q2, cash flow from operations increased and returned to more normalized levels at 24% of net sales compared to 5% of net sales in Q1. As a reminder, Q1 includes our annual disbursements for supplemental compensation. We repurchased approximately 446,000 shares for approximately $20 million during the quarter, and our stock repurchase authorization now stands at approximately $161 million. We expect to continue to use our cash to opportunistically repurchase our shares, make strategic investments and pay down our debt. In Q2, accounts receivable decreased 12% sequentially due to improved shipments linearity and represented 42 days of sales, which is within our target range of 40 to 45 days. Net inventory in absolute dollars increased 2% sequentially and days of inventory increased to 129 days, which is above our target range of 90 to 100 days. In Q3, we expect net inventory to decline in both absolute dollars and days as we work to get inventory back in line within target range. In the summary, we were very pleased with our execution in Q2 despite this difficult macro environment. Our gross margin was stable, operating expenses were under control and cash flow generation was strong. While the recent geopolitical challenges continue to contribute to near-term customer uncertainty, we believe our diversified customer base and end markets, along with the secular nature of our growth engines, position us well for the future growth. I will now hand the call over to Mohan.

Thank you, Emeka. Good afternoon, everyone. I will discuss our Q2 fiscal year '20 performance by end market and by product group and then provide our outlook for Q3 of fiscal year '20. In Q2 of fiscal year '20, net revenues increased 4% over the prior quarter to $137.1 million. We posted non-GAAP gross margin of 62.2% and non-GAAP earnings per diluted share of $0.38. In Q2 of fiscal year '20, net revenues from the industrial end market increased 24% sequentially led by very strong growth from our LoRa business and represented 36% of revenues. Net revenues from the enterprise computing end market increased 4% and represented 27% of revenues. Net revenues from the communications end market increased 10% over the prior quarter and represented 10% of total net revenues. Net revenues from the high-end consumer market decreased 15% sequentially driven by lower smartphone demand and represented 27% of total net revenues. Approximately 16% of high-end consumer net revenue was attributable to mobile devices and approximately 11% was attributable to other consumer systems. I will now discuss the performance of each of our product groups. In Q2 of fiscal year '20, net revenues from our Signal Integrity Product Group increased 10% over the prior quarter and represented 40% of total net revenues. As expected, demand increased sequentially across the data center and the wireless base station markets, while the PON market remained soft. In Q2 of fiscal year '20, data center demand rebounded as customer inventory levels have reduced over the last 2 quarters and demand from cloud and hyperscale data center providers appears to have stabilized. In Q2, we saw strong bookings for our ClearEdge CDRs used in 100 gigabit per second NRZ optical modules. We expect demand for our ClearEdge CDRs to continue to increase driven by global cloud and mega data center deployments. In Q2, we were pleased with the progress of our Tri-Edge PAM4 CDR platform that we are now sampling to data center customers. We expect our first Tri-Edge revenues in Q4 of this fiscal year with growth accelerating in the second half of next year. Our Tri-Edge platform delivers low-cost, low-power and low-latency performance, ideal for PAM4 base optical modules. In September, Semtech will be part of the Open Eye MSA Interop demonstration for 10-kilometer, 50 gigabit per second PAM4 links. The Open Eye MSA, which consists of 19 companies, builds on key performance advancements or PAM4 CDRs and optics to enable lower cost and lower power PAM4 optical modules. Our FiberEdge PMD platform, which complements our Tri-Edge and ClearEdge CDR platforms, also continues to gain momentum with key data center PAM4 module customers where we have collaborated with DSP partners targeting PAM4 optical modules. We expect to see our FiberEdge PAM4 revenues also ramp in FY '21. In Q2 of fiscal year '20, demand from the wireless base station market increased. Semtech's market opportunity from 5G deployments is expected to triple compared to 4G due to the higher 5G volumes and additional CDR content. For the rest of FY '20, we expect 4G and 5G deployments to increase modestly with much stronger growth from 5G platforms expected in FY '21. In Q2 of FY '20, our PON business, which is largely driven by China, remains soft due to lower China government investment in PON and the impact of the Huawei ban. We expect this weakness to continue through the second half due mostly to the Huawei ban. Over the next few years, we do expect the PON market demands to increase driven by 10 gig PON deployments. Semtech remains the PON market leader, providing highly integrated solutions for 1 gig, 2.5 gig and 10 gig PON platforms. The greater demand for higher optical data rates at the lowest power and cost is driving greater demand for Semtech's ClearEdge, Tri-Edge and FiberEdge platforms. We expect this trend to continue driven by the global expansion of cloud and hyperscale data centers, the global transition to 5G base stations and the acceleration of 10 gig PON, and we expect our SIP product group to benefit from these global trends over the next few years. Our broadcast video business has been very stable for the last few years, and with the acquisition of AptoVision, we are finally starting to see an opportunity to drive significant growth in this business. As a reminder, we are focused on transitioning the pro audio/video industry from expensive proprietary equipment to standard IP-based solutions through the adoption of software-defined video over ethernet. The primary market focus has been healthcare, enterprise, industrial and entertainment. Recently, we received post-silicon of our SDVoE platform, which appears to be functional and we now expect to have production silicon by the end of this year. We believe this will be a significant catalyst in the adoption of SDVoE for all Pro AV applications as customers realize the benefits of delivering uncompressed, ultra-high definition, 4K TV content over a standard 10 gig ethernet network. We will update you on the progress of our AptoVision platform on future earnings calls. For Q3 of FY '20, we expect net revenues from our Signal Integrity Product Group to be flat to up modestly as global demand increases will be offset by the Huawei ban. Moving on to our Protection Product Group. In Q2 of fiscal year '20, net revenues from our Protection Product Group grew 4% over the prior quarter and represented 29% of total net revenues. Our Protection business growth was driven by increases in broad-based demand from the industrial, automotive and consumer markets. In particular, we saw nice increases from our North American smartphone business and from our automotive business. These were somewhat offset by lower Korean and China smartphone demand. Several of our newly released parts such as the RClamp3324P deliver higher performance protection for the most