Earnings Call Transcript
Coherent Corp. (COHR)
Earnings Call Transcript - COHR Q1 2026
Operator, Operator
Greetings, and welcome to the Coherent First Quarter Fiscal Year 2026 Earnings Call. It is now my pleasure to introduce your host, Mr. Paul Silverstein, Senior Vice President of Investor Relations for Coherent. Please go ahead.
Paul Silverstein, Senior Vice President of Investor Relations
Thank you, operator, and good afternoon, everyone. With me today are Jim Anderson, Coherent's CEO; and Sherri Luther, Coherent's CFO. During today's call, we will provide a financial and business review of the first quarter of fiscal 2026 and the business outlook for the second quarter of fiscal 2026. Our earnings press release can be found in the Investor Relations section of our company website at coherent.com. I would like to remind everyone that during our conference call today, we may make projections or other forward-looking statements regarding future events or the future financial performance of the company. We wish to caution you that such statements or predictions are based on information that is currently available and that actual results may differ materially. We refer you to the documents that the company files with the SEC, including our 10-Ks, 10-Qs and 8-Ks. These documents contain and identify important risk factors that could cause the actual results to differ materially from those contained in our projections or forward-looking statements. This call includes and constitutes the company's official guidance for the second quarter of fiscal 2026. If at any time after this call, we communicate any material changes to this guidance, we intend that such updates will be done using a public forum such as a press release or publicly announced conference call. Additionally, we will refer to both GAAP and non-GAAP financial measures during this call. By disclosing certain non-GAAP information, management intends to provide investors with additional information to permit further analysis of the company's performance and underlying trends. For historical periods, we provided reconciliations of these non-GAAP financial measures to GAAP financial measures in our earnings release and investor presentation that can be found on the Investor Relations section of our website at coherent.com. Let me now turn the call over to our CEO, Jim Anderson.
Jim Anderson, CEO
Thank you, Paul, and thank you, everyone, for joining today's call. Coherent is the world's leading innovator and provider of photonic technology and solutions. Photonics is critical to growing applications in AI data center networks, communications, and a wide range of industrial applications. We're well positioned for long-term growth across all these applications and especially in AI data centers where we're experiencing unprecedented demand for our optical networking products. In particular, we expect continued strong sequential revenue growth throughout this fiscal year given the record level of orders we are receiving from our customers and the continued expansion of our production capacity. In addition, we continue to streamline our portfolio and ensure that our investments are focused on the areas of greatest long-term growth and profitability for the company in order to drive sustained shareholder value creation. Turning to our Q1 operating results. Revenue increased by 6% sequentially and 19% year-over-year on a pro forma basis, which excludes revenue from our recently divested Aerospace and Defense business, a sale that enhanced our portfolio focus and accelerated deleveraging. Non-GAAP gross margin expanded by 70 basis points sequentially and 200 basis points year-over-year. The combination of revenue growth and gross margin expansion drove non-GAAP EPS growth of 16% sequentially and 73% year-over-year. I'll now provide some highlights from our two operating segments. We'll begin with our Datacenter and Communications segment, which is our largest and fastest-growing business. Q1 revenue grew by 7% sequentially and by 26% year-over-year driven by growth in both our Datacenter and Communications markets. In our Datacenter business, Q1 revenue grew 4% sequentially and 23% year-over-year. Our Datacenter growth in Q1 was constrained by the supply of indium phosphide lasers. However, we expect data center growth to accelerate to approximately 10% sequential growth in the current quarter followed by strong sequential growth through the balance of this fiscal year given very strong demand and improving supply. I'd like to provide some additional color on both the demand and supply picture within our Datacenter business. First, we are experiencing an exceptionally strong level of demand. In our fiscal Q1, we received direct bookings that represent a step function increase in already strong customer demand. We are seeing strong demand for both our 800 gig and 1.6T transceivers with broad adoption of our 800 gig transceivers and accelerated adoption of our 1.6T transceivers. A significant portion of the sequential growth we expect in the current quarter is driven by 1.6T adoption. As a reminder, earlier this year at OFC, we were the only company to demonstrate three different types of 1.6T transceivers based on three different types of laser sources: silicon photonics, EML, and VCSEL. Our 1.6T transceivers based on silicon photonics and EMLs are ramping first, and we expect our 1.6T transceivers based on our 200-gig VCSELs to ramp next calendar year. We see strong demand for 1.6T transceivers across multiple customers and expect both 800-gig and 1.6T to grow significantly in calendar 2026. Our deep portfolio of optical networking technology, combined with our vertical integration and diversified supply chain, are key competitive advantages with our customers and uniquely position Coherent within the industry. On the supply side, given the strong demand growth we are seeing, we are continuing to expand our production capacity for transceiver modules and the key optical components used in those modules. For example, one of the key constraints across the industry is indium phosphide laser capacity. Over the course of Q1, we saw improving EML supply, and we expect both internal and external EML supply to improve significantly in the current quarter and throughout the balance of this fiscal year. In particular, we continue to expand our internal indium phosphide production capacity. We are aggressively ramping six-inch capacity