Good day, everyone, and welcome to the Lumentum Holdings First Quarter Fiscal Year 2023 Earnings Call. All participants will be in a listen-only mode. Please also note that today’s event is being recorded for replay purposes. At this time, I'd like to turn the conference call over to Kathy Ta, Vice President of Investor Relations. Ms. Ta, please go ahead.

Thank you, operator. Welcome to Lumentum's Fiscal First Quarter 2023 Earnings Call. This is Kathy Ta, Lumentum's Vice President of Investor Relations. Joining me today are Alan Lowe, President and Chief Executive Officer; Wajid Ali, Chief Financial Officer; and Chris Coldren, Senior Vice President and Chief Strategy and Corporate Development Officer. Today's call will include forward-looking statements, including statements regarding our expectations regarding our recent acquisition of NeoPhotonics, including market opportunity, expected synergies and financial and operating results and expectations regarding accretion, strategies of the combined company and benefits to customers and the markets in which we operate. The impact of COVID-19 on our business and continuing uncertainty in this regard, macroeconomic trends, trends and expectations for our products and technology, our markets, market opportunity and customers and our expected financial performance, including our guidance as well as statements regarding our future revenues, our financial model and our margin targets. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our current expectations, particularly the risk factors described in our SEC filings. We encourage you to review our most recent filings with the SEC, including the risk factors described in the quarterly report on Form 10-Q to be filed for the quarter ended October 1, 2022, and those in the 10-K for the fiscal year ended July 2, 2022. The forward-looking statements provided during this call are based on Lumentum's reasonable beliefs and expectations as of today. Lumentum undertakes no obligation to update these statements, except as required by applicable law. Please also note, unless otherwise stated, all financial results and projections discussed in this call are non-GAAP. Non-GAAP financials are not to be considered as a substitute for, or superior to, financials prepared in accordance with GAAP. Lumentum's press release with fiscal first quarter 2023 results and accompanying supplemental slides are available on our website at www.lumentum.com under the Investors section. This includes additional details about our non-GAAP financial measures and a reconciliation between our historical GAAP and non-GAAP results. With that, I'll turn the call over to Alan.