advanced HDMI, ethernet and USB interfaces. The increasing proliferation of the high-speed interfaces across multiple market sectors is driving our growth in demand. In particular, the rapid adoption of these high-speed interfaces in automotive systems such as infotainment, in-vehicle communication and advanced driver assistance systems is contributing to the growing demand for Semtech's high-performance protection products. In Q3 of fiscal year '20, we expect our Protection business to increase due to continued strength from the automotive and industrial segments and stronger smartphone demand from North America and from Korea. Turning to our Wireless and Sensing Product Group. In Q2 of fiscal year '20, net revenues from our Wireless and Sensing Product Group were approximately flat from the prior quarter and represented 30% of total net revenues. Very strong sequential growth from our LoRa business was offset by very weak demand for our proximity sensing products due to the Huawei ban. In Q2, our LoRa-enabled business grew nicely. The momentum and interest in LoRa is very strong, and we are seeing more and more IoT use cases emerge every day. LoRa is rapidly becoming acknowledged as a critical technology for low power IoT sensor networks, and we expect to see LoRa emerge as the de facto standard for low power wide area networks over the next few years. Some of the more recent noteworthy use cases include Comcast announced it has partnered with Universal Parks & Resorts to deploy LoRaWAN networks in its parks to increase operational efficiency in the parks. LoRa sensors will be used to monitor temperature, monitor energy consumption and track assets across the parks. Seluxit, a leading European IoT provider, has developed a LoRa smart meter and cloud platform to enable their customers to closely monitor energy usage realtime. Customers using Seluxit get insight into their energy usage and consumption patterns, enabling a reduction in energy waste and reduction in energy cost that enables a more sustainable energy grid worldwide. Axino, a European IT solutions integrator added LoRa into its smart refrigeration solutions used to track food temperature, helping customers reduce food wastage and ensuring food safety. Skysens, a Turkish provider of IoT solutions, is deploying 10,000 LoRa-based sensors in its smart asset tracking solution at Istanbul airport. Conserv, a leading IoT solutions provider for art and museum applications, has developed a smart conversation solution based on LoRa that utilizes low-power sensors to provide museums with accurate, efficient and simple art help metrics in real time. Oizom, an IoT solution provider for environmental applications, is leveraging LoRa using Tata Communications' LoRaWAN infrastructure in India to deploy smart agricultural solutions, enabling farmers to optimize their water usage and create smarter and more efficient farms. And Lacuna Space in Europe announced it has completed its first phase of testing in its mission to provide complete satellite IoT global coverage from LoRa sensors anywhere in the world, however remote. Lacuna's demonstration, LoRa constellation, will be completed by the end of this year. Lacuna also demonstrated a connectivity range of over 300 miles. These are just a handful of examples of new use cases emerging in the LoRa ecosystem. Interest in our recently announced cloud-based LoRa services, which includes our LoRa-based geolocation services, has been very high as we start to demonstrate the unique value of a LoRaWAN-based geolocation service offering. We believe that customers will begin transitioning from testing our geolocation services to qualification and commercialization early next year. Based on our anticipated growth in LoRa sensors and the assumed attached rates of sensor geolocation, asset tracking and other services, we expect our LoRa Cloud services to grow to $100 million in recurring revenues within the next 5 years. Our LoRa momentum continues to build nicely, and we are seeing very exciting momentum across the globe underscored by the key LoRa metrics we track. Our key metric -- our key metrics update includes the number of public or private LoRa network operators increased in Q2 to approximately 120 from 100 at the end of FY '19. We expect 130 LoRa network operators by the end of fiscal year '20. The number of countries with LoRa networks grew to more than 82 countries. By the end of FY '20, we expect over 90 countries to have LoRa networks. The estimated number of LoRa gateways deployed increased to more than 350,000. These gateways will support approximately 1.5 billion connected end nodes. We expect the number of LoRa gateways deployed to exceed 500,000 by the end of FY '20, supporting a LoRa end node capacity of over 2 billion end nodes. The cumulative number of LoRa end nodes deployed increased to 105 million. We now expect this number to reach 130 million by the end of FY '20. The LoRa opportunity pipeline is now over $475 million with an additional $200 million of leads feeding the opportunity pipeline. We anticipate that, on average, 40% to 50% of this pipeline will convert to full deployment over a 24-month timeline. Our pipeline of opportunities is geographically well-balanced and also includes a growing number of consumer use cases where the volumes could be significantly higher. We will continue to provide LoRa metric updates on future earnings calls. In FY '20, given the slower than expected start to the year driven by extremely soft demand from China, we are now expecting our LoRa-enabled revenues to come in between $80 million and $100 million. We expect to exit the year at a quarterly run rate closer to the high end of this updated range. We still anticipate a 40% CAGR over the next 5 years, and we continue to expect LoRa to become the de facto standard for LPWAN use cases over the next few years in what we expect to be a multibillion unit industry. In Q2 of fiscal year '20, demand for our proximity sensing platforms decreased as expected driven by lower China smartphone demand due to the Huawei ban. While our Huawei smartphone business will continue to be a challenge, we believe our proximity sensing business will benefit from increasingly stringent global SAR regulations as governments recognize the health risks associated with increasingly powerful 5G radios. Over the next few years, we expect the majority of smartphones and wearable devices to have SAR sensors included in their system designs. For Q3 of fiscal year '20, we expect net revenues from our Wireless and Sensing Product Group to increase due to stronger LoRa-enabled demand. Moving on to new products and design wins. In Q2 of fiscal year '20, we released 12 new products and achieved a record 2,460 new design wins. Now let me discuss our outlook for the third quarter of fiscal year '20. We are currently estimating Q3 net revenues to be between $135 million and $145 million. To attain the midpoint of our guidance range or approximately $140 million, we needed net terms orders of approximately 36% at the beginning of Q3. We expect our Q3 non-GAAP earnings to be between $0.38 and $0.42 per diluted share. Our Q2 guidance assumes no further direct shipments to Huawei in this fiscal quarter. I will now had the call back to the operator and Sandy, Emeka and I will be happy to answer any questions. Operator?

