Lumentum Holdings Inc (LITE) 2018 Q3 法說會逐字稿

Good morning. My name is Kelly, and I will be your conference operator today. At this time, I would like to welcome everyone to the Lumentum Fiscal Third Quarter 2018 Financial Results Conference Call. (Operator Instructions)

I would now like to turn the conference over to Chris Coldren, Vice President, Strategy and Corporate Development. Please go ahead.

Thank you, Kelly. Welcome to Lumentum's Third Quarter Fiscal 2018 Earnings Call. This is Chris Coldren, Vice President of Strategy and Corporate Development. Joining me on today's call are Alan Lowe, President and Chief Executive Officer; and Aaron Tachibana, Chief Financial Officer.

This call will include forward-looking statements, including statements regarding the markets in which we operate, including potential market sizes, trends and expectations for products and technology, purchasing trends and demand for our products, Lumentum's expected financial performance, expenses and position in the market as well as statements regarding our pending acquisition of Oclaro. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expeditions. I encourage you to review our most recent filings with the SEC, particularly the risk factors described in our 10-Q filing for our third quarter ended March 31, 2018, that we expect to be on file with the SEC later today.

The forward-looking statements we provide during this call, including projections for future performance, are based on our 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 are non-GAAP. Non-GAAP financials should not be considered as a substitute for or superior to financials prepared in accordance with GAAP. Our press release with our third quarter fiscal 2018 results is available on our website, www.lumentum.com, under the Investors section, and includes additional details about our non-GAAP financial measures and a reconciliation between our GAAP and non-GAAP results. Our website also has our latest SEC filings, which we encourage you to review, and supplementary slides relating to today's earnings release. A recording of today's call will be available by 11:30 a.m. Pacific Time on our website.

Before turning the call over to Alan, we have some additional comments related to the pending acquisition of Oclaro. Today's call is neither an offering of securities nor solicitation of a proxy vote in connection with our announced transaction with Oclaro. Information discussed today is qualified in its entirety by the proxy statement/prospectus that Lumentum will file with the SEC in connection with our proposed transaction. Information in the preliminary proxy statement/prospectus may not be complete and may be subject to change. Lumentum may not sell the common stock referenced in the proxy statement/prospectus until the registration statement on Form S-4 that we filed with the SEC becomes effective. We encourage security holders to read the definitive proxy statement/prospectus and other documents filed with the SEC carefully when they become available, because they will contain important information about the proposed transaction.

Further, on the pending Oclaro transaction, last month the U.S. Federal Trade Commission granted early termination of the waiting period under the Hart–Scott–Rodino Antitrust Improvements Act of 1976 as amended. This transaction is still subject to antitrust regulatory approval in China as well as the vote of Oclaro's stockholders and certain other closing conditions. We continue to work with Oclaro on this pending transaction.

During the Q&A session, please keep in mind that the focus of this call is our earnings report and guidance, and we will not be sharing incremental information relating to our pending acquisition of Oclaro.

Now I would like to turn the call over to Alan for his comments and third quarter business highlights.

Thank you, Chris, and good morning, everyone. Strong demand drove telecom, datacom and lasers revenue up in the third quarter. Global markets in which Lumentum participates have fundamentally robust long-term trends. Every day the world is reliant on ever-increasing amounts of data flowing through the world's optical networks and data centers. New networks and data centers need to be built to satisfy this insatiable demand for data.

Globally, regardless of who is supplying the optical network and equipment or who is deploying the network, the types of products and technologies Lumentum supplies are essential. Higher levels of precision, new materials, [factory] and energy efficiency are all increasingly important to manufacturers around the world. To address these trends, suppliers of manufacturing tools globally are turning more and more to laser-based approaches and the types of lasers Lumentum supplies.

Laser-based 3D sensing is a rapidly developing market. The technology enables computer vision applications, enhanced security, safety and new functionality in the electronic devices that people rely on every day.

Lumentum's strategy is to leverage our photonics technology across all of these growing markets, invest in and quickly ramp the best products, and focus on close relationships with market-leading customers helping them to win. This strategy is succeeding.

In the third quarter, our commercial lasers segment achieved new record revenues, driven by strong demand from customers in both micro and macro material processing markets. Lasers growth margin at 48.4% improved sequentially due to higher volumes in the mix of products. I'm proud of the Lumentum team, whose execution on ramping capacity enabled the strong 18% sequential growth and the large sequential gross margin improvement in the quarter. We expect continued strength in our lasers business as we ramp our newest fiber laser products to meet strong customer demand.

Later this calendar year, we will be introducing a full turnkey fiber laser system to broaden our fiber laser customer base and further accelerate growth.