because a six-inch wafer compared to a three-inch wafer will produce more than four times as many chips at less than half the cost. This will provide increasing benefit to our gross margin as we continue to ramp production. Our six-inch indium phosphide line in Sherman, Texas, which is the world's first six-inch indium phosphide production line, began production last quarter and continues to ramp well. I am very pleased to share that our initial six-inch indium phosphide production yields are actually higher than our current three-inch indium phosphide yields. This is an outstanding accomplishment by our production team and also a testament to the tremendous experience that we've gained over the past five years, producing almost two billion VCSEL devices on our six-inch gallium arsenide technology. Given the healthy yields we are seeing with six-inch production, we began production of six-inch indium phosphide at a second site in Jarfalla, Sweden. Ramping at two sites in parallel will significantly accelerate our production capacity ramp. Additionally, we are in production on three different types of key transceiver components on six-inch indium phosphide: EMLs, CW lasers, and photodiodes. With the ramp of six-inch production at two sites in parallel, we expect to roughly double our total internal production capacity of indium phosphide over the next year. We also expect to continue to supplement our internal indium phosphide capacity with sourcing from external suppliers. We expect our external supply of EMLs to increase sequentially this quarter and next calendar year through continued partnership with our key external suppliers. In addition to critical laser production capacity, we are also expanding transceiver module assembly capacity. While we continue to expand production at our existing site in Ipoh, Malaysia, we will now be expanding production capacity in parallel at a new transceiver production facility that we recently opened in Penang, Malaysia. In addition, we will be adding transceiver production capacity at our existing site in Vietnam, which already produces transceiver components. This additional production capacity allows us to continue to rapidly ramp module capacity to support the demand growth in front of us. I'd like to pivot to some technology developments that we expect to further benefit our data center business over the long term. We continue to make progress on LPO, LRO, CPO, and NPO related products and technologies with strong engagements across a wide range of customers. For example, we've shipped both LPO and LRO 800-gig and 1.6T transceivers to customers. Also in September, we announced that we have commenced sampling of our 400-milliwatt CW lasers designed for CPO and silicon photonics applications. We expect to address a broad range of CPO form factors for both scale-out and scale-up data center applications with this new product. We also continue to see significant customer engagement around our 200-gig VCSEL-based solutions for NPO applications. Multiple customer engagements on integrated optics applications reinforce our view that the incremental market opportunity for optical solutions in the scale-up portion of the AI data center networks will be very compelling, and we believe Coherent is well positioned to address these applications using both CW and VCSEL-based solutions. We continue to expect to see initial CPO deployments in calendar 2026, with growth continuing in the following years, while pluggable form factor continues to grow in the scale-out portion of the network. Another area of new growth is our optical circuit switch platform, which continues to progress well with expanding customer engagement. We believe this product line adds over $2 billion of addressable market opportunity over the coming years. Both the breadth of customers and the range of applications are wider than our initial expectations. The underlying technology in our OCS system is a nonmechanical field-proven liquid crystal technology that has been successfully deployed for many years in demanding telecom applications and has a significant competitive advantage over other solutions. To date, we've shipped systems to seven customers and expect that number to continue to expand this quarter. Shipments have included both 64x64 and 320x320 system sizes. Both revenue and backlog for OCS grew sequentially in our fiscal Q1, and we expect it to grow again in the current quarter. Our current backlog includes both 64x64 and 320x320 systems with the majority of the backlog weighted toward the larger system size. Given the strong customer demand and backlog, we are aggressively ramping production for both small and large capacity systems, and we expect revenue to ramp throughout calendar 2026. Given the multiple growth vectors across pluggable transceivers, CPO, and OCS, we are very excited about the opportunities ahead of our Datacenter business. Turning to our communications market. In Q1, revenue grew 11% sequentially and 55% year-over-year. Growth was driven by products for data center interconnect, but we also saw strong growth in traditional telecom applications. We expect our communications business to grow sequentially again in the current quarter and throughout the balance of this fiscal year. In hyperscale DCI, we continue to see strong growth in customer demand for our ZR/ZR+ DCI-focused products. Our product lineup, which includes 100 gig, 400 gig, and 800 gig ZR/ZR+ Coherent transceivers, is growing quickly, and we expect these products to continue to ramp throughout the course of this fiscal year. We also continue to see steady recovery in our telecom business. In addition to market recovery, we've introduced multiple new industry-leading telecom platforms for which we are seeing significant customer interest and expect strong future revenue contributions, such as our new award-winning Multi-Rail technology platform. This platform is a breakthrough solution that amplifies multiple fiber pairs while cooperating within the physical and electrical constraints of existing infrastructure. Customer engagement on this new platform is very strong, and we see this as one of many growth vectors for our Communications business in both the near and long term. Turning now to our Industrial segment. Revenue grew 2% quarter-over-quarter and 4% year-over-year on a pro forma basis, excluding revenue from the recently divested Aerospace and Defense business. While