[Operator Instructions] Cody?

Just a clarification on that last point. You're not shipping to Huawei this quarter -- any further this quarter. Are you zeroing out your Huawei expectations going forward? And are you shipping, as many other companies are, a new portion of your prior revenue?

Yes, Cody, we are shipping as Huawei requests us to ship and of course, if we are allowed to ship. The comment is that we don't plan in our guidance to ship anything more even though we have backlog to Huawei and that's really related to them. There is an indirect impact as I have mentioned on previous calls where we may be able to ship a product, but if they can't get a component from another -- a key component from another manufacturer, then they can't ship their system anyway. And so part of that is -- our kind of approach is assuming that they're going to have difficulty in assembling all the components they need to build their systems.

And then just the Chinese versus the Huawei implications. How have you seen the ban or the trade conflicts impact your broader Chinese activity, particularly in the smartphones market, not necessarily PON. Just broadly, are you seeing any hesitation? Or are you seeing any share shifts that might give you encouragement that you could see China grow even if Huawei is not?

Yes, I don't think the tariff situation is so much an impact for us. I think the China demand softness is obviously an issue for everybody and that is more -- has been what's going on before the tariff situation. The tariff situation has compounded I think the uncertainty and there's some elements of that. But I don't think those really are the major impact for us. I think the Huawei ban is clearly a direct impact and that's really the major impact. Outside that, I think we still have pretty high expectations of growth in China.

Our next question comes from the line of Tore Svanberg with Stifel.

First of all, so just to close the loop on Huawei. So it's about 5% of your revenues last quarter, right? So roughly $7 million and that's going to go away in the October quarter, is that the math?

We've estimated about $10 million impact this quarter, Tore, from a direct standpoint. There may be additional indirect impact, again, that we're not aware of, but the direct impact for us is about $10 million.

Very good, that's helpful. And then as we sort of look at outside of China and Huawei, I know last quarter, you had talked about backlog kind of firming, inventories were pretty low, as you mentioned, in the data center market. As we now are here 90 days later, would you say that, outside of China, the environment is still relatively healthy?

Yes, I think that's fair to say. I mean, I think the smartphone market is a little bit skewed because of Huawei's inability to shift. So we don't really know if someone else is going to pick that up or they're picking that up when we see a pickup there. So outside that though, I do think that the rest of the markets, data center for sure, IoT for sure, are doing reasonably okay. So it's very segment specific and yes, I don't see any other regional issues.