Our industrial diode laser product line, which is primarily driven by customers building their own fiber lasers, also delivered continued strong results. Growth in this business was limited by production capacity. The combination of external customer demand and internal demand for use in our own fiber laser outstripped our ability to supply in the third quarter. We are expanding capacity in these product lines to enable higher external sales as well as increased supply into our own fiber lasers. Parts of these capacity additions are in our new -- are in our own factory in Thailand, which started shipping qualified industrial diode laser products in April.

As expected, our third quarter 3D sensing revenue declined substantially, driven by customer seasonality. This seasonality is continuing into the fourth quarter, but we expect volume will ramp up again in the first half of fiscal 2019.

Third quarter revenues contained modest contributions from Android customers, including those purchasing our latest high-performance, edge-emitting lasers. As previously highlighted, these customers are expected to drive far more business in the future as we look to our fiscal 2019 and beyond. Between these customers and numerous additional customer engagements underway, we expect we will broaden our customer and product mix over time. With our proven manufacturing scalability, proven field reliability and new product pipeline, we believe we are well positioned to be the partner of choice for 3D sensing customers around the world in fiscal 2019 and over the long run.

Turning to our optical communications business. Third quarter demand was strong, which drove an 11% quarter-on-quarter revenue growth in telecom. We had notably strong ROADM sales, which grew 27% sequentially. We shipped record levels of our newest TrueFlex ROADM products. ROADM shipments were limited by production capacity in the quarter.

Telecom pump laser sales continued to be strong, but quarter-on-quarter growth was also limited by capacity. With strong ROADM line card sales, our internal need for pumps further exacerbated pump capacity limitations. We are expanding pump laser and ROADM capacity to meet customer demand, which we expect to remain strong.

Telecom transmission and datacom revenues also grew sequentially after having had a few slow quarters. However, margins in datacom remain challenging because market prices for sales into the hyperscale data center space have been declining faster than we have been able to reduce the cost of our products.

As I have highlighted on prior calls, later this calendar year we are planning to introduce a significantly cost-reduced transceiver, targeting the hyperscale data center market to increase our competitiveness and margins.

In March, we were at the OFC trade show and had several product demonstrations that received a lot of attention from customers, industry media and analysts. I would like to highlight 2 of these for you. First, we had a live demonstration of our next-generation 400G datacom transceivers in the 2 main form factors of interest to customers, OSFP and QSFP-DD. This demonstration included a single wavelength 100G transceiver also utilizing PAM4 modulation and our high-performance EML chips. Second, we showed our new TrueFlex nano ROADM product, which won the best optical subsystem award from Lightwave Innovation's reviews. This disruptive and extremely compact product enables the use of flexible spectrum ROADMs in new applications and expands the market for our leading TrueFlex ROADMs. Production shipments of this product began in the third quarter.

The final third quarter highlight I'd like to discuss is our announcement of entering into an agreement to acquire Oclaro. I believe this is not only a major milestone for Lumentum, but for the entire optical industry. One of the key motivations in Lumentum becoming a stand-alone company in 2015 was to be able to engage in major M&A transactions that would accelerate our strategy and industry road maps.

Earlier in my remarks, I highlighted significant long-term trends that make markets -- the markets in which we participate increasingly dependent upon our photonics solutions. These trends, along with our investments in new products and technologies and intimate relationships with industry-leading customers, create strong long-term growth opportunities for us here at Lumentum. We have a lot going on and it is a very, very exciting time at Lumentum.

I will now hand it over to Aaron for more details on our financial results and our guidance for our fourth quarter of fiscal 2018.

Thank you, Alan. Net revenue for the third fiscal quarter was $298.8 million, which decreased 26.1% sequentially and increased 16.8% compared with the same period last year. The sequential decline was driven by the expected reduction of our 3D sensing product revenue, partially offset by an increase in telecom, datacom and commercial laser product revenues.

GAAP gross margin for the third quarter was 32.5% and included a $3.5 million inventory reserve related to ZTE. Our revenue from ZTE during the last 12 months was less than 0.5% of total revenue.

GAAP operating margin was 8.5% and GAAP diluted net income per share was $0.04.

Our third quarter non-GAAP gross margin was 36.3%, which decreased 8.6 percentage points sequentially and increased 1.9 percentage points compared with the same period last year.

Non-GAAP operating income was $49.4 million, and operating margin for the third quarter was 16.5% and decreased 11.8 percentage points sequentially. The decrease in operating margin was primarily due to the 8.6 percentage point decrease in gross margin from the change in mix and lower volume.

Non-GAAP net income was $50.6 million for the third quarter. Non-GAAP earnings per share was $0.78 based on a fully diluted share count of 64.8 million and included $2 million of interest income and an $800,000 tax expense.

Now for some additional detail. Optical Communications revenue including 3D sensing was $246.3 million, a decrease of 32% sequentially and an increase of 14% compared with the same period last year.

Telecom revenue at $122.6 million increased 11% sequentially and decreased 25% compared with the same period last year.