we maintain a cautious outlook on near-term demand, given the macroeconomic backdrop and ongoing tariff and regulatory uncertainty, we were pleased to see growth in our first fiscal quarter, and we expect the Industrial business to be stable to slightly up sequentially in our current quarter on a pro forma basis. Within our Industrial segment, there are several key growth areas. For example, we expect ongoing strong demand in display capital equipment, driven by OLED screen adoption expanding to larger format devices like tablets and laptops. We also expect growth over the long term in our semiconductor equipment market, given the industry-wide expansion in semiconductor production. Another promising growth opportunity that I'd like to highlight is our advanced materials for thermal management and cooling. Traditionally, these materials are used in a wide range of applications in our industrial markets. However, the rapid expansion of AI data centers has created a significant growth opportunity. We see potential widespread adoption of these materials to address the thermal and power challenges posed by ever larger AI data centers. For example, our proprietary Thermodyne material moves heat twice as effectively as copper, which is a tremendous advantage in data center cooling applications. We're engaged with multiple hyperscaler customers on this new emerging application of our materials technology. Lastly, I'd like to give an update on our portfolio optimization initiative. As a reminder, we are focused on streamlining our portfolio and concentrating our investments in the areas of greatest long-term growth and profitability. We are shifting investment from non-core areas and realigning our footprint to drive better asset composition and utilization efficiency across the organization. We completed the sale of our Aerospace and Defense business at the beginning of September. The proceeds of the sale were used to pay down debt, and the sale is immediately accretive to both gross margin and EPS. In addition, we recently announced the sale of our product division based in Munich, Germany, that makes tools for materials processing and is part of our Industrial segment. We made the decision to sell this product division because it was not aligned to our long-term strategic focus areas, and it did not support our long-term financial goals. This transaction is expected to close in our fiscal Q3. The proceeds of this transaction will be used to reduce debt, and the sale is expected to be immediately accretive to both gross margin and EPS. In addition to streamlining the product portfolio, we are also continuing to streamline our physical footprint. Since the beginning of our last fiscal year, roughly five quarters ago, we have sold or exited 23 sites, and we plan to continue to streamline our footprint and exit additional underutilized or unnecessary sites over the coming quarters. While I'm pleased with the progress we've made streamlining our portfolio, we still have more work to do. I view portfolio optimization as an evergreen process, and we will continue to reevaluate our asset portfolio to streamline and focus on the areas of greatest profit growth and ensure we are optimizing our return on invested capital. In summary, we delivered strong revenue and EPS growth in Q1 and are on track for strong sequential growth over the coming quarters, driven by exceptionally strong demand in our Datacenter and Communication segments, along with continued expansion in our production capacity. I want to thank the Coherent team for all their hard work and dedication. I'll now turn the call over to our CFO, Sherri Luther.
Sherri Luther, CFO
Thank you, Jim. We are pleased with our first quarter 2026 results and execution. We continue to drive strong double-digit year-over-year revenue growth, gross margin improvement, and enhanced profitability. We significantly paid down our debt, reducing our interest expense and further strengthening our balance sheet. At the end of the quarter, we successfully completed our debt refinancing, lowering our cost of capital and improving our financial flexibility. I will now provide a summary of our Q1 results. First quarter revenue was a record $1.58 billion, up 3% sequentially from the fourth quarter and up 17% year-over-year, driven by growth in AI data center and communications demand. In our Q4 25 earnings call, we announced an agreement to sell our Aerospace and Defense business. As expected, this transaction closed in Q1 '26. On a pro forma basis, excluding $33 million of Aerospace and Defense revenue for Q1, revenue increased 6% sequentially and 19% year-over-year. Our Q1 non-GAAP gross margin was 38.7%, a 70 basis point improvement compared to the prior quarter and a 200 basis point improvement as compared to the year-ago quarter. I am especially pleased with the progress we have made on gross margin expansion, driven by the cost reduction and pricing optimization initiatives that we continue to focus on as we drive to our target model of greater than 42%. The sequential and year-over-year increases in gross margin were driven by cost reductions and product input costs as well as yield improvements primarily in our Datacenter and Communications segment. Pricing optimization contributed meaningfully in both the Industrial segment and the Datacenter and Communications segment. First quarter non-GAAP operating expenses were $304 million compared to $307 million in the prior quarter and $278 million in the year-ago quarter. Operating expenses as a percentage of revenue declined to 19.2% as compared to 20.1% in the prior quarter and 20.6% in the year-ago quarter. The reduction in operating expenses as a percentage of revenue is due to the continued focus on driving efficiencies and greater leverage in SG&A. We have made good progress on these initiatives with the benefits expected to kick in at various points in time. The year-over-year increases in R&D were primarily in the Datacenter and Communications segment as we continue to focus on investments with the highest ROI that drive the future growth of the company. The sequential decline in R&D was driven by the timing of these investments, which can fluctuate on a quarterly basis. Our first quarter non-GAAP operating margin was 19.5% compared to 18% in the prior quarter and 16.1% in the year-ago quarter. First quarter non-GAAP earnings per diluted share was $1.16 compared to $1 in the prior quarter