Very good. And just last question on LoRa. As cloud services start contributing to revenues perhaps early next year, is this going to be a separate line item? Are you kind of going to talk a little about perhaps where you're seeing the geographic implementation there?

Yes, we will start to give more color as we start to get revenues from the geolocation services and as it becomes a material number, of course, we'll break it out.

Our next question come from Rick Schafer with Oppenheimer.

Maybe my first question, Mohan, is on LoRa, just kind of going back to that. Obviously, that business continues to show really solid growth, but I think probably slower than maybe you expected or we expected sort of starting last year. So I don't know if you can spend a second just kind of what's been the biggest surprise there versus your expectation even 2 or 3 years ago? And maybe it's as simple as just, like you said, it's just China slowing down kind of surprisingly here? And then the second part of that question is I'm just curious what we should watch for, what kind of milestones on LoRa revs as we track toward, I know you guys have talked about $500 million to $1 billion in the next 3 to 5 years. That certainly implies a pretty good hockey stick at some point in the future to hit that kind of run rate. So sort of any color there, maybe if next year that big hockey stick year or just some -- if you could frame some of that, that would be helpful.

Yes, so I think some key points is we've been growing at 60% a year from a revenue standpoint, and this year, our expectation was no different. Obviously, we started the year very soft with China. China is still 60% of our revenue for LoRa is generated out of China. But one of the key things to really look at is the opportunity pipeline. The opportunity pipeline is more balanced. I think it's going to be more geographically balanced. There's a lot more different, new types of use cases. I think that's one thing to look out for. As I said in my remarks that we're still anticipating 40% CAGR going forward for the next 5 years. You layer on top of that cloud services, it will probably generate something like a 50% CAGR. And so I think the key things to look out for are still the opportunity pipeline, the conversion rate, the number of gateways deployed, which indicates really what type of end node capacity we can support, the end node deployments themselves and then just general momentum. And as you said, we are expecting -- in this pipeline of opportunity, we have some very good, very potentially high more consumerish, more smart building, smart home kind of use cases that we think could be a real catalyst. And once we see that momentum go, I think it's going to be clearly obvious to everybody that LoRa will become the de facto standard for LPWAN. Obviously, we are still working hard at those use cases and still a ways to go, but we're fairly optimistic about them.

And just a quick follow-up on -- shifting gears to base station. I think it's around sort of a mid-single-digit kind of contributor to revenues. I know you talked about that business growing modestly in the back half, and I assume that's without Huawei. So is that really -- is that just a function of higher the content as you mentioned in your prepared remarks? Is that share gains for you guys at sort of the non-Chinese wireless OEMs like the Nokias, Ericssons, Samsungs? Just any color there would be great. You guys obviously have a great friendship with Samsung, for instance, the handset side, so I don't know if that was an opportunity for you guys.

Yes, a bit of everything you mentioned, Rick. I think we are generally seeing a pick up in the demand of 5G deployments. I wouldn't say it's huge. I would say it's very modest, but it is a pickup. Obviously, Huawei is a bit of a headwind for us on that, but I think, as with smartphones, we do expect over time, someone else to pick up the demand that Huawei can't ship. So we'll see how that plays out, but yes, that's our expectation.

Our next question comes from the line of Craig Ellis with B. Riley FBR.

And just to make sure I'm clear on the Huawei effect, are you saying that there was $10 million of Huawei revenue in the fiscal second quarter but you don't expect there to be any so that's the $10 million sequential headwind?

Yes, we've shipped some already, Craig. But we're not expecting to ship anymore. And so the total impact is about $10 million for us.

Got it. And then following up on some of the LoRa questions, Mohan. So it seems as I look at the performance of the business versus targets, you're actually tracking in network operators and countries potentially to exceed the targets that you had set at the beginning of the year. And yet, we did reduce the end node target from $140 million to $130 million, I believe, and then you updated the revenue target. But if I look at that data, it would seem to suggest that the business is getting good traction outside of China, but maybe not getting the end node deployments as fast as we had thought perhaps 3 and 6 months ago. Is that a fair depiction or is there really something else going on?

No, I think that's a fair depiction, Craig. I think that the only thing to remember is that predicting end node deployments is really predicting how fast the opportunities turn into -- and the proof of concepts turn into revenue. I mean, the actual deployments. And so it really is a guesstimate. Right now as we look at it, at the moment, LoRa is still a small business and it's still a sub-$100 million business. And so a small change like China softness and smart metering for example, can impact that. But I think as the business starts to scale and gets larger, and as I mentioned in the opportunity pipeline, being more balanced, then those small changes, I think, won't have such a significant impact. And that's -- when we look at the opportunity pipeline being so large, if we can convert those, we're going to see the 40% or more CAGR that we are projecting.

Okay, that's helpful. And then switching over to Signal Integrity. So it seems like the company is pleased with the momentum it has with the ClearEdge parts and the Tri-Edge PAM4 parts. I think we're specific that we'd start to see revenues for some of these PAM4 parts in the fourth quarter. But then, really more again in the second half of calendar '20. Is the point there that seasonally, we would expect the business to be softer in the first half of the year just given enterprise and data centers spending? Or is there something else going on and should we expect a similar revenue and demand profile for your ClearEdge parts?