Our industry-leading ROADMs increased 27% quarter-on-quarter. Datacom was $36.3 million and increased 6% sequentially, and declined 7% compared with the same period last year.

Consumer and industrial revenue at $87.4 million decreased 59% sequentially and increased more than 600% compared with the same period last year due to 3D sensing revenue volume.

Optical Communications gross margin at 33.7% decreased 11.3 percentage points sequentially due to the mix of products and lower revenue volume.

During the quarter, Optical Communications gross margin was diluted by lower margin datacom products and start-up expenses related to our Thailand manufacturing operation.

Commercial lasers revenue was a record high at $52.5 million and increased 18% sequentially and 32% compared with the same period last year. The increase in volume was from both micromachining and kilowatt laser products.

Third quarter commercial lasers gross margin was 48.4% and increased 3.7 percentage points sequentially.

Operating expenses totaled $59.1 million or 19.8% of revenue compared with $67.2 million or 16.6% of revenue from last quarter.

R&D expense was $35 million and SG&A expense was $24.1 million.

We exited the third quarter with cash and short-term investments of $692.8 million, which increased $68 million sequentially. During the last 2 quarters, we have generated over $160 million of cash representing 22.8% of revenue. Capital equipment additions were approximately $17 million in Q3.

Now on to our guidance for the fourth quarter of fiscal 2018, noting again that all projections are on a non-GAAP basis. We project net revenue for the fourth quarter to be in the range of $275 million to $300 million, with operating margin in the range of 14% to 16% and earnings per share to be in the range of $0.55 to $0.75.

Now I will turn the call back over to Chris to begin the Q&A session.

Thank you, Aaron. Before starting the Q&A session, I would like to remind everyone of the earlier comments relating to the pending Oclaro acquisition. We will not be adding anything further on this matter than we had in our prepared remarks, and all questions about the pending acquisition will receive such a response. As usual, I would like to ask everyone to limit discussion to one question and one follow-up.

Kelly, let's begin the question-and-answer session.

(Operator Instructions) Our first question comes from Alex Henderson from Needham & Company.

I'd love to ask a question about Oclaro. No, I'm just kidding. So I was hoping you could give us a little bit of color on what you're seeing in China, whether -- and specifically whether you think there's any change of behavior as a result of the Commerce Department actions against ZTE and Huawei. And along those lines, are you seeing acceleration in the ROADM demand particularly in China or is that broadly globally? Can you give us any color on those 2 elements? I assume, by the way, the -- you've read The Street reading on Huawei that suggests that most of people on The Street think that, that will not come to a blockage. Would you agree with that?

Well, I'm not going to speculate on what the U.S. government and China relations are going to do over time, but I can tell you the behavior that we've seen has been no change in overall demand pictures from China. I'd say that the strength in ROADMs was primarily outside of China, although I'd say that the growth in Q3 in China was modest. I'd say that the forward-looking demand for us and backlog looks to be growth across the globe including China. So I think what we've always been saying is that the ROADM deployment in China as well as in North America continues to look very strong, and strong for quite some time. So really no change in behavior so far.

Your next question comes from the line of Simon Leopold from Raymond James.

Last quarter you were kind enough to give us some color on the 3D expectations that you thought you would do in the neighborhood of $60 million in your March quarter. Presumably, you exceeded that nicely, but it's not crystal clear. So could you give us a little bit more color on 3D this quarter and the expectations or what's implied in your June quarter?

Simon, this is Aaron. So in terms of specific product breakout, we're not going to provide exact numbers. But in terms of what Alan has said in the prepared remarks, 3D sensing was down in the March quarter due to seasonality, like we expected going into the quarter. And in terms of the June quarter, same type of seasonality is expected in terms of directionally down.

Okay. And I wanted to shift gears to the more traditional optical component business. I'm a little bit confused by what's gone on in gross margins in that we've generally thought that ROADM and WSS gross margins were particularly good, and I understand and heard you talk about pressure in datacom, but I'm still surprised by the -- by what's implied in your gross margins for the traditional components, looking like they're certainly below 30% gross margin in the quarter based on our guesstimates around 3D. Could you help us understand what's gone on in that segment?

Yes. So Simon, as we had said during the prepared remarks, in terms of the Optical Communications gross margins of 33.7%, yes, it does include better than corporate average 3D sensing margins. However, datacom has been very challenging and the pricing in the hyperscale arena as well as in other areas that datacom products go into, have been challenging and that's why we've been unable to make money in that arena. And so it's been very, very dilutive through our Optical Communications gross margin. Also noting that we've incurred some start-up expenses in terms of bringing up our Thailand operation as well, which has been dilutive and we'll remain dilutive for the next 5 quarters, 6 quarters or so.

But can you confirm -- yes, I just wanted to make sure you could confirm that the ROADM WSS products are certainly much better than that average?