and $0.67 in the year-ago quarter. From a capital allocation perspective, we paid down $400 million in debt, significantly reducing our debt leverage ratio to 1.7x, down from 2.4x in the year-ago quarter. As mentioned in our Q4 '25 earnings call, we used the proceeds from the sale of the Aerospace and Defense business to make this debt payment. We also completed the refinancing of our debt at the end of the first quarter, reducing our interest rate by 60 basis points and doubling the amount of our revolving credit facility to $700 million. We will use the revolving credit facility to increase liquidity and provide greater flexibility. As Jim noted, we plan to use the proceeds from the sale of our product division in Munich, Germany to further reduce our interest expense by paying down additional debt, which will be immediately accretive to our gross margin and EPS. For reference, over the past four quarters, this business contributed average quarterly revenue of $25 million with a gross margin well below Coherent's corporate gross margin. The sale will reduce our employee headcount by approximately 425 employees. I will now turn to our guidance for the second quarter of fiscal 2026. We expect revenue to be between $1.56 billion and $1.7 billion. We expect non-GAAP gross margin to be between 38% and 40%. We expect total operating expenses of between $300 million and $320 million on a non-GAAP basis. We expect the tax rate for the quarter to be between 18% and 20% on a non-GAAP basis. We expect EPS of between $1.10 and $1.30 on a non-GAAP basis. In summary, I'm very pleased with the solid progress we made in Q1. Looking ahead, we're seeing exceptionally strong demand in our Datacenter and Communications segment. To meet this robust momentum, we are ramping capacity and investing strategically in the business. We remain focused on disciplined execution against our long-term financial target model. These dynamics reinforce our confidence in driving long-term growth and durable value creation for our shareholders. That concludes my formal comments. Operator, please open the call for Q&A.
Operator, Operator
Our first question comes from Samik Chatterjee with JPMorgan Chase.
Samik Chatterjee, Analyst
Jim, maybe if I can start on the demand side. You do mention the strong demand you're seeing as well as record orders in some cases. Maybe if you can flesh that out a bit more, like how broad-based is this and what are you seeing in terms of or hearing from customers in terms of demand drivers and how broad-based across the portfolio is the demand across your Communications portfolio? And I have a follow-up.
Jim Anderson, CEO
Yes. Thanks, Samik. Yes, I would call it very broad-based. So very strong demand across both Datacenter and Communications. When I look back at our fiscal Q1, we really saw a record level of bookings in that quarter. And bookings not just for near-term quarters, but bookings further out in time than we normally would see. So bookings leading out, in some cases, over a year from now, right? So we see that as a very good sign. That's customers placing orders well ahead of time. That gives us great visibility and allows for really good planning and product mix and capacity planning. But also, as I said, broad-based, definitely saw strong orders for data center, strong orders, in particular, for 800 gig and 1.6T transceivers. We're seeing the adoption of 1.6T transceivers accelerate. And so we're seeing strong orders there. But also on the communications part of our business, very strong orders in DCI, the data center interconnect portion. This is our ZR/ZR+ product lineup of transceivers. And then also really pleased to see strong orders in what I call kind of traditional telecom as well. And so in particular, in that Communications segment, we've seen now five quarters of sequential growth in that segment, really good growth last quarter of 11% sequential and 55% year-over-year, but we've seen now five sequential quarters of growth in not just DCI, but also in traditional telecom. And we're expecting that Communications segment to grow sequentially this quarter and through the balance of this fiscal year.
Samik Chatterjee, Analyst
Got it. Indium phosphide capacity, I mean that's been quite a talking point this quarter for you guys. You outlined you're doubling the capacity over the next 12 months. But maybe if you can just flesh out for investors what are the milestones to watch on that front? And how to think about the roadmap beyond even a 12-month horizon? And where would that leave you from an EML mix perspective in relation to sort of internal versus external?
Jim Anderson, CEO
Sure. Thanks, Samik. So first of all, I just want to thank the Coherent team for the outstanding job they've done in getting six-inch indium phosphide up and running. This is something when I joined the company that I asked the team to significantly accelerate their timeline. And I just want to take the opportunity to thank the team for the outstanding job they've done. We started production of six-inch indium phosphide in the September quarter and started it at our Sherman, Texas facility and really pleased with that ramp. As I mentioned in the prepared remarks, one of the big milestones that we achieved is the initial yields of that six-inch indium phosphide are actually higher than our three-inch indium phosphide lines. And keep in mind that those three-inch lines are very mature full production lines. So that's a very positive milestone and signal for us on yields of six-inch. And that's exactly why we decided to double down on the ramp of six-inch and begin six-inch ramp at a second facility in Jarfalla, Sweden. And so now we're ramping at two sites in parallel. And so that's what really allows us to hit that twofold capacity goal about a year from now. And I think milestones along the way will certainly be shared, but beyond the next 12 months, we expect to continue to expand capacity even beyond that 12-month goal. The demand that we're seeing from our customers is extremely strong. And with some of our big customers, they're now showing their forecast out through calendar 2028. And given that demand signal that we're seeing, not just for next calendar year, but now for '27 and '28, our plan is to continue to ramp indium phosphide capacity beyond the next 12 months as well. And certainly, we'll share more thoughts on the rate and pace of that ramp over the next 12 months.