Thank you, Kathy, and good morning, everyone. Our first quarter financial and operational performance was excellent, and we achieved a record revenue quarter. I would like to thank our global team for their solid execution, which drove first quarter revenue above the midpoint of our guidance, earnings per share at the high end of our range, and operating margin above guidance. We are well positioned for the long term. The recent closure of two acquisitions further strengthens our Optical Communications business. We now have the photonic industry's most comprehensive product portfolio to serve our networking and cloud data center customers. We continue to see strong fundamental demand drivers for network infrastructure. We are seeing strong demand from our customers who have reported record order backlog levels. Leaders in optical fiber are reporting record shipments of new fiber to handle the unrelenting need for bandwidth. Our products and capabilities are well aligned to telecommunication market inflections now occurring. In fiscal Q1 compared to the same quarter last year, we delivered $136 million of incremental revenue dollars in Telecom, a 79% increase, which includes two months of revenue from our recent acquisitions. Organically, we grew Telecom 38% year-over-year. Over the years, we have built a foundation of customer trust as our differentiated solutions have been proven within network architectures. Also, Lumentum's revenue exposure to infrastructure markets through our communications and commercial lasers product lines has never been stronger. We expect that greater than 85% of company-wide revenue will come from infrastructure markets outside of consumer in fiscal '23. This is due to the share normalization in consumer discussed on previous calls and recent strategic investments. As we are now three months into the integration of our recent acquisitions, I am even more excited about the high quality of the products and the technology expertise that we have added to our global team. We are in an excellent position to capitalize on our strength in Optical Communications, and we are executing upon our strategic plan. We plan to expand our product offerings in Communication Networking with our combined R&D teams, realize synergies and greater benefit of manufacturing scale with an overall higher volume of business, and enter adjacent markets now accessible to us with more tools in our tool belt. These acquisitions position us to accelerate long-term technology trends in advanced networking hardware in adjacent markets and to expand our share in the growing telecom infrastructure market. Since closing these acquisitions, we have even higher confidence in accomplishing our goals. We look forward to sharing more on our progress in the upcoming quarters. Last quarter, we gave a full-year financial outlook to help the investment community model our fiscal '23 business. Since then, there have been several developments in the supply and demand landscapes. In Telecom, IC supply shortages are not improving as quickly as previously anticipated. We now expect these shortages to gate our revenue throughout fiscal '23. In addition, like many others, we are now seeing incrementally lower cloud and consumer end-market demand from our customers. Taken together, these changes result in a new outlook for fiscal '23 revenue, which Wajid will discuss in detail later. Overall demand for our Telecom products remains strong, especially in edge networking applications, which are transitioning to wavelength tunable technologies, higher-speed components and modules and advanced transport products. All of these play into the industry's transition to 400G and above speed networks. Now, let me provide some detail on our first quarter results. Telecom and Datacom revenue was up 67% year-on-year with organic Telecom and Datacom up 33% year-on-year. Our supply chain team continues to work diligently to close the gap on IC chip shortages as we work to fulfill robust demand for our products. We expect the revenue impact of these chip shortages to be approximately $80 million at the end of the second quarter, similar to that of the first quarter. In the first quarter, we achieved record quarterly revenues in three transmission product leadership areas: narrow-linewidth tunable lasers, tunable products for edge networking applications, and coherent components for high-speed coherent modules and line cards. Our narrow-linewidth tunable laser business performed to our expectations in the quarter. I am impressed with the deep bench of talent that we have added to our team with the recent acquisitions. Our R&D teams are very excited about the expansion of our photonic toolkit in leading-edge modules, silicon photonics, high-bandwidth coherent components, ultra-narrow-linewidth external cavity tunable lasers, coherent DSPs, and RF integrated circuits. Regarding DSPs, we are focused on our production tape-out of a 400G capable coherent DSP to enable significant cost reduction in our growing ZR and ZR+ module business. Our tunable products for network edge applications have unique capabilities that help to expand bandwidth in metro access, fiber deep, and wireless 5G fronthaul applications. We are expanding both our front-end wafer fabrication and back-end assembly and test capacity to serve these growing applications. We doubled our Q1 revenue from the same quarter last year, and the next phase of manufacturing expansion in the coming quarters will further increase our capacity by another 80% to 100%. As edge network data rates increase, we are uniquely positioned to serve the growing demand from a diverse set of cable and wireless networking customers. Our 400G and above coherent components also reached a new revenue record in the quarter, with approximately one-third coming from 800G applications. We are very excited about our robust product pipeline of next-generation 800G and above components and modules. In the quarter, ROADM revenue grew 23% sequentially and 34% from the same quarter last year due to continued strong demand, along with better access to critical ICs. Shipments of contentionless MxN ROADMs grew over 50% sequentially as next-generation networks need to increase scalability to handle new fiber deployments. In the quarter, we also closed a significant new opportunity for pump lasers in the area of satellite communications. We continue to lead the industry in transport product innovation. In the quarter, we began shipping the next generation of transport products, including ROADM node-on-a-blade architectures and our next generation of contentionless MxN WSS blades to leading customers, further distancing ourselves from our competitors. In Datacom, we saw a sequential decline in EML revenue from a record fourth quarter. The decline was due to lower demand by a subset of cloud data center customers. We anticipate continued softer demand from hyperscale operators, which has lowered our Datacom revenue outlook for the balance of fiscal '23. We continue to drive the next phase of the Datacom industry road map with our 200G per lane EMLs for 1.6 terabit per second applications. We expect these to enter production as we exit fiscal '23, and we are engaged with multiple customers in design-in activities for these leading-edge chips. In addition, we are excited about enabling the transition from copper to optical fiber and data center applications with our 100 gig per lane VCSELs. We expect to ramp this product line during fiscal '24. Turning to Industrial & Consumer, Q1 was up from Q4 due to the new smartphone product launch. As expected, share normalization caused our Q1 3D sensing revenue to be approximately half of last year's level. We are optimistic about our 3D sensing business as applications in automotive and industrial markets begin to ramp. Underscoring this, in the first quarter, we recognized approximately $4 million in revenue from automotive and IoT applications, and we expect this to grow significantly in the coming years. In the first quarter, Commercial Lasers revenue was up 4% sequentially and 26% from the same quarter last year. Fiber Lasers serving industrial applications grew 25% from the same quarter last year. We have a growing set of applications with the introduction of new laser products, which is generating new customers for us, such as in solar cell and EV battery processing. Looking ahead to the second quarter, we expect laser revenue to grow again quarter-on-quarter. I'd like to take a moment to share the significant progress we have made toward achieving our corporate social responsibility goals toward a low-carbon future. In September, we published our second CSR report, which outlines the excellent progress our team has made in ESG initiatives. Our company-wide use of renewable electricity has expanded from 3% to 31%, and we are poised to increase this percentage again this year. We have extended our award-winning diversity, inclusion, and belonging program to include training at all of our global sites. We've established new employee resource groups for career development mentorship and employee retention. We look forward to realizing the measurable benefits of this year's initiatives in fiscal '23 and beyond. I'm very excited about Lumentum's strategy, our competitive position, and our unique opportunities to grow in advanced communication and networking technologies, edge and cloud computing, Industrial 4.0, and machine vision markets. To capitalize on these trends in the communication, consumer, and industrial end markets and consistent with our prior earnings call, we are increasing R&D investments during fiscal '23, which we believe will accelerate top-line growth in fiscal '24 and beyond. Lumentum is extremely well positioned to win in the current environment, execute our strategy to invest in our product portfolio, grow in existing and adjacent markets, and expand profitability over the long term. I would like to thank our employees around the world for all of their hard work and resilience that has put us in such a great position today. With that, I'll turn it over to Wajid.