They are. ROADMs and most of the transport products do have better margins than the rest inside of Optical Communications.

Aside from 3D sensing.

Sorry, Alan, go on. I didn't want to cut you off.

No, no problem, Simon. It's just a comment on the datacom. As I talked about in the prior earnings call as well as in my prepared remarks, we are very close to releasing a very low-cost hyperscale-focused datacom transceiver later this year. And in continuing those engagements with those hyperscales is our strategy to keep that door open as we introduce the new lower-cost product. So through this quarter and next, we're going to continue to have some challenges with respect to the margins on the hyperscale, but we expect to rectify that later this year.

Your next question comes from the line of Joseph Wolf from Barclays.

I guess, I wanted to focus on a comment on the Android market being potentially or far more business in fiscal '19 than the rest. Given the difference in types of approaches technology-wise, how much capacity do you have on the non-VCSEL side of that business in terms of meeting that kind of growth? And when you said far more business, is that the technology or that's just the number of customers and the kind of demand curve that you're seeing from customer engagements?

Yes. So Joseph, I wasn't to imply that the edge-emitting or Android business would be far more than our VCSEL business. I implied that it would be far more than it is today, which is relatively small. So we do have capacity to handle the demand over the next several quarters and are adding capacity to -- in anticipation of really a calendar '19 more significant ramp on edge-emitters. What we have seen though is that the Android market is mixed with respect to edge-emitters and VCSELs, so we are supplying VCSELs to some Android markets -- some Android customers as well as edge-emitters, and in some cases one of each. So I think we're still trying to sort out exactly where we need to add capacity and when we need to add it. Our comments were really more to the point of it should contribute significantly to our growth in 3D sensing both in fiscal '19 as well as beyond.

All right. That's helpful. And just as a follow-up, how much more room is there for gross margin and expansion in the commercial laser business. They got pretty high pretty fast. Can that go through 50%?

Yes. So Joseph, the commercial lasers gross margins at 48% are still not where we believe they can go. We still believe that there's plenty of room to operate. In terms of dependency, the mix of product inside commercial lasers does have a factor. And over the past several quarters, we've been working to ensure that we could meet customer demand. We have an inordinate amount of demand and the next stage here is to go through cost-reduction activity as well.

Your next question comes from the line of Michael Genovese from MKM Partners.

First of all, on the 27% growth in ROADMs sequentially, seems like it was driven by the U.S. more than China, I assume the Tier 1 carriers in the U.S. Can you talk about the sustainability of that for the rest of the calendar year? Is this a spike or should this level of strength continue?

Yes, Michael. As we've said in the past, ROADM deployments tend to be lumpy, although I would say that at this point in time, we're seeing sustained growth both from the North American Tier 1 carriers, but also the cable operators and MSOs. So I think it's a broad-based growth that I believe will continue through this calendar year. And I think we're gaining share as a result of our leading-edge technology that it will continue to really drive us forward. And then you put on top of that real, real deployments in China, and I think we have a pretty interesting long-term growth story with ROADMs.

Great. And then just secondly, can you talk about the evolving competitive landscape in 3D sensing? How you're seeing your share trending? How you're seeing your yields trending? And whether you're picking up anything on any competitor yields out there?

Yes. It's a pretty secretive industry and our customers don't tell us a lot about what's going on with respect to share. I think just based on some of our competitive earnings results, I'd say we still have a very, very large share of the business and we expect to do our best to maintain that. Our yields are very solid and through these slower 3 months and into the June quarter, we're focused on continuing to drive yields and eking out 1% or 2% more to be able to drive the costs down and the margins up and be able to really make sure we maintain our share and do what our customers need from a supply standpoint as we look into the second half of the calendar year.

Your next question comes from the line of Doug Clark from Goldman Sachs.

My first one is on 3D sensing as well. I'm curious if -- as you're working with customers, if for kind of next-generation products to the extent that you start on those with certain customers, are the specs and designs of the VCSEL arrays changing in any way? Or the designs kind of from prior years or prior generations being reused?

I would say that in the short term, specs are changing and modifying slightly. And I'd say that for next-generation products, they range from slight modifications to radical changes in design. So I think as we address the new applications for 3D sensing, I think we're going to see a range of improvements and changes in both the design of the VCSEL and how our customers use it as well as the design of the edge-emitters and how they use it. So I think we're seeing a broad range of it. And whether that's a result of both the front-facing and world-facing applications coming or not, our customers don't tell us, but we can kind of imply that the products that we're working on are addressing different applications in different use cases. And so that's why we're pretty excited about the opportunity ahead of us.

And to be clear, so from year-to-year, you see at least some modest kind of tweaks or modifications to the specifications?

Yes.