Samik Chatterjee, Analyst
Got it. I'll just ask one quick question. You’re projecting a 10% quarter-over-quarter growth in datacom. What kind of supply-demand gap do you see? How would that number change if you had more flexibility on supply or more supply available given the current constraints?
Jim Anderson, CEO
Yes. Looking back at the previous quarter, data center growth was about 4% sequentially, which was limited by the supply of indium phosphide lasers. The backlog we had in the first quarter has now carried over into the second quarter, where we are addressing it. Additionally, we achieved record bookings, mainly for 800 gig and 1.6T transceivers, indicating that demand is still increasing. One positive development as we enter the current quarter is the sequential growth in indium phosphide supply, both internally and externally, from the previous quarter. We expect this growth to continue into our fiscal third quarter. We are observing consistent improvements in indium phosphide capacity due to both external and particularly internal capacity expansions.
Operator, Operator
Our next question comes from Simon Leopold with Raymond James.
Simon Leopold, Analyst
I wanted to follow up on your discussion around the OCS, optical circuit switches. There was quite a buzz at the ECOC show about this, and you certainly sounded upbeat tonight. I guess, what I'm looking for a little bit more help is understanding how to think about maybe, let's call it, calendar 2026, where one of your peers also participating in the market has sort of laid out a trajectory to get to $100 million a quarter. How do you think about your trajectory and your place in the OCS market?
Jim Anderson, CEO
Yes, thanks, Simon. We feel very positive about our position in the market, starting with our technology. Our nonmechanical liquid crystal technology offers exceptional reliability, which our customers appreciate. The potential for our OCS market continues to grow larger than we initially anticipated. We’re seeing a wider range of customers interested in the technology and various applications for its deployment. As mentioned earlier, we have shipped systems to seven different customers. Last quarter, both our revenue and backlog increased, and we expect this trend to continue this quarter. However, we anticipate that a more significant revenue contribution will occur next calendar year, likely increasing steadily throughout the year, with a stronger focus on the second half. We are pleased with our progress, the backlog, and the expected revenue growth ahead. As we approach next calendar year, we will provide additional insights into our expected revenue trajectory.
Simon Leopold, Analyst
And then you talked a lot about the progress you've shown on the indium phosphide. I've been fielding investor questions that I find a bit puzzling, but maybe you could help us shake this out in that there's been sort of this narrative that the indium phosphide is producing photodiodes and hasn't helped you with laser production. But your outlook, your commentary on 800 gig, 1.6T certainly suggests that you're producing more lasers, both CW and EML. Can you explain maybe how people might have been confused or whether I'm confused? Can you give us some clarification on this debate?
Jim Anderson, CEO
Yes. Thanks, Simon. I'll try to clarify. I don't know where the confusion is coming from, but I'll just kind of reiterate what I said in the prepared remarks. So as I said, we're ramping production now in two sites, Sherman, Texas, and Jarfalla, Sweden. And across those two sites, we're ramping production of three different types of products based on indium phosphide, right? So the EML lasers, certainly CW lasers as well and then photodiodes. And all three of those are very critical components to our transceivers. I'm really pleased to be ramping production of all three of those devices across those two facilities.
Operator, Operator
Our next question comes from George Notter with Wolfe Research.
George Notter, Analyst
I'm interested in your thoughts on the manufacturing changes and the real estate footprint. It's great to see that. I'm curious about how much more opportunity exists. I know you're increasing capacity in Penang. Are there additional moves you can make in manufacturing, potentially in industrial lasers? Is there still more real estate consolidation planned? Any further information would be appreciated.
Jim Anderson, CEO
Thank you, George. We certainly have a lot going on. It's interesting because we're both increasing capacity and consolidating in certain areas at the same time. Starting with consolidation, over the last five quarters since the beginning of fiscal '25, we've either sold or exited 23 sites, which is a significant achievement, but we still have more to do. Sherri and I are focused on maximizing our return on invested capital while driving efficiency and productivity in our physical footprint. We believe there's substantial opportunity to continue consolidating, and we will keep exiting and downsizing any sites we consider unnecessary or underutilized. So there's definitely more to do there, and I encourage you to stay tuned. On the capacity increase side, especially for Datacenter and Communications, we are actively expanding. We've discussed indium phosphide capacity, and regarding transceiver module capacity, we're enhancing capacity at our primary facility in Malaysia, located in Ipoh. Simultaneously, we're expanding at a new transceiver facility that has already started production. We also plan to add transceiver module capacity at our Vietnam site, which is already operational and producing components for transceivers. We're excited that we have the capability to add transceiver production there. All these capacity expansions are aimed at supporting the strong demand we anticipate for both data centers and communications, reflecting the customer demand and forecasts we are receiving.
George Notter, Analyst
Got it. Any manufacturing moves on the Industrial side of the business?
Jim Anderson, CEO
Yes. There are a number of the consolidations that we've done. The 23 sites of sales exits. Some of those have been on Datacenter and Communications side, but many of those have been on the Industrial side. And so I think we still see opportunity for consolidation on both Datacenter and Comm and Industrial. But there are places within the Industrial segment where we are investing and expanding in facilities as well. But it's all about trying to make sure that the footprint is optimal in terms of driving the maximum productivity and efficiency of the facility.