Yes, I think it's more weighted to when the market is ready for PAM4. I think we see customers interested. We see design and activity, but revenue, I think, is still towards the back end of next year. And we are working very closely with them. Obviously, as we bring out our products and we see momentum, that may change, maybe a first half phenomenon. But I think at this point in time, we'd project more second half next year revenue.

Okay, that's helpful. Last one's for Emeka. Emeka, I haven't forgotten about you. The guidance on gross margin was helpful as it relates to the fiscal '21 color rising back towards more normal levels. The question is, what is "normal?" Would that be the 61% to 62% range or is that 62% plus? And I take it that's driven by valuation, but would there be any micro services revenue included in that guidance?

I think the normal levels that I'm responding to. If you look at the last several quarters, we have been about 62% and above. So that's what I sort of consider as normal for us now. I would expect that as we go into the next fiscal year and as we look at where we expect to get our growth from, getting our growth from LoRa, getting growth from hyperscale data center, getting growth from our Pro AV products, from our -- the industrial or protection products. These are all end markets that we know come with a much higher gross margin expectation. So that is why I do have the belief that as we get into the next fiscal year, and especially also as demand overall strengthens and is fast to come back to normal levels, we can get back to the same levels of manufacturing activity. And so those are the reasons why I do believe that we should get back to the normalized levels of 62% and above.

Our next question comes from the line of Tristan Gerra with Baird.

When you mentioned 5G content opportunity to triple, could you give us some color on how does that translate in dollars in terms of the 5G content per base station and also the pace of increase that you expect for next year?

Yes. Tristan, I think it's difficult to say. Everybody is -- it depends on the architecture, how many fronthaul, backhaul, middle links there are in each system deployment. What we are seeing, obviously, is that there is more demand for CDRs and so that increasing content is obviously beneficial to us. Also, 5G architecture in general requires more base stations. And so we are just seeing, at least our customers are telling us that that's likely to be the case. So there will be more base stations, different type of base stations and more CDRs, and so that drives the content. We're already starting to see modest pickup, as I mentioned. I think next year, again, we'll see if it plays out in the first half, I think more likely the second half. But there is definitely a pull from the market. So I think the need is there and it's just now a question of whether the technology is ready and whether the customers are ready to service providers are willing to put the money in. So I think it's going to happen starting next year.

Okay. And then moving on to the impact of 5G but this time on the consumer side. Does your Protection business potentially benefit from the rise of 5G phones? Are there any changes that you expect in the regulatory environment for 5G model powering phone that would have an impact on your content per cellphone?

Yes, the main shift would be on what we expect our proximity sensing. As I mentioned in the call, that 5G radios are pretty powerful. And as you have more 5G radios and because of the range, you need to have an increase in power to get to more distance as you have high bandwidth there. Typically, those radios are going to be more powerful and therefore, I think, potentially more dangerous. And I think one of the things we expect is most phones, whereas the attach rate today or proximity sensing for SAR functionality is fairly not so high. I think for 5G phones, it's going to be much higher. So that's really a good opportunity for us. In addition, for Protection -- so that's for proximity sensing, and from a production standpoint, we see the same type of improvements required, high-speed interfaces for more advanced processors, different displays requiring protection, and it's just a more challenging environment as everything is faster and has more advanced lithography. So -- and more advanced displays. So again, Protection and proximity sensing, we expect to do quite well going forward due to 5G also.

Great. And then last one, in terms of the growth for LoRa that you see for this year, how should we model China? I thought China will have decline as a percentage of total LoRa revenue. Do you actually expect China to be flat to up year-over-year this year? Or is the new target embedding China to be down year-over-year?

I would think that China would be maybe slightly up year-over-year, Tristan. But I think we did anticipate it would be a much higher growth this year, to be fair, as we planned the year. A lot of the growth that we did expect from China. But I make the comment on the opportunities being more balanced just for that reason, and we just don't know where this whole tariff thing is going to lead to and those types of things. And one of the things we pride ourselves on is having geographical balance and end-market balance and this is one of the reasons, it's that we can't predict what's going to happen regionally. All we know is we have very good momentum also in North America. We have a good momentum in Europe. But yes, for this year, the projection was that China would be growing faster and I think it's going to be fairly muted growth.

Our next question comes from the line of Karl Ackerman with Cowen and Company.

Emeka or Mohan, your comments on China PON demand largely echo peers who have reported already, but I think you sound a little bit more optimistic on 100 gig optical components than peers. So what are you seeing here in terms for bookings for 100 gigs for the second half of the year? And how should we think about the opportunity for your PON business as 5G ramps later this year?