Yes. Okay. And then my second question was actually back on China. You mentioned that overall -- the overall demand picture in China hasn't changed much. But I was curious if that overall demand picture was one of stabilization and troughing or you're seeing return to growth? How would you just characterize China in terms of growth and go-forward expectations?

Yes. My comment about not seeing a change in behavior, I think, was really around all of the U.S.-China discussion. I'd say that we are seeing demand in China being robust, especially as we look forward to ROADM. So I'm pretty bullish on expectations for China, mostly in the second half of '19. So we're -- our positioning is pretty solid there and the relationship with multiple customers is strong.

Okay. And some of your competitors have talked about inventory restocking. Would you agree with that characterization?

From what perspective?

From optical systems vendors in China restocking historically-low inventory levels.

I think it depends on product, and we're constrained on 980 pump lasers, Raman pump lasers, ROADMs. And so I'd say that there's not a restocking event happening with respect to those things. But I'd say that overall, the levels of inventory from what we can tell anecdotically seem to be in a much healthier position. And I think, from that standpoint, the sellout on their end and the sell-in from our end is getting more equalized as opposed to where it's been in the past, where they were shipping out more than they were taking in. So I think we're to a point that equilibrium has been reached and the real demand that the Chinese customers are seeing should result in real demand to...

Your next question comes from the line of James Kisner from Loop Capital.

So I know you said you wouldn't talk about the Oclaro acquisition. Would you just answer a factual question? I mean, can you clarify does MOFCOM have to approve this deal? Can you give us any thoughts there? And just -- on 3D sensing, I'm just wondering, do you have any sense or visibility for the inventory levels at your customer? I mean obviously demand for some key models that use 3D sensing was very low. And you started shipping a pretty decent size number of [wipes] versus it looks like in the March quarter? I mean, do you feel confident that your shipping and demand, I guess, netting for all the yield issues at the module level or perhaps inventory building right now?

James, this is Chris. I'll handle the first question. So in our prepared remarks, we highlighted that transaction is subject to China antitrust review. But beyond that, we're not going to add any additional color. I'll hand it to Alan on the 3D sensing question.

Yes. Our customers don't share a lot and they ask us not to share a lot with respect to inventory and demand. So I prefer not to comment.

Okay. And to clarify your guidance, I mean, can you kind of go through it business by business here. What are you expecting the up versus down? Is it sequential downtick in the midpoint? Is it all 3D sensing? Telecom is up, what's commercial lasers doing? It's obviously capacity constraints. And also maybe you could comment on the trends for OpEx and gross margin at a high level in your guidance?

Yes. So James, in terms of what we said in terms of direction, yes, so 3D sensing obviously will be down primarily because of seasonality. All others are going to be up. In terms of what's baked into the guide from a gross margin standpoint, gross margins will be down a bit from the Q3 or March levels, primarily again because of the 3D sensing and the mix impact. OpEx levels, so the OpEx levels will be probably similar to what we saw in the March quarter, plus or minus 100 basis points or so.

Your next question comes from the line of Tejas Venkatesh from UBS.

I was hoping you could comment on gross margin again. You mentioned datacom as a reason it came below Street expectations, but I was wondering if it's reflective of ASP pressure at all in 3D sensing?

So Tejas, in terms of pricing, we're not seeing anything unusual from a pricing standpoint company-wide in terms of our price points today versus what we've seen historically. As we had mentioned, in terms of gross margins, pressures in Optical Communications, datacom has been very, very dilutive in terms of our gross margins. We're unable to make money in that marketplace today. And Alan had talked a little bit about some of the strategic reasons for continuing in that regard. We are able to cover our cash costs and be able to make some variable margin. And that's why it still makes sense to stay there as well as our customers and strategic reasons for the next generations of product. Also, we've got a little bit of dilution there from the Thailand manufacturing costs to start up.

And is fiber laser demand still driven by the major Japanese customer? Is -- or is demand broadening?

Yes. Historic demand is still mainly the Amada relationship we have. And as I said in the prepared remarks, later this year, we'll be introducing our own turnkey fiber laser, which is a complete solution that other customers will readily purchase and put it into their tools as an alternative to [this sea] supply or other technologies, CO2 for instance. We're broadening our customer base later this year.

Got it. And one final one. I was hoping you could comment on why you aren't seeing the same sort of sequential decline for 3D sensing in the June quarter as some others in the supply chain of this major mobility customer?

Well, I think we did say that sequentially, the June quarter is going to be down from a seasonality standpoint and all other products will be up.

Your next question comes from the line of David Williams from Drexel Hamilton.

I wanted to see if you could give us a little indication or maybe what you're seeing in the Android space and kind of those adoption trends? And what your expectations are for maybe the OEMs as we head into the first half of '19?

Well, we're engaged with several of those customers. And as they finalize their designs and get past the pilot stage of build, they'll be introducing models that include 3D sensing. I'd say that our expectations are that most of these customers will introduce this technology and capability on a high-end phone and then it'll proliferate over time. So I'd say that our expectations in the calendar '19 will be a modest start, but a ramp-up from then as it gets on to more and more of the models and further down into their product line.