Operator, Operator
Our next question comes from Blayne Curtis with Jefferies.
Blayne Curtis, Analyst
I wanted to go back to the datacenter guide plus 10%. Is there a way to think about how much that is still capacity constrained? And is there anything beyond EMLs that is constrained in that?
Jim Anderson, CEO
No, Blayne. I would say the main constraint we've encountered, particularly last quarter, was the capacity for indium phosphide, specifically with EMLs. We have seen a significant improvement from the previous quarter to the current one, both in external and internal supply. However, we are still somewhat constrained in the current quarter. That said, we anticipate that the supply of indium phosphide lasers will increase from the current quarter into the next, and we expect continuous improvement in supply throughout the next calendar year, thanks to the external capacity we have secured, along with the internal capacity ramp I mentioned earlier.
Blayne Curtis, Analyst
I'm curious about the timing regarding your plans to double capacity, especially since it takes time to get your lasers in and qualified. Is there a way to think about when this will happen? Also, is there a difference between EMLs and CWs in how revenue from the lasers is recognized across the fleet?
Jim Anderson, CEO
Yes, I would say there isn't a significant difference between EML and CW regarding the timeline for entering production and achieving full qualification. Just to clarify, all of our EMLs and CWs are intended for internal use only. We don’t sell indium phosphide on the open market because our entire capacity is entirely consumed by our own transceiver requirements. I wanted to ensure that was clear. However, within transceivers, once a laser or photodiode is qualified at a facility, increasing capacity on a parallel line or an existing line is quite standard. No special qualification is necessary or at least the qualification process is very simple. Now that we are producing across numerous products and facilities, the production capacity we are expanding over the next year will be extremely valuable. Our customers are also very eager to assist in getting everything qualified for production as quickly as possible.
Operator, Operator
Thank you. The next question comes from Tom O'Malley with Barclays.
Tom O'Malley, Analyst
First one is a little more short term. So you gave the sequential into December on data com up 10%. Could you maybe help us understand what was the driver in the September quarter? I think you called out datacom as maybe being a little bit more of a driver, but any color on the telecom side or the relative vectors of both? And then into the December quarter, what are you seeing from the telecom business?
Jim Anderson, CEO
In the previous quarter for the data center, we experienced a growth of 4% sequentially and 23% year-over-year. For communications, which includes telecom and DCI, we saw an 11% sequential growth and 55% year-over-year. Looking ahead to the December quarter, we anticipate that data center growth will improve from the 4% in the last quarter to around 10% sequential growth this quarter. Conversely, we expect communications to also grow sequentially, but by a slightly smaller margin than the previous quarter, landing in the single digits. Lastly, regarding the industrial segment of our business, we expect it to be stable or possibly increase slightly this quarter.
Tom O'Malley, Analyst
I have a longer-term question regarding the six-inch production. Is there a way to connect the production from that facility to margin improvement? It seems like there is significant acceleration in capacity expansion expected in the first half. Previously, you mentioned that the initial modules would start to be implemented by late 2025. Considering the recent trends in gross margins, it seems logical that there could be an acceleration. Can we correlate the percentage and amount of production to the expected gross margin expansion?
Jim Anderson, CEO
Yes. I can start by discussing this qualitatively and then Sherri can add if she'd like. Since we began production in the previous quarter, this quarter marks our first full quarter of production. We started mid-quarter last time. The effect on gross margin for the current quarter is quite small. However, as we enter the next calendar year, we will begin to see benefits from the six-inch production reflected in our gross margin. As we increase production, the effect on gross margin will become more significant throughout the year, so you can expect to see more meaningful changes in each successive quarter. Sherri, do you have anything to add?
Sherri Luther, CFO
Yes, I'll mention that the six-inch indium phosphide, which costs less than half of the 3-inch version, will positively impact our gross margin over time. This improvement in our cost structure is beneficial, as is the introduction of new products like the 1.6T. Additionally, as we increase our capacity, these factors will further enhance our gross margin moving forward.
Jim Anderson, CEO
We are definitely concentrating on six-inch indium phosphide as a contributor to our gross margin growth. However, there are many other areas within the company that we are also addressing to reach Sherri's gross margin goal of 42%. In the Industrial sector, while growth remains stable, we are not currently experiencing significant growth. We are committed to enhancing gross margin in that sector as well, and we anticipate continued improvement in gross margin for the company overall.
Operator, Operator
Our next question comes from Papa Sylla with Citigroup.
Papa Sylla, Analyst
Congratulations on the impressive results. Jim, could you elaborate on the anticipated increase for the December quarter linked to 1.6 trillion? I understand there’s flexibility among EML, VCSEL, and others, but which of these are you seeing the greatest demand for, both in terms of percentage and qualitatively? Also, do you foresee any changes in 2026?