Thank you, Alan. Net revenue for the first quarter was $506.8 million, which exceeded the midpoint of our guidance range and was a record in quarterly revenue. Net revenue was up 20.1% sequentially and up 13% year-on-year. GAAP gross margin for the first quarter was 39.7%, GAAP operating margin was 2.7%, and GAAP diluted net income per share was a net loss of $0.01. First quarter non-GAAP gross margin was 48.2%, which was down sequentially and year-on-year, primarily driven by product mix, including NeoPhotonics revenue as expected. During the quarter, we incurred $7.3 million in extraordinary charges to acquire IC components from various brokers to satisfy customer demand. These incremental charges were excluded from the non-GAAP gross margin as disclosed in our filings. First quarter non-GAAP operating margin was 27.1%, which decreased sequentially and year-on-year due to product mix, including NeoPhotonics and our DSP investment with the IPG Telecom acquisition and was above the high end of our guidance range. First quarter non-GAAP operating income was $137.4 million, and adjusted EBITDA was $161.9 million. First quarter non-GAAP operating expenses totaled $106.7 million or 21.1% of revenue. SG&A expense was $45.9 million. R&D expense was $60.8 million. Interest and other income was a net income of $2 million on a non-GAAP basis. First quarter non-GAAP net income was $119.2 million and non-GAAP diluted net income per share was $1.69, which was at the high end of our guidance range provided on our last call. Our fully diluted share count for the first quarter was 70.6 million shares on a non-GAAP basis. Our non-GAAP tax rate remains at 14.5%. Moving to the balance sheet. We ended the quarter with $1.625 billion in cash and short-term investments. During the quarter, we repurchased 300,000 of our shares for $25.7 million. As of the end of the first quarter, we have purchased a total of 9.4 million Lumentum shares for $815.5 million over the last six quarters, reflecting our confidence in long-term growth. Turning to segment details. First quarter Optical Communications segment revenue at $453.4 million increased 22.2% sequentially due to robust demand in our Telecom business and the addition of NeoPhotonics revenue. Optical Communications segment gross margin at 47.6% decreased sequentially and year-on-year, primarily due to product mix and NeoPhotonics. Our first quarter Laser Segment revenue at $53.4 million was up 4.3% sequentially and up 25.9% year-on-year. First quarter Lasers gross margin of 52.6% was sequentially down, but up year-on-year. Before we turn to our guidance, I would like to add some color to what Alan said regarding our outlook for fiscal '23. We continue to experience IC supply shortages which are not improving as quickly as previously anticipated and are now expected to gate our revenue throughout fiscal '23. In addition, like many others, we now expect lower cloud and consumer end-market-driven demand from our customers. Based on these factors, our new revenue outlook is $1.9 billion to $2.05 billion. At the midpoint, this is a reduction of approximately 9% from our August outlook, and still represents greater than 15% growth from fiscal '22. Our fiscal '23 operating margin outlook is in the range of 19% to 22%, and annual EPS is in the range of $4.65 to $5.65 per share. The delay in the improvement of the supply of a small number of ICs is the largest factor within our lower fiscal '23 outlook. Within this outlook, we are reducing spending in discretionary areas while increasing our R&D investments and growth initiatives, both in existing markets and new markets. As we execute on acquisition synergies and work down shortages in IC supply, and we begin to realize the benefits from the accelerated R&D investments, we expect to return to our target financial model of 50% gross margin and 30% operating margin in the longer term. Now, let me move to our guidance for the second quarter of fiscal '23, which is on a non-GAAP basis and is based on our assumptions as of today. We expect net revenue for the second quarter of fiscal '23 to be in the range of $490 million to $520 million. Our Q2 guidance incorporates approximately $80 million of impact to revenue driven by shortages of third-party components. Based on this, we project second quarter operating margin to be in the range of 20% to 22%, and diluted net income per share to be in the range of $1.20 to $1.45 per share. Our non-GAAP EPS guidance for the second quarter is based on a non-GAAP annual effective tax rate of 14.5%. These projections assume an approximate share count of 70.2 million shares. Given continued IC supply constraints, 3D sensing seasonality, and the lower hyperscale data center spending embedded in our outlook, we now expect Q3 revenue to be down a high single-digit percentage from Q2, followed by a stronger Q4. With that, I'll turn the call back to Kathy to start the Q&A session.