Well, Karl, I think -- so separate PON from data centers so there's really 2 markets we play in. PON is the one that's majority China, mostly China driven and mostly today 2.5 gig and 1 gig PON. We are seeing growth in 10 gig deployments. The challenge for us with PON is that Huawei has really been one of the key drivers of that business in China, and obviously with the Huawei ban, that puts some challenges around that business. In addition to that, China has been the main region for PON deployments. There are other regions deploying, but China has been by far the highest volume and so you combine the slightly modest investments in -- reduction in investments by the China government in PON and then combine that with the Huawei ban, that puts really a headwind on the PON business. Now separate that from the data center business, the data center business, we spoke about inventory builds in Q4 and Q1. We started see that free up now in Q2, started to get more balance and we expected the rest of this year to be a little bit better for data center and most of those are 100 gig, 4x25 gig and our Z optical module deployments. And so that's where we see the benefit there on our CDRs.

Understood. For my last question, if I may, could you elaborate on what you expect from the proximity sensing business for the back half of calendar 2019? I understand that Huawei is an overhang, but I guess I was under the impression that business outside of smartphones should grow at kind of high teens or plus or minus clip. So if you could elaborate a bit more on what you're seeing in that market outside of Huawei/smartphone, that would be helpful.

Yes. The proximity sensing business is doing quite well outside China. It's also obviously Korea. So it's mostly -- today it's mostly smartphones, even though we're getting design wins in wearables and other areas where the radio is touching the human body. But I think today the mass -- majority of the volume is still smartphones. And as you know, the big smartphone manufacturers, the major volume drivers are in Korea and handful of that in North America and then China. And we've done actually a phenomenal job of diversifying this business. It used to be all Korea driven, but China this year obviously because of Huawei with who were the main drivers of that proximity sensing business in China have had challenges, and so now the back half, we were expecting Samsung to pick up a little bit. Haven't had a strong year-to-date. I think there's indications that they may do better. And as I mentioned, I think it's likely that if Huawei can't ship phones outside China, that someone will pick up that demand, not clear who it will be, but we do expect that demand to benefit us in some shape or form in the proximity sensing world.

Our next question comes from the line of Harsh Kumar with Piper Jaffray.

A couple of questions. You guys call out -- Mohan and Emeka, you called out LoRa and data center for growth. LoRa historically has been highly China-dependent, but you saw some pretty strong growth in this July quarter you reported. I'm curious if this growth that just came in, in the July quarter, did it come from China? Or did it come from other places? And then on data center, I was curious, similar sort of geographic-based question. Are you seeing growth from data centers in U.S. and Europe and not from China? And further maybe you could clarify between cloud, enterprise or hyperscale.

Yes. So let's start with that first question -- the last question first, Harsh. So data center is clearly being driven today mostly out of North America. The shipments might be -- we might be shipping into China because the supply chain is there, but the end demand is to service North America. So that, without question, is the answer to that. And it's mostly hyperscale data centers today, I would say, a mix of cloud as well, but mostly hyperscale care centers. And then on the LoRa side, yes, it is China. I would say a large chunk of that growth is China but it's also rest of the world. As you know, Q1, we had pretty weak LoRa business and that was driven mostly by China's softness and I think we saw a little bit of a pickup from that in Q2, but I would say it's more balanced but still yet a lot of the growth is driven by China.

Got it. And then would say like some of the other companies, Mohan, that have reported -- actually a lot of them already reported the June numbers and even July. Most of them have said that China has bottomed out, ex Huawei, of course. Would you say that you would share that sentiment for your business?

Yes. I would say that's probably true, Harsh, although Huawei is a fairly significant influencer in the region. So I think if you would exclude them, then you have to look at the whole ecosystem around them. But I think outside that, yes, I do think that China seems to be doing better now. As I mentioned, there are indications that the China demand as a total is now starting to do better outside the tariff uncertainty, which doesn't really impact our demand so much. I think it's just the uncertainty of it kind of creates an overshadowing nervousness, but I think outside that I think China demand seems to be doing better.

Our next question comes from the line of Gary Mobley with Wells Fargo.

Let's start with a quick question for Emeka on the OpEx. So your Q3 OpEx guide implies a $2 million year-over-year decrease. And just to get to the question of sustainability for that lower level, is there anything more than just lower bonus accruals or putting the cap on any sort of travel expenses and whatnot?

No. There's not that much more to it, I think, as you can imagine. Coming into the year, we actually had much better expectations for the current year. So our bonus programs were very much aligned to those. But unfortunately, we're not seeing that so we don't expect other programs to pay out as much as we had anticipated. And overall, managing operating expenses is something that we do very well. We probably still have about 20% to 25% of our operating expenses are variable, so those are opportunities for us to keep this in control. So -- but there isn't anything that is extraordinary that we are doing to manage our operating expenses.