Jim Anderson, CEO
Yes. Thanks for the question. So, as I mentioned in the prepared remarks, the sequential growth in datacenter, a good chunk of that is driven by 1.6T revenue. And then within that, that early wave or first wave of 1.6T revenue, it's really a combination of silicon photonics, which uses obviously CW lasers, but also EML-based 1.6T transceivers. So the first adoption in that first wave of the ramp of 1.6T will primarily be driven by a mix of silicon photonics and EML. And then later, we'll start to see, we believe, the adoption of VCSEL-based 1.6T transceivers. Those use our 200-gig VCSEL technology, which we demonstrated at, I believe, OFC earlier this year. We would expect that to begin to go into production, I would say, mid-calendar 2026, so it would start to generate revenue in kind of the second half of calendar '26. So definitely, the early ramp or the first part of the ramp is driven by a combination of EML and silicon photonics.
Papa Sylla, Analyst
Got it. That's very clear. And for my follow-up, Jim, I'm curious about how you are thinking about the allocation of your indium phosphide capacity between EML, CW, and photodiode. I guess, how far ahead do you need to make that decision and perhaps what are the factors that go into that decision? Is the priority mainly feeding where demand is strongest? Or is there a profitability angle as well?
Jim Anderson, CEO
Yes, that's a good question. Let me discuss the trade-off between EML and CW. From our perspective, there isn't a significant profitability trade-off between the two. The production mix of EML versus CW is primarily driven by customer demand. If there is a higher demand for silicon photonics-based transceivers, we will allocate more capacity to CW lasers. Conversely, if the demand is more for EML, we will allocate to EML. Generally, we can make these decisions about four to six months in advance, and even as early as four months prior. This timeframe is essential for our capacity planning between EML and CW. The advantage of our indium phosphide capacity is its flexibility; we can adjust the capacity to either EML or CW as needed. Regarding photodiodes, they are simply receivers for the laser signals, and we produce the number of photodiodes required for that purpose. Therefore, it's a straightforward calculation. Ultimately, our capacity planning is guided by the mix our customers require for EML and silicon photonics transceivers, and we are prepared to support them with either option for their applications.
Operator, Operator
The next question comes from Michael Mani with Bank of America.
Michael Mani, Analyst
This is Michael Mani on Vivek Arya. As you look out over the next year, what's your confidence level in your ability to expand your share in 1.6T over 800 gig? And could you also talk about the 1.6T ramp from a customer breadth perspective? Is this a ramp that's very concentrated with a few customers? Or are you seeing more of a balanced ramp into next year?
Jim Anderson, CEO
Thank you, Michael. I will address the second part of your question first. Regarding the 1.6T ramp, we are engaging multiple customers and expect to see several of them ramping up in parallel. Furthermore, many customers are speeding up their adoption of 1.6T, which we view positively. We are proud of our lineup of 1.6T transceivers. Earlier this year, at OFC, we were the only company to showcase 1.6T transceivers utilizing three different technologies: silicon photonics, EML, and VCSEL. Our product range is impressive, our customer positioning is strong, and we are seeing acceleration in 1.6T, making us confident in our position. As for the first part of your question, we believe we are well positioned in the 1.6T space. Looking ahead to calendar 2026, we anticipate continued year-over-year growth for 800 gig, with very strong demand, and we expect the 1.6T ramp to also progress at a healthy rate.
Michael Mani, Analyst
Great. And for my follow-up, I just wanted to ask about your progress on portfolio optimization and specifically pricing. So it seems like there's been a good amount of progress there in the last couple of quarters, but how much left is there in terms of these pricing tailwinds you can recognize, whether it's from the core data communications side or industrial? And maybe more specifically as well, just what are you seeing from a pricing perspective for transceivers? Just if you could talk about that environment.
Jim Anderson, CEO
Maybe I'll answer the last part of the question on transceivers, but I'll let Sherri also comment on pricing as it relates to gross margin. I would say on pricing of transceivers, pricing dynamics are very much as we would expect. So I don't think we're seeing anything unexpected with respect to pricing. Then, of course, in a more supply-constrained market in general, that's certainly always a positive dynamic for pricing. Then, kind of in the first part of your question, just sort of pricing optimization in general and how it relates to gross margin, I'll ask Sherri to answer that part.
Sherri Luther, CFO
From a pricing optimization perspective, I was really pleased to see that during the quarter, part of the improvement in gross margin, the 70 basis points improvement sequentially and a 200 basis points year-over-year, was due to pricing optimization. We saw benefits in the Industrial side of our business as well as in the Datacenter and Communications segments. While we generally expect greater benefits from the Industrial part, we also see positive impacts in Datacenter and Communications. Pricing is about aligning our products with the value they offer. In the Industrial segment, we often are the sole provider of these products, and our customers value what we provide and how it helps them stand out. That was a key factor in the improvement during the quarter. Additionally, we also saw enhancements from cost reductions, particularly in yield, which we have discussed in previous quarters. We continue to prioritize that area, and we experienced benefits in Datacenter and Communications as well as from lower product input costs. These are the two main areas we are focusing on to reach our long-term target of over 42%. I was very pleased with the results we achieved.
Operator, Operator
Our next question comes from Meta Marshall with Morgan Stanley Investment Management.