Great. And then maybe can you rank order -- the geography from maybe a strength standpoint where you're seeing the most demand maybe to the least demand?

On which product?

Well, I guess company-wide. What are you seeing in terms of -- from a geographic standpoint, do you see anything stronger out of China, I guess, today than you are in some of your North American customers? Or where do you, I guess, see the greatest strengths overall?

Well, I think you have to look product by product or area by area. For example, in terms of telecom transport with ROADMs, we're seeing very strong demand here in North America, but that doesn't mean China is not growing either. There is some strength in China that's coming up. Most of our business in terms of where we ship product to is heavily weighted to shipping product internationally, and more specifically, into the Asia region. And so it's hard for us to know exactly where that product ends up over time. But in terms of strength, we are seeing strength across the globe at this point in time.

Our next question comes from the line of Meta Marshall from Morgan Stanley.

First question on datacom and just where your thoughts are currently about the timing of the 400 gig transition and when could see some uptick there? And then second question, just on the use of 3D sensing in Android, any trends as far as what the use cases are of security versus AI and if there's anything -- discernible trends currently?

Sure. So I think timing of 400G is still a ways out. I don't think we'll see anything meaningful until the end of calendar '19 and into early 2020. I'd say from a 3D sensing Android market, it varies and they don't tell us what they're doing with some of their -- they're all very, very secretive. So I think from that perspective, it's hard to really comment or know. I can only speculate at this point in time and I'd hate to even speculate.

Great. And then -- sorry, just a follow-up on Doug's question. I just missed -- when you said on the China uptick in the second half of '19, were you referring to fiscal year or calendar year?

Doug's question. I was speaking specifically about ROADMs and the growth in ROADMs. In the second half of calendar '19, expectations are that they become more meaningful ROADMs. They're off of a pretty good base today, but we expect more meaningful deployments within China as well as our customers they're exporting from China.

Your next question comes from the line of Mitch Nordon from B. Riley & Co.

Just with regard to 2 things. ZTE, what's your view there? You took a small reserve in the quarter. Going forward, how are you viewing that? And secondly, with regard to the -- you cited the merger proxy, but we haven't seen that yet and it has been about a month and a half. When might we get a look at that?

So in terms of -- this is Aaron. In terms of the impact of ZTE on the Lumentum business -- and that's what we can comment on. Like I had mentioned in the prepared remarks, the business with ZTE has been, looking backward in the last 12 months, less than 0.5% of total revenue. So the impact is minimal for us. We did take a charge of $3.5 million for an inventory reserve, primarily because of the ban, not being able to ship to ZTE. The inventory is going to be excess and potentially obsolete and we can't reconfigure that or use it for any other customers, so we've written it down.

Yes, and this is Chris. On the comment on the filing of the S4, yes, we will file an S4. We are not going to comment on any timing at this point in time.

Just curious. I mean, you're talking about this transaction being a major milestone for you, yet you seem hesitant to talk about the transaction and it appears to be a compelling transaction. Can you speak to -- is this related to the ZTE news? Or why not tout the benefits that you touted back on March 12?

I don't think we're not touting the benefits of March 12. You're asking procedural questions about a transaction, which we don't have information to share at this point in time.

Your next question comes from the line of Jun Zhang from Rosenblatt Securities.

Could you talk a little bit about the VCSEL content and pricing trends compared with the [first division] in a smartphone 3D sensing module in order to support this market model to adding some of the new functions for applications for their 3D sensing in the second half this year? And also could you talk a bit -- a little bit about the current lead time for the VCSEL [retrieve of] wafer production and 3D sensing module shipments to the end client. So considering this lead time, would you start shipping the new VCSEL in the month of June for the main model ramp in the second half?

I'm sorry, Jun. We had a little bit of trouble hearing your first question. Can you repeat your question, please?

My first question is about the VCSEL content and the pricing trends compared with the [first] model to support the new function or applications in the 3D sensing in the second half this year.

Yes. So we're not going to comment on specific customer pricing. I would say that pricing usually is a function of chip size and the yield of those chips. And so I think from our perspective, we're comfortable with our pricing and our yields and our costs to be able to maintain better than corporate average margins on all of our 3D sensing products. Lead times for VCSELs -- after we ship the VCSEL, our customer doesn't tell us their lead times or their yields. So it's hard for me to comment on that. Given our guidance for 3D sensing in the June quarter, I would say that it would be very limited new products that would be shipped in the June quarter for the second half new product introduction -- should there be new products introduced.

Okay. Got it. And also, could you talk a little bit about how we see the benefits from bringing manufacturing in totally with the further expansion in the Thailand factory?