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

Our first question comes from Samik Chatterjee of JP Morgan.

Yes. Hi. Thank you. Thanks for taking my questions. I guess for the first one, if you can delve into the full year guide a bit more. You're guiding down the full year by about $200 million. The fiscal second quarter though, when I look at and compared to consensus, I think the shortfall was about only $35 million, so it does imply the headwinds sort of become greater relative to sort of at least what consensus was thinking in F 3Q and 4Q. So I'm just wondering if you can maybe share some insights on that as well as break down the sort of $200 million into how much of that is supply versus the lower cloud demand as well as the lower 3D sensing demand that you highlighted, if you can break down the pieces for us? And how do we think about sort of the risk to sort of further cuts on lower demand. That's one question I'm getting as well. And sorry for the long question here. I have a quick follow-up after this.

Great Thanks, Samik. So, I think you can look at it a couple of ways. As Wajid said in the prepared remarks, the biggest impact of the reduction is our expectation that the chip shortage will continue through the year and into the beginning of fiscal '24. So, that's the biggest part of the reduction in the full-year guide. I'd say that the combination of the hyperscale customers or subset of customers and 3D sensing is probably about the same impact. But keep in mind, we still have a $150 million range of outlook. So, there's certainly a lot of uncertainty as to shifts in that business and how we look at potential upside and potential impact. To your point, there's no crystal ball in our future to know what's going to happen in the economy, and that's why we still have a wide range given that we only have the second half guide. So certainly some uncertainty there. But I think we're very, very confident in the outlook for Telecom as the demand is extremely strong and our Commercial Lasers business continues to grow as we enter new markets and gain share there. So, I'd say those are kind of the moving pieces as we look at the full-year guide.

I'm hearing a lot of questions about the supply situation, and I want to clarify that based on reports from various companies, we are not seeing a worsening of supply shortages. In fact, the situation seems to be aligning with or improving compared to previous quarters. This has caught some investors off guard, especially considering the challenges implied in your full-year guidance for the second half. Can you provide insights on your current view of the supply chain? What factors might lead to better-than-expected outcomes, and what supply challenges are you anticipating for the third and fourth quarters?

Yes. I mean, certainly, supply is getting better, as you saw from our telecom growth in Q1 and our forecasted telecom growth in Q2. So situation is getting better, but it's not catching up with the growth in demand. As we talked about at the end of Q2, our shortages are expected to be $80 million plus or minus some. And that's the same as when we exited Q1. So, we're growing Telecom pretty strongly. At the same time, the demand is growing just as strong as our output. So, we're not catching up with that demand given supply chain shortages. And it is fewer suppliers and fewer components that we're chasing. But at the same time, those few components are needed to ship product. And so, I'd say that we're still constrained by a handful of suppliers with a couple of handfuls of parts that are restricting our ability to meet this very, very strong telecom demand.

Our next question comes from Simon Leopold of Raymond James.

My question may be a bit nuanced. So I apologize if it’s not clear. But I guess one of the things I'm struggling with is on the softer cloud demand you've called out. It's been my impression that some of the cloud operators are trying to rebalance inventory basically trying to get everything in line with what they have plenty of versus what they don't have enough of. And that, to me, sounds different than softer demand you described. And if I'm splitting hairs, tell me so. But I'm just trying to understand it. And if it's not softer demand, maybe you could help us understand what specific chips you're short of. Thank you.

When we discussed the softness in hyperscale, I want to clarify that it only affects a portion of the market, and not all players are experiencing it. I believe this situation arises from a need to rebalance inventory. They were previously placing a high demand for EML chips in data centers, resulting in a build-up of stock. While they are currently adjusting their supply, this rebalancing is contributing to a decrease in demand for us. However, as they reduce their inventory, we anticipate that our demand will increase. We also recognize that there is still inventory of these chips with their suppliers, and we expect them to work through it over the next couple of quarters. Therefore, as we approach the end of the fiscal year and move into fiscal '24, we anticipate that demand will rebound. Does that address your question?