Meta Marshall, Analyst
I have a couple of questions. Sherri, last quarter you mentioned foreign exchange headwinds affecting gross margins. Given that some currencies have remained strong, I wanted to get your thoughts on whether there were additional headwinds this quarter for gross margins. Also, I noticed that you are increasing ZR capacity. How are you approaching the intersection of this capacity with the demand we are seeing? Will ZR be integrated into that, or how are you ramping up capacity in that area?
Sherri Luther, CFO
Yes. So Meta, on the first part of your question regarding FX and the impact to gross margin, did we have any headwinds during the quarter? So nothing material. Certainly no incremental headwinds in terms of a negative impact from the prior quarter, but nothing significant during the quarter to note on FX.
Meta Marshall, Analyst
On the second part of your question regarding the scale of demand, I would describe this demand as exceptionally strong. This is primarily due to the optical connections between data centers that are handling AI workloads across multiple locations, which is increasing the need for expanded high-speed optical networking between these data centers. Our ZR/ZR+ product portfolio is a perfect fit for this application, and we are experiencing robust demand. We offer 100 gig, 400-gig, and 800-gig ZR/ZR+ transceivers, and we are ramping capacity for these transceivers as quickly as possible. Additionally, we play a role in this market as a module vendor for ZR/ZR+ and also provide components for various DCI equipment and applications. Demand for these components is currently extremely strong, and we are also increasing capacity for all components used in DCI applications and related telecom applications. For example, we are seeing very strong demand for the pump lasers we produce.
Operator, Operator
Our next question comes from Ruben Roy with Stifel.
Ruben Roy, Analyst
Jim, could you elaborate on the OCS updates regarding the shipments to seven different customers? It's encouraging to see this customer diversification. You mentioned engaging in a wider variety of applications. How would you describe the successes you've achieved so far? Are these early applications primarily focused on redundancy and possibly packet switch replacement, as the industry has indicated? Are you noticing an expansion into other applications as well? Additionally, are there technical benefits to using a nonmechanical solution in some of these new applications you are discussing?
Jim Anderson, CEO
Yes, thanks, Ruben. That's a great question. I would say the initial adoption regarding the backlog and early production ramp has been primarily as you've noted, in redundancy and spine switch applications, which align with traditional uses for OCS that we've observed historically. However, looking further ahead, we've been pleasantly surprised by the range of applications emerging as we connect with a wider array of customers. For instance, some are considering using an OCS switch in a scale-up network with optical connections. Conversely, others are discussing the application of OCS switches within DCI networks. The breadth of potential applications customers are exploring has exceeded our expectations. Although these opportunities may be more long-term, we believe it indicates that the total addressable market could be significantly larger than our original estimates.
Ruben Roy, Analyst
Perfect. And a really quick question, I hope, for Sherri. And apologies if I missed this, Sherri, but with the Aerospace and Defense divestiture and the leverage coming down below 2, which is great to see, is there an update on the way you're thinking about debt on the balance sheet or capital allocation?
Sherri Luther, CFO
Yes. I'm very pleased that we were able to reduce our debt leverage down to 1.7x for the quarter after the $400 million debt paydown from the sale of the Aerospace and Defense business. Additionally, we plan to use the proceeds from the sale of the Munich product division to pay off more debt, which is expected to close a bit later. Debt reduction is a priority for us, but our primary focus continues to be investing for long-term growth in the business, particularly in R&D and capital expenditures. While we will keep an eye on debt reduction, it remains a secondary priority.
Paul Silverstein, Senior Vice President of Investor Relations
Operator, we'll take one more question.
Operator, Operator
Our next question comes from Karl Ackerman with BNP Paribas Asset Management.
Karl Ackerman, Analyst
Just one from me. Jim, you spoke of record transceiver module bookings in datacom, but what about transceiver components for telecom? And as you address that, can you quantify the level of order visibility with your customers, maybe in terms of quarters as you and your peers seek to add both later and transceiver capacity and fulfill customer demand.
Jim Anderson, CEO
Thanks, Karl. We definitely experienced record bookings for transceivers. Regarding the components for our communications applications, including DCI and telecom, we saw the same trend with record levels of bookings. There's been significant demand across both data center and communications. In terms of visibility, we are observing the typical near-term bookings, but customers are also placing orders well in advance, sometimes over a year ahead. This is likely due to substantial increases in their demand and supply needs, prompting them to secure their bookings for better supply coverage. Additionally, many of our large customers are providing us with excellent forecast visibility not just for the next year or the year after, but extending out to 2028. This long-term visibility from major customers is extremely beneficial for our business.
Operator, Operator
Ladies and gentlemen, as we have come to the conclusion of the allotted time for today's call, I will now turn the floor back to Coherent's CEO, Mr. Jim Anderson, for closing comments.
Jim Anderson, CEO
Thank you all for joining the call today. I'm pleased to report that we have started our fiscal year on a high note with nearly 20% pro forma revenue growth and over 70% EPS growth in Q1 compared to last year. We anticipate that this fiscal year will be another period of strong growth for the company. I want to express my gratitude to my Coherent teammates for their hard work and dedication. Thank you for your continued support. That wraps up our call.
Operator, Operator
This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.