Yes. So in terms of bringing manufacturing in house, today the data rates are far more advanced than they were many years ago. And so we did have internal production 10 years ago or so in China. And today, we believe that we're going to have some benefits with regards to improving flexibility, overall cycle time to bring new products to market to satisfy customer requirements, improve quality and reduce cost, right? There has to be a good compelling return on investment for doing this. In terms of our manufacturing model, that's not to say that we're moving away from contract manufacturers. We're going to continue to use a hybrid model, and we will have partnerships that we have today and continue to use contract manufacturers where it makes sense.

Your next question comes from the line of Tim Savageaux from Northland Capital Markets.

Two questions. One on the comm side and one on 3D, I guess they're kind of related. And this has to do with the magnitude of the decline you're forecasting for 3D and what that says about guidance across the rest of the business. Assuming it's in the range of what you saw and that is the sequential decline in 3D sensing revenue in the March quarter, in June, or somewhere in that neighborhood, now it looks to me imply a significant uptick in acceleration on the telecom side. I wonder if you can comment on whether that's the case?

Yes. So Tim, this is Aaron. Yes, in terms of the specific numbers, we won't quantify that, but that's correct. So in terms of 3D sensing, it is seasonally down, again, in the June quarter from the March quarter. The rest of the business will increase and most notably would be coming from telecom transport. We have a lot of demand today for ROADMs, pumps, amps, things that drive the network in terms of install.

Okay. At least my interpretation is you expect an acceleration in that sequential growth rate from the 11% you saw in June, and you can comment on that, if you like. Moving over to the 3D sensing side. Coming out of OFC, some commentary around the company's -- Lumentum's VCSEL array capacity kind of running -- or standing at a level of 10 million units a week, which actually strangely marries up pretty nicely to kind of 100 million unit iPhone build plus some iPads in the second half, and depending on what you assume on pricing, I think puts revenue capacity on a quarterly basis well above peak levels you achieved in the second half or in the fourth quarter of last year. I wonder if you could talk to those capacity metrics, whether they make any sense and what sort of expectations we should have with regard to potential peak quarterly revenue levels in the second half when ostensibly phones are being built?

Yes. So I think, Tim, the -- if you recall the calendar Q4 ramp, we ramped production through that quarter and produced approximately $200 million of revenue, but we had more capacity exiting the quarter than we had entering the quarter and that capacity still exists. So I think you can extrapolate from there what our capacity is. And a lot of it has to do with the size of the chip and the yields, but I'm confident that our yields have increased since then. And I'm not going to comment on whether going into other products on existing customers or other, but I think you're not crazy with respect to your math on capacity.

Yes. And just to follow-up to what Alan just articulated, wafer fabs are very expensive. And In terms of -- the reason we've chosen this model in terms of using foundry partners is to, a, go up a ramp that steep that quickly and be able to reap the benefits. And then, when the cycle or the seasonality turns down, then we're not stuck with that fixed cost load on our balance sheet and income statement. A lot of benefits with the foundry model.

Your next question comes from the line of Richard Shannon from Craig-Hallum.

I guess, most of mine will be probably on 3D sensing. Alan, I'm wondering if you look at your 3D sensing negotiations for customers in the calendar second half of the year, to what degree is capacity an important metric, meaning, maybe not as much coming from your other competitors versus other things like functionality, yield or ability to deliver on a short time frame. What are the most important metrics in those negotiations?

Well, I mean, I think they all play into the equation. I think proven capability on scalability. I think reliability and dependability are super important as well. And we ship a lot of VCSELs at extremely high reliability rates and that goes a long way as well. So I think it's a combination of all of above. And I hope to be challenged again with respect to capacity. So I'm looking forward to the second half of the -- of calendar '18 rather to go up another significant ramp.

Just a follow-up on that, Alan. Are there any one of those characteristics that are more important as you get into the second half of the year or they're all kind of balanced?

I mean, I think it's a function of how we are performing and how our competitors are performing and how we continue to gain confidence in our customers with respect to our ability to meet their needs and our ability to continue to ship high-performance, high-quality, very reliable product into their product [mix]. That's a huge concern of theirs with respect to making sure that every component works, every time we ship it. So I think it's a combination of all of the above and I'd say that reliability and performance -- the reliability and quality is super critical.

Okay. Fair enough. My second question, again, on 3D sensing. In the prior question, you talked about changes in specs and you said some of them were modest changes and some of them were more radical. How long does it take to change a spec? And does that provide you any competitive advantage, given your long experience, and frankly, high volume experience in manufacturing after that as well?

Well, I think the comment around specs is around different customers and changes in design to address different functionality and different applications for various products and various customers. I'd say from the time that we engage with a customer until that product becomes production is 2 years. And so we're working on products today that we aren't going to introduce into production for 2 years from now. So that gives us confidence that our continued pipeline of new products and growth in 3D sensing -- as 3D sensing becomes more ubiquitous, I think, gives us excitement that this a long-term trend that has very good growth rate.