I appreciate that. Can you break down what NeoPhotonics contributed to the quarter? Specifically, were the ZR related products, including both lasers and transceivers, disproportionately affected?

Yes. Hey Simon, this is Chris. Moving forward, we're one company, and we've already begun implementing synergies. Therefore, we won't be separating Neo from Lumentum revenues. Mentioning Neo within the company could cause issues, so we're unified going forward. That said, our product lines like ZR continue to grow, although it's still in the very early stages. As Alan mentioned, we view the current situation more as an inventory correction affecting more mature product lines that we've been shipping for quite some time.

Our next question comes from Meta Marshall of Morgan Stanley. Please go ahead.

Great. My first question is to clarify whether the IC shortages affecting your ability to deliver are strictly related to your supply chain, rather than any shortages your customers might be experiencing that could be impacting their demand. I'm trying to ensure that it's your supply chain at play and not the customers. Additionally, I have a second question regarding the process of cross-selling NeoPhotonics and Lumentum products to customers. How is the communication going for promoting the joint portfolio that customers can purchase?

Sure, Meta. So, when we talk about the supply chain shortages, that's the impact on our ability to supply to our customers. Certainly, our customers are having challenges as well as the whole industry having challenges getting what they need to supply. But when we talk about the $80 million at the end of Q2 and $80 million at the end of Q1, that's demand, we were unable to satisfy to our customers in the quarter. As far as cross-selling, having the broad portfolio that we have now, we will see the benefit of that when we're able to go to a customer with our broad portfolio. I think that just takes time as we go and say qualification does take quarters and so we should expect to see some of that in the back half of the year. But certainly, our customers are very happy with the acquisitions we've made and are excited about the future product portfolio and the 800 gig and above product and component technology that we bring to the market.

Our next question comes from George Notter of Jefferies.

I guess I was curious about your plan to increase R&D investment. I guess I was wondering what areas of the business you're looking to grow R&D in. And then also, I guess, specifically on that, I wanted to ask about the IPG Photonics division that you guys acquired. I know the plan was to invest in that DSP development program. I think at one point, you guys said $20 million to $25 million in R&D investment there. I'm just wondering if that's still the right number to think about.

Sure. Thanks, George. So, I'd say the R&D increase is in a couple of areas, one of which is continuing to have the best products that are differentiated in our core business. And so, that's the ongoing growth in R&D that we expect. I'd say that we're also investing in R&D for new markets, and as we look at the markets that are emerging that could capitalize on our technology and photonics in general, we're doing product development and technology development to be able to enter those markets. And then, to your point, we are increasing our R&D with the acquisition of IPG Telecom transmission product line, specifically in the DSP area where we have a very, very talented team that had been working on 400 gig ZR DSP. And as I said in the prepared remarks, our focus now is to complete the production tape-out of that 400 gig ZR, ZR+ DSP and really drive cost efficiencies as we have been full vertical integration for our ZR and ZR+ componentry that should give us the best-in-class cost for the market. So that's continuing. We're excited about the progress. The team is great. We're growing that team and we continue to make those investments. As far as the $25 million, yes, I'd say that's in the ballpark of what we're looking at to complete that. But then we're going to continue to invest in DSP technology with next-generation DSPs that we're developing in our roadmap.

Our next question comes from Blake Friedman of Bank of America.

Hi. Thank you. This is Blake Friedman on for Vivek. Just a quick one on gross margins, looking at the guide. I know you mentioned you have to realize synergies in the NeoPhotonics acquisition, but there's some mix issues. So, as we kind of progress forward, I was hoping you can kind of provide maybe any high-level commentary on the trajectory of gross margins, specifically in the back half of the year as well with revenue projected to decline half-over-half? Thanks.

Yes. So, I'll start off on answering this, and Alan and Chris can jump in if they'd like. So yes, so quarter-on-quarter, moving into Q2, we're seeing negative seasonality on our 3D sensing business, quite certainly that's dropping greater than 25% going into Q2 versus Q1. And so, given that that's a chip business, that certainly has an impact on our gross margins. Alan already talked about some of the challenges that we're seeing with our cloud customers or a subset of our cloud customers. And that business is also a chip business. And so, that's having a negative impact on our gross margins as well as we move through fiscal Q3 and Q4. With the overall lower revenue levels, we'll also see some negative manufacturing overhead absorption throughout our fiscal year. Now offsetting that, we are doing very well with our synergies that we had communicated out to all of you as part of the acquisition, both on the operating expense side as well as on some of the consolidation from a facility standpoint as well. The facilities consolidation takes outside of the fiscal year. And so, we'll see most of that benefit in fiscal '24. But for operating expenses, we're already starting to see some of that benefit in the first half of this fiscal year, and we'll certainly see more of that, and it's embedded within the outlook that we've provided for Q3 and Q4 of our fiscal.

Helpful. Thank you. And then just kind of a quick follow-up on the 3D sensing side just because we've heard some of smartphone vendors kind of also exposed to your largest customer in that area have some relatively resilient results. I just wanted to confirm that the lower outlook is more related to like a unit issue and less of higher-than-anticipated share loss.

Yes. Hi, Blake. This is Chris. Our 3D sensing outlook reflects our current expectations. As a reminder, we anticipate a significant year-over-year change due to the high share of that business we had in previous years. The main reason for this year's change is share normalization, and we see this as a transition year. We plan to build on that normalized business moving forward. However, in the short term, there are other factors affecting our assumptions, such as global manufacturing and supply chain disruptions and the ecosystem we are part of, as well as our overall expectations regarding demand. These factors have led to some adjustments in our updated outlook.

Our next question comes from Alex Henderson of Needham.

So last quarter, you had Datacom sold out, up 17% quarter-to-quarter and you were adding significant amount of capacity in the headlights. And now you're telling us that your Datacom products are anticipating much weaker demand and guiding down in it. So I guess there's a couple of related questions related to that. One is are we sure that this is simply a function of inventory? Or is there a shift in the type of Datacom products that the hyperscalers are using as a result of shifting to AI, and is there a pricing pressure in it or any other variable? And are you changing your production timing targets or anything of that sort to bring the time of new capacity coming on more in line with this lower demand?

Thanks, Alex. So, I would say, as we said in the prepared remarks, this is a subset of our hyperscale customers burning off inventory and of existing chips. We're not changing our production targets and our production investments given that it takes 18 to 24 months to have an impact on our ability to grow our wafer fab business. So, those investments that we've made over the last couple of years are coming online. And I'd say they're right on track with aligning with that next generation of products for us, which is the 200 gig per lane EMLs as well as the 100-gig per lane DMLs. And so, we need that capacity as we expect continued growth as we look at fiscal '24 and beyond. So, I'm not disappointed with our innovation engine in Datacom. I think it's exciting, and our customers are telling us it's exciting. I'd say more of a six-month air pocket with respect to a subset of hyperscalers that are burning off inventory and lowering the demand on us. So, I think we're still excited about the business. And we think the long-term Datacom business for EMLs, DML, silicon, photonics, all that we have access to in our broad portfolio make us confident that that's a long-term growth business for us.

Just to clarify, there hasn’t been any change in the competitive landscape or a decline in pricing, correct? Additionally, regarding 3D sensing, your market share has significantly decreased. Where do we stand now? Are you just dividing the market with your main competitor, or are there still risks of further loss in market share? These declines are quite steep. Also, is there any update on pricing for 3D sensing? You mentioned a disruption in demand, but not pricing. Is pricing under additional pressure? Thank you.

I'll address the competitive situation in Datacom and ask Chris to handle the question about 3D sensing. In all our markets, there is competition and pricing pressure. The consolidation in the industry over the last decade has created a different dynamic than what we’ve seen before. As we enter the second or third year of a product, some competitors begin to catch up, leading to competitive pricing dynamics in the Datacom business. However, this has not significantly affected our outlook for fiscal '23 as much as the overall decline in demand and the reduction of inventory at some of our hyperscalers. Looking ahead, pricing for 200 gig and above EMLs will feature a highly competitive product that will be economically attractive for our customers, as their costs will decrease at 1.6 terabits compared to their current situation. So, from that angle, we anticipate a reset in pricing, and we are excited about our advancements in this area. Chris, would you like to address the 3D sensing question?

Sure, good morning Alex. I can't discuss specific share numbers, but it's a fair assumption that the situation is more balanced now than it has been in the past. Prices tend to decrease year-over-year, and considering last year, many new chips were introduced. Generally, the most significant price drops occur in the second year following the launch of a new chipset. Currently, there's nothing unusual regarding pricing. Regarding the comments about demand and disruptions related to the earlier question, we were focusing on the recent changes in our outlook for this quarter compared to last quarter, in relation to our revenue, which we noted would decrease by 40% to 50%. We are now at the higher end of that estimate due to recent changes in demand. I hope this clarifies your question.

Our next question comes from Tom O'Malley of Barclays.

I wanted to explore the fiscal year guidance a bit more. You're adjusting the revenue expectation to a high single-digit decline, but the operating margin is also being reduced by nearly 20%. Can you explain the reasons behind this? It seems there's a stronger emphasis on the Telecom segment. First, you previously expected the telecom business to grow more than 20%. Is that still the case? Secondly, considering the new business mix with the addition of Neo, you mentioned a goal of returning to a 50% gross margin model in the long term. Given the shifts in the Datacom business and Neo's impact, is it realistic to expect to achieve that margin structure again with this new mix? Thank you.

Yes, I'll begin and then Alan and Chris can chime in. We are still experiencing growth in our telecom business, and the figure you mentioned of over 20% remains valid. The addition of our NeoPhotonics business is enhancing our product mix, which we previously discussed in our August conference call. However, as we observe a decline in demand for some chip-based businesses, particularly in 3D sensing and Datacom, this is negatively affecting our overall operating margins compared to the growth we see in Telecom due to the product mix. Additionally, the reduction in manufacturing overhead within our Datacom business for Q3 and Q4 is putting further pressure on operating margins. As we noted in our prepared remarks, we are continuing to invest in R&D and will not be scaling back in response to what we consider temporary demand shortfalls. This is why our operating margin outlook is now set at 19% to 22%, which is lower than our projection in August. Looking at our long-term goals, we are still investing in our Datacom business, and as Alan mentioned, it takes 18 to 24 months to increase capacity in this area. We maintain our belief in the secular growth of this part of our business and are also investing in automotive and IoT, both of which are chip-based sectors. Once these segments rebound, we expect to see improvements in our overall operating margin profile. Regarding synergies, which I mentioned earlier, the consolidation of facilities in NeoPhotonics will take longer than 12 months to materialize. As we see that progress, it will provide us with additional support. This confidence in these factors is why we have not changed our overall target model.

I'm looking for more clarity on the Datacom side of the business. Alan mentioned areas of weakness, which suggests it's specific customers rather than a widespread issue. Can you share when during the quarter you started noticing that weakness? Some of your competitors are predicting continued strength in the data center sector, while others have discussed inventory, but this is the first indication we've heard about a potential decline in demand. Could you clarify when that change occurred? Transitioning from being capacity constrained to experiencing sequential declines is a significant shift. Thank you.

I don't know the exact date when our customer informed us about their inventory, but it's difficult to say whether our infrastructure investments have changed since three months ago. One of the analysts referred to it as inventory balancing, and I would agree that it's more of an inventory adjustment rather than anything more significant because we have received large orders. A year ago, our book-to-bill ratio for Datacom was substantial, and as we increased capacity, we could meet that demand. It seems our customer might not have expected us to be able to fulfill it. As we met that demand, the inventory surfaced, and they revised their future demand for this product. Therefore, I don't think this indicates a fundamental change in overall demand; it's more of an inventory correction among a specific group of our customers. Overall, I believe our long-term Datacom business will remain very strong.

Our next question comes from Christopher Rolland of Susquehanna.

This is Matt Meyers on for Chris. I wanted to ask on your broker IC purchases. I was just kind of curious what the ASP premium is purchasing from brokers versus directly from customers. And was this for FPGAs? And then, as a follow-up there, when do you think you no longer need to be buying these products through brokers?

Yes, it really varies, and it also depends on the products. We see anything from 2x to 100x the average selling price for a given component. If it goes into a lower average selling price product for us and the broker is asking for 100 times the price, we typically decline because it doesn't make sense. I would say it's not as common in FPGAs as it once was. This improvement is more in the analog components, power integrated circuits, and typical items for which we see a need to pay brokers. However, while we see this situation improving, we don’t expect it to be fully resolved in the next six months, which is why we have included it in our outlook for fiscal '23.

Our next question comes from Ananda Baruah of Loop Capital.

Yes. Two quick ones for me, if I could. On the operating margin fiscal year outlook reduction, proportionately how much of it is some gross margin, and how much of it is from incremental OpEx? And then I have a quick follow-up to that. Thanks.

Our perspective on operating expenses remains consistent. We will continue to increase our R&D investment each quarter, and our operating expenses for fiscal Q2 are expected to be higher, likely in the high single digits compared to Q1. The decline we are observing is primarily related to gross margin due to product mix issues that we've previously discussed, including 3D sensing, Datacom, and lower factory utilization in the latter part of the fiscal year. This is how we expect the P&L to develop over the coming quarters.

So just to add to Wajid's comment about operating expenses in Q2. Yes, we have one extra month of the NeoPhotonics and IPG acquisition in Q2, whereas we only had two months in Q1. So that's one of the key drivers for why OpEx is going to be up in Q2.

And just a quick follow-up, Wajid, you started to touch on it, is regarding the gross margin. Proportionately, how much is related to the product mix and how much is due to revenue leverage or changes in utilization in the fiscal year?

Yes. So just very high level, probably a little bit more than 50% is product mix and then the remaining is factory utilization. Probably most of it is product mix.

Thank you. Our next question comes from Michael Genovese of Rosenblatt Securities. Michael, please go ahead.

Great. I'll just ask two questions in one. Thanks for getting me in here. I just want to ask very directly, is there any change in the telecom outlook in terms of demand? I mean, this sounds like it reads well for telecom demand to me, but are you seeing any change with the change in the revenue guide? And then in terms of solving this supply problem, it seems like it's going to line up at the beginning of fiscal '24, sort of mid-calendar '23 is the current expectation. And I'm wondering, is that because the analog vendors will be adding new fabs or new lines of this like older stuff, like A-to-D converters and power supplies and things like that that you guys need, and that's what's going to solve the problem, and that's why that timing is. Thank you.

Yes. Thanks, Michael. You're correct that the demand for Telecom remains very robust. I'm still receiving numerous calls from executives and clients, indicating that this demand is genuine and not just a buildup of inventory. Therefore, I believe the outlook and key factors driving demand in Telecom are strong. I would say we continue to have a solid lineup of products in this area. Regarding the supply chain issue, I would describe it as a mixture of our expectations that suppliers are working on increasing and freeing up capacity for us, especially as they notice some easing in other parts of their business. This transition takes time as they start new wafers or expand capacity. These investments began over a year ago and are expected to come online in calendar '23. This explains why we anticipate ongoing impacts for the remainder of our fiscal year. Additionally, we have to consider production cycle times. We need the chips by April to influence our shipments in June. This timeline informs our expectations and supports our belief that we will continue to face challenges, particularly as demand is anticipated to keep rising.

Our final question comes from Dave Kang of B. Riley.

My first question is regarding the expedite fees, I think it was about $7 million first quarter. What was it previous quarter? And how much are you baking in the current quarter, December quarter? And my second question is for 3DS projections that you provided at OFC being flat, do you need to update that for us?

Yes. The IC charges were $7.3 million this quarter, which was significantly higher in the previous quarter. You can refer to our filings for more details on that. As we move into fiscal Q2, we are depleting some of the inventory purchased in Q1. We'll provide an update on this at the end of the next quarter since it's excluded from our non-GAAP operating guidance. It won’t affect that, but it will be included as a reconciling item in our results. Chris?

Yes, certainly. Regarding 3D sensing, we discussed a projected compound annual growth rate ranging from minus 5% to plus 5% over three years. This translates to an expected decline or increase of a little over 15% in that timeframe, based on anticipated revenues of $400 million to $450 million for the 3D sensing segment. We're observing that the market share normalization is occurring potentially quicker than we had anticipated. The trend seems to follow a deeper V or U shape. Nonetheless, we still regard this as a robust growth area and believe we can enhance the business, which has now stabilized in terms of market share, particularly by expanding our customer base and exploring new applications. Therefore, we are not retracting those figures at this moment, and we see the potential to generate additional revenue to reach that target range.

Thank you so much, Dave. And I think that was our last question. So, I'd like to pass the call back over to Alan for some concluding remarks.

Thank you, Kathy. I'd like to leave you with a few thoughts as we wrap up the call. I am very excited about the tremendous opportunities ahead of us as we serve the exponential requirements for data bandwidth in the AI, 5G, and cloud computing market inflections. We have a proven playbook on how to win with our best-in-class products and technologies. We also have a unique opportunity to drive manufacturing scale in the photonic industry, and we are committed to strongly invest in both innovation and manufacturing capacity and capability to deliver on customer needs today and in the future. With that, I would like to thank everyone for attending, and we look forward to talking with you again during upcoming investor events, which you will find posted on our website. Thank you.

This concludes today's call. Thank you for joining. You may now disconnect your lines.