Okay. Kind of an odd question. So one thing this Huawei shipment ban in the U.S.-China trade issue has taught China companies to try to accelerate their -- and reduce their dependence on Western chip companies. So as you sit here today driving 35% of your revenue from China, have you seen any sort of anti-U.S. sentiment as it relates to design win activity or maybe even adoption of, what, LoRa, which may be viewed as a U.S.-based technology?

Yes. Actually, that's a really good question. I think we have seen that, but I think that's nothing unusual. I mean, that was going on before any tariff situation. The Chinese have been driving a whole kind of vision of having more component suppliers in the region. Fortunately for us, most of the stuff we do is really high-end stuff and I think they're challenged. I mean, the companies, they are challenged to do -- kind of achieve the levels of performance we achieved. Now that said, because of some of the situations we have like the Huawei ban, it may drive the customers, the end customers to actually change their specifications to accommodate poor performing devices. And so we have to be faced with that. I think that's just one of the challenges we have to deal with, in addition to being faced with Chinese competition as customers may be changing their specs to accommodate lower-performing devices. That said, I think that for us we have enough opportunity across both China and the rest of Asia and other regions of the world to still expand our SAM and our opportunity.

Our next question comes from the line of Quinn Bolton with Needham & Company.

Wanted to ask first on the data center business. With the nice uptick that you saw in the second quarter and the guidance for continued growth into the second half of the calendar year, do you think you're now sort of through all of the inventory correction? Or do you think even in the second half you may still be shipping under and consumption of optical modules in the data centers?

Quinn, we think most of the inventory is now burnt through. I mean, I think it's been 2 quarters now where we've seen softness in data centers. Difficult to call it, it's not a huge increase we're seeing, but we are seeing modest increase, and so our feeling is, yes, in the second half that's going to be a little bit stronger. So I think assumption from that is that inventory mostly is reduced.

Okay. Great. And then just a question on the smartphone business. I know historically the company has had very high share in the OLED display protection market. I think certainly that was the case with the Korean manufacturers. But as you see Chinese manufacturers ramping OLED displays, do you have the same market share with some of the newer Chinese OLED manufacturers on the protection side like you did with the Korean OLED manufacturers?

Yes. I think -- so first of all, a lot of the Korean -- a lot of the China phones are still using, I think, Korean displays and will do so for quite some time, I think. And so -- but yes, we have a reasonable position. I wouldn't say it's as good as the Korea smartphone area, but I will say that our relationship with Samsung has always been very strong and our relationship in China is emerging, I would say, on the display side. But we still believe that we have a pretty good share across the globe.

Got it. And then my last question is on the LoRa business. You've sort of discussed that it was a little bit of a slower start this year and the new revenue target for fiscal '20 sort of implies a low single-digit to maybe a mid-20% year-on-year increase, so below that 40% kind of CAGR that you expect for the next 5 years. Should we think that to the extent we get into a better economic environment in 2020, that you could rebound above that 40% level for a year? Or would you sort of encourage us to think that the best way to think about that LoRa business is that the growth rate is going to be much closer to that 40% kind of off the fiscal '20 base that you've just given us.

Yes. The way I would think about it, Quinn, so we have been growing at 60%, right, so -- and that was our expectation coming into this year. And so we've kind of reset that to a 40% CAGR. But as I mentioned, one of the things I have mentioned is that we are expecting a major catalyst or 2 over the next 12, 18 months here that I think will drive much faster growth. And obviously, when that happens, then we can talk about what that does for the numbers, but it's still a ways off. We still have to execute on it. We still need our customers to go through the POC process and demonstrate the value and then indicate to us that that's something that they're going to do and it's going to drive a lot of volume. So for now, I think the 40% is a good number to model in.

Our next question comes from the line of Scott Searle with Roth Capital.

Quick clarification on the guidance, just want to make sure I was clear. Proximity sensors, you are expecting to be down sequentially, but overall the Wireless and Sensing Group is expected to increase into the third quarter, is that correct?

That's correct.

Okay. So just to follow up. Samsung has historically been a slightly larger customer for you. I think in the last several quarters they've been running $10 million to $14 million; was a little bit softer this quarter. It sounds like proximity sensing was part of the issue there. But is there something else going on? Is there a share loss or something else? Are we just clearing some inventory here before you expect that demand to come back to a more normalized level?

You're talking about -- you're referring to Samsung cellphone business?

Yes.

Yes. Samsung just hasn't been as strong for us in the first half. I think we're anticipating a little bit stronger Q3 from them. But in the first half as they've told us, their demand hasn't been as strong as they had anticipated and I think that's part of the thing we're looking at, is whether they're going to be able to pick up some of the China smartphone demand for Huawei. But yes, I think maybe it's been because they had business in China and Asia and Huawei is said to become more aggressive in those regions, but I don't know. Really, the China smartphone Korea -- sorry, Korea smartphone has been weak for us in the first half. We are expecting that to come back a little bit in Q3.

Got you. And to follow up on a couple of earlier questions around data center. Nice snapback in the second quarter. It sounds like you're continuing to look for a sequential increase into the third quarter. China had been expected to be a component of internal or domestic demand and consumption for new data centers being built out in Chinese mainland. Is that still part of your outlook going forward to see that kind of growth and that coming back? Or is this recovering -- sustained recovery still all being built from North America hyperscale cloud environments?

No, China is included in that, just not Huawei. So I think we include other China customers, yes.

Okay. And lastly just to wrap up on LoRa. As you exit the fourth quarter, more that $100 million type run rate, China has been a big component of that. What is your expectation of what China is as a component of that $25 million in the fourth quarter? And then just to follow up on your earlier comment. You're expecting a big catalyst on the lower front to drive growth. I was wondering if you could expand upon that a little bit, give us a little bit of color. Is that tags? Is it something else?

Yes. So as we end the -- exit the year, Scott, I still think China will be about 60% of the revenue and it's really the pipeline is a lot more balanced, but I think we have to see evidence of that, the other regions and more in those other locations turning into revenue before we can move the -- change the shift in revenue profile geographically and it doesn't usually change that quickly. So China may go from 60% to 58%, 55% or something like that until we see a big catalyst. The catalyst are many. I mean I think there's not one. I think there are a lot of consumerish-type use cases, tags and things related to devices and also in the Smart Home. But they just have a higher volume than the industrial smart metering, smart cities, smart building kind of use cases. And so that's what we are referring to and what that do -- will do really for LoRa is move it from being kind of an industrial IoT sensor to being a true IoT for many different segments, including consumer and industrial and enterprise and that's what we're looking for, that type of catalyst.

Our next question comes from the line of Hamed Khorsand with BWS Financial.

Just a couple of questions here on LoRa. Outside of China, are you seeing any pricing pressure that's creating this issue with revenue not growing as fast to offset the weakness in China?

No, Hamed, we don't see any pricing pressure really. I think it's more just conversion of POCs. We are seeing momentum in other regions, it's just faster revenue in China. China, one of the reasons why China has been more rapid adopter of LoRa and generating revenue faster is they typically have access to more system integrators, software engineers, hardware engineers, sensor developers in the region and they tend to be very fast, solving bottlenecks and providing a solution to issues. That takes -- it's a little bit more challenging in Europe and North America and other regions, but it's starting to get there.

And how much of a factor is the slowdown in the automotive industry playing a role in your Protection business?

Not really impacting our Protection business at all, Hamed. I think our Protection business is mostly today driven by smartphones and then the automotive is growing quite nicely for us. It's relatively new segment for our Protection business. As I mentioned in my script, we're seeing a lot of infotainment and ADAS and new applications emerge in the vehicle that all need very high-end protection because they have advanced lithographies in them. And so our Protection business is growing nicely now in that space, so yes, we -- but it's more for us today.

Our final question comes from the line of Craig Ellis with B. Riley FBR.

Thanks for taking the follow-up question, team. I just wanted to follow up and see if I could ask a question about how you would look at the fiscal fourth quarter seasonality in this environment given all of the macro crosscurrents? It's hard to think of any quarter seasonality. But to the extent that you have a view there, can at least share some of the positives and negatives that you would see from this early juncture, I'd appreciate the color.

Yes. It's tough to call, Craig, mostly because of Huawei, I would say. I think we would expect Samsung to be down obviously, in Q4, but they haven't had a great year. So normally, when they've had a fairly modest year, sometimes their Q4 is not as extreme downward. So that may be not as weak. I think data center will continue to be quite strong. Obviously, we expect LoRa and IoT to be quite strong. So it's going to be tough to call it. I think we'll just have to wait and see how China plays out. And the Huawei ban is the one thing that obviously does impact us, would expect a similar type of impact in Q4, unfortunately, so we'd to look at that. But my sense is Q4 could be better than we normally would see it.

You mean just the margin there is a headwind or you mean there could be an incremental $10 million headwind in the fiscal fourth quarter, Mohan?

I think the $10 million we have is -- would be included in the numbers. So if you take Q3 run rate, I would anticipate normal seasonality from that standpoint and then you look at my comments on Korea. So Q4 could be stronger than we have seen in the past in terms of the -- typically it's down for us, at least 5%, I would say. I would say probably it's not going to be down as much, but we'll see.

We have reached the end of our question-and-answer session, and I would like to turn the call back over to Mohan Maheswaran for any closing remarks.

Yes. In closing, despite the ongoing uncertainty and geopolitical headwinds that contributed to a slower first half and despite the ongoing Huawei ban, we are seeing modest signs of recovery in several of our targeted markets. We remain confident in the underlying strength of the secular drivers behind our growth engines, in the IoT, data center and mobile markets, and we remain confident that our overall end market, geographical and product balance will enable us to outperform the industry. With that, we appreciate your continued support of Semtech and look forward to updating you all next quarter. Thank you.

This concludes today's teleconference. You may now disconnect your lines at this time. Thank you for your participation, and have a wonderful day.