Your next question comes from the line of Alex Henderson from Needham & Company.

Just a couple of pieces. Could you just remind us what you think your tax rate would just look like in FY '19? I know that's a little further out than you normally guide, but it is something that seems like it's a fairly important piece of the out-period puzzle.

Sure, Alex. In terms of our tax rate, historically it's been relatively low. It's up 6% or so. In terms of '19, so with the -- we're still evaluating a lot of the new tax legislation, but it's our belief at this point in time that our tax rate will probably be somewhere in the 8.5% to 10% range. So modeling 9% is probably reasonable. Longer-term beyond '19, tax rate could go up to 11% to 12%.

And going back to the Thai facility for a second, you've cited ramp-up cost as one of the elements that's pressuring gross margins. Can you give us some scaling of the magnitude of that? And what the trajectory is for that cost to fall back out as you get the benefit of that facility running more smoothly?

Sure. It's probably close to 100 basis points of impact to gross margin. And as we look forward here, we're continuously ramping and investing. And it's probably 5 quarters to 6 quarters of continued dilution until we hit a breakeven point.

Okay. And going back to 3D sensing, if I could, very briefly. There was a lot of discussion about other competitors ramping some capacity in 3D sensing, a lot of noise around [Pendisar] getting [Sherman] up. But the other side of that coin, there's been a fair amount of concern around the yields that -- at [Alan] being a pressure point in constraining their ability to supply. Can you talk a little bit about how as you went into -- as we go into the seasonal trough period that's reflected into the relative shares, are you gaining share in the June quarter as a result of being the dominant supplier and the best yield? Or is any of the competitors bringing capacity up that would in turn result in some diminishment of your share as we go into that seasonal trough?

Well, Alex -- I mean, I think we've had such high share, I'd be surprised if we're gaining share from where we've been in the past. I don't know that we're losing it either. As we went up the ramp a year ago, there were challenges in -- that we lived through. And we used facilities that are used to making high-volume, 3-inch gallium arsenide before. So I think, while there's a learning curve that everyone has to go through, we had a jump start on it. So I can't really speculate on what's going on with our competitors. It's probably a better question to ask them. I think just anecdotically, based on what some of our competitors have said in the past, I'd say that we still have a significantly high share of the existing market. And we expect to do that as we go forward with new designs and new customers and new products that we have in our pipeline.

One last question, then I'll cede the floor. On the edge 3D products, to what extent do you see your ability to sustain the same high level of share in that space? Do you see any difference in the competitive landscape there? And when do you think the edge side of the market starts to metastasize into a meaningful contributor?

Well, I think from a competitive landscape, there are fewer competitors in the world that can make edge-emitters for 3D sensing. So from that perspective, I expect that our share will be large. I can't predict how our competitor will perform with respect to the ramp of edge-emitters. I'd say that while we're relatively small volume today, we expect that to pick up as we look at the beginning of calendar '19 in more of a meaningful way.

Your last question comes from the line of Dave Kang from FBR Riley.

First of all, clarification. Alan, did you say that China ROADM cycle will really begin in second half calendar '19 or fiscal '19? Just wanted to clarify.

I think we're seeing a pickup in order rates as we speak. So we'll see growth in the June quarter in China. I'd say that more meaningfully, deployments within China will happen in the second half of calendar '18.

Calendar '18, got it. All right. And then on the datacom side, as far as gross margin is concerned, so right now it's dilutive. When you introduce new products later this year, will their products have corporate average gross margin or will they still be below corporate average?

Yes. So a lot of that's going to depend upon what the market prices are going to dictate, Dave. Right now, it's our belief that we're going to be able to be very competitive and be able to make decent money with it, but we'll have to wait until that point in time and see. And then, depending...

Certainly, a whole lot closer to corporate average than we are today.

And then are we targeting like maybe September, December, any granularity?

I would say it's in that September, October timeframe that we'd see volume picking up on those products. And that's why we've stayed engaged with the hyperscale guys even at margins that are not very attractive at this point in time. We want to have that footprint and that experience and be able to prove to them that we can be a reliable supplier with high-quality shipments on time. And so we're going through that now in anticipation of having this low-cost product coming out in a few months.

There are no further questions at this time. I will now turn the call back over to Mr. Alan Lowe, President and CEO, for closing remarks.

Thank you, Kelly. I want to thank our customers for their business and partnership. I also want to thank our employees for all their hard work and putting us into an excellent position for long-term growth. We regularly discuss our business at investor relations events. These events are listed on our website in the Investor Relations section and are regularly updated. This concludes our call for today. We would like to thank everyone for attending, and we look forward to talking with you again in another 3 months. Thank you.

This concludes today's conference call. You may now